A portfolio is a bundle or a combination of individual assets or securities. The portfolio theory provides a normative approach to investors to make decisions to invest their wealth in assets or securities under risk.
It is based after the assumption that investors are risk-averse. This implies that investors hold well diversified portfolio instead of investing their entire wealth in a single or a few assets. One important conclusion of the portfolio theory is that if the investor of the portfolio theory is that if the investor holds a well-diversified portfolio of assets then their concerns should be the expected rate of return and risk of the portfolio, rather than individual assets and the contribution of individual asset to the portfolio risk. The second assumption of the portfolio theory is that the returns of assets are normally distributed. This means that the mean and variance analysis is the foundation of the portfolio decisions. Further, we can extend the portfolio theory to derive a framework for valuing risk assets. This framework is referred to as CAPM.
The CAPM is a model that provides a framework to determine the required rate of return on an asset and indicates the relationship between return and risk of the asset. The required rate of return specified by CAPM help in valuing an asset. Once can also compare the expected return and determine whether the asset is fairly valued. As we exemplifies the relationship between an asset’s required rate of return.
Risk is of many kinds, they can be classified as systematic or unsystematic risk. Systematic risk covers the risks of market, interest rate risk and purchasing power risk and unsystematic risk consist of business and financial risk. The systematic risk is therefore, effecting the total environment and is outside the control of one firm on individual. Unsystematic risk is inherent to the system. It may be due to bad financial planning or wrong management decisions. These risks are internal and can be avoided or controlled.
Risk is fundamental to the process of investment. Every investor should have an understanding of the various pitfalls of investment. For the convenience of the investors, analysts measure risks to able to combine securities and to reach that portfolio which suit’s the individual needs of an investor risk is measured through beta test.
