What Is a Portfolio?

A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and cash
equivalents, including closed-end funds and exchange traded funds (ETFs). People generally believe
that stocks, bonds, and cash comprise the core of a portfolio. Though this is often the case, it does
not need to be the rule. A portfolio may contain a wide range of assets including real estate, art, and
private investments.

KEY TAKEAWAYS

 A portfolio is a collection of financial investments like stocks, bonds, commodities, cash, and
cash equivalents, as well as their fund counterparts.
 Stocks and bonds are generally considered a portfolio's core building blocks, though you may
grow a portfolio with many different types of assets—including real estate, gold, paintings,
and other art collectibles.
 Diversification is a key concept in portfolio management.
 A person's tolerance for risk, investment objectives, and time horizon are all critical factors
when assembling and adjusting an investment portfolio.

Types of Portfolios
There can be as many different types of portfolios and portfolio strategies as
there are investors and money managers. You also may choose to have
multiple portfolios, whose contents could reflect a different strategy or
investment scenario, structured for a different need.

A Hybrid Portfolio
The hybrid portfolio approach diversifies across asset classes. Building a hybrid portfolio requires
taking positions in stocks as well as bonds, commodities, real estate, and even art. Generally, a
hybrid portfolio entails relatively fixed proportions of stocks, bonds, and alternative investments.
This is beneficial, because historically, stocks, bonds, and alternatives have exhibited less than
perfect correlations with one another.

An Aggressive, Equities-Focused Portfolio

The underlying assets in an aggressive portfolio generally would assume great risks in search of great
returns. Aggressive investors seek out companies that are in the early stages of their growth and
have a unique value proposition..

A Defensive, Equities-Focused Portfolio

A portfolio that is defensive would tend to focus on consumer staples that are impervious to
downturns. Defensive stocks do well in bad times as well as good times. No matter how bad the
economy is at a given time, companies that make products that are essential to everyday life will
survive.

An Income-Focused, Equities Portfolio

This type of portfolio makes money from dividend-paying stocks or other types of distributions to
stakeholders. Some of the stocks in the income portfolio could also fit in the defensive portfolio, but
here they are selected primarily for their high yields. An income portfolio should generate positive
cash flow. Real estate investment trusts (REITs) are examples of income-producing investments.
Measurement of Portfolio risk and return
We have learned about how to calculate the returns on single assets. However, portfolio managers
will have many assets in their portfolios in different proportions. The portfolio manager will have to
therefore calculate the returns on the entire portfolio of assets. The returns on the portfolio are
calculated as the weighted average of the returns on all the assets held in the portfolio.

Let’s say the returns from the two assets in the portfolio are R1 and R2. Also, assume the weights of
the two assets in the portfolio are w1 and w2. Note that the sum of the weights of the assets in the
portfolio should be 1. The returns from the portfolio will simply be the weighted average of the
returns from the two assets, as shown below:

RP = w1R1 + w2R2

The formula for portfolio returns is presented below:

 Let’s take a simple example. You invested $60,000 in asset 1 that produced 20% returns and

$40,000 in asset 2 that produced 12% returns. The weights of the two assets are 60% and 40%

respectively.

The portfolio returns will be:

RP = 0.60*20% + 0.40*12% = 16.8%

 For example, if an asset constitutes 25% of the portfolio, its weight will be 0.25. Note that sum

of all the asset weights will be equal to 1, as it will represent 100% of the investment. The

returns here are single period returns with same periods for each asset’s returns.

Let’s take an example of a two asset portfolio to understand how portfolio returns are calculated.

Let’s say that our portfolio comprises of two assets A and B and has the following details.
The table presents the amount invested in each asset and the returns from each asset. The total

amount invested is $100,000. We can calculate the weights for each asset as follows:

wA = 25000/100000 = 0.25

wB = 75000/100000 = 0.75

We can now calculate the portfolio returns as follows:

The same calculation can be extended for multiple assets.

Risk calculation of a Portfolio

Let’s now look at how to calculate the risk of the portfolio. The risk of a portfolio is measured using

the standard deviation of the portfolio. However, the standard deviation of the portfolio will not be

simply the weighted average of the standard deviation of the two assets. We also need to consider

the covariance/correlation between the assets. The covariance reflects the co-movement of the

returns of the two assets. Unless the two assets are perfectly correlated, the covariance will have

the impact of reduction in the overall risk of the portfolio.

The portfolio standard deviation can be calculated as follows:

let’s say the standard deviation of the two assets are 10 and 16, weightage of two asset 60% , 40%

and the correlation between the two assets is -1. The standard deviation of the portfolio will be

calculated as follows:

σP = Sqrt(0.6^2*10^2 + 0.4^2*16^2 + 2*(-1)*0.6*0.4*10*16) = 0.4

Correlation and Covariance

As you can see, the standard deviation can be calculated using either covariance
or correlation. The relationship between the two is depicted below:

As the number of assets in the portfolio increase, the complexity will increase as
we will have to consider the covariance between each pair of the assets in the
portfolio. For a three-asset portfolio, the risk and return will be calculated as
follows:
Problem:
Given the following example, find out the expected risk of the
portfolio.

Efficient Frontier and selection of Optimum Portfolio (Markowitz Portfolio

theory)
The efficient frontier is the set of optimal portfolios that offer the highest expected return for a
defined level of risk or the lowest risk for a given level of expected return. Portfolios that lie below
the efficient frontier are sub-optimal because they do not provide enough return for the level of risk.
Portfolios that cluster to the right of the efficient frontier are sub-optimal because they have a
higher level of risk for the defined rate of return.

The efficient frontier theory was introduced by Nobel Laureate Harry Markowitz in 1952 and is a
cornerstone of modern portfolio theory (MPT).The efficient frontier rates portfolios (investments)
on a scale of return (y-axis) versus risk (x-axis).

The Portfolio Theory of Markowitz is based on the following assumptions:

(1) Investors are rational and behave in a manner as to maximise their utility with a given level of
income or money.

(2) Investors have free access to fair and correct information on the returns and risk.

(3) The markets are efficient and absorb the information quickly and perfectly.

(4) Investors are risk averse and try to minimise the risk and maximise return.

(5) Investors base decisions on expected returns and variance or standard deviation of these returns
from the mean.

(6) Investors choose higher returns to lower returns for a given level of risk.

Optimal Portfolio
One assumption in investing is that a higher degree of risk means a higher potential return.
Conversely, investors who take on a low degree of risk have a low potential return. According to
Markowitz's theory, there is an optimal portfolio that could be designed with a perfect balance
between risk and return. The optimal portfolio does not simply include securities with the highest
potential returns or low-risk securities. The optimal portfolio aims to balance securities with the
greatest potential returns with an acceptable degree of risk or securities with the lowest degree of
risk for a given level of potential return. The points on the plot of risk versus expected returns where
optimal portfolios lie are known as the efficient frontier.

Assume a risk-seeking investor uses the efficient frontier to select investments. The investor would
select securities that lie on the right end of the efficient frontier. The right end of the efficient
frontier includes securities that are expected to have a high degree of risk coupled with high
potential returns, which is suitable for highly risk-tolerant investors. Conversely, securities that lie on
the left end of the efficient frontier would be suitable for risk-averse investors.