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An objective risk management approach to efficient portfolio asset allocation decisions.
Modern portfolio theory, credited to Markowitz [1952, 1959], has become an important tool for the development of investment portfolios. The technique derives its power from defining the relationship between expectations of return and the corresponding portfolio volatility. Diversification is shown to reduce overall portfolio volatility, and the concept of meanvariance optimization can be used to develop the frontier of "efficient portfolios."
For a given set of assets, the efficient frontier represents the family of portfolio asset allocations that will produce the minimum volatility for a given expected, or average, return. The efficient frontier exhibits the classic risk-reward relationship in that higher portfolio return expectations are typically associated with higher portfolio volatility and, by inference, increased investment risk. What is not clear, however, is how to decide between a low-return, low-volatility efficient portfolio and a high-return, high-volatility efficient portfolio.
The problem in efficient portfolio asset allocation selection, then, becomes one of how to choose the specific efficient portfolio that is the optimum to achieve a particular long-term investment goal.
PORTFOLIO SELECTION BASED ON RISK MANAGEMENT
Risk management is the process of...