Why Is the Risk of a Portfolio of Shares Normally Lower than the Average Risk of the Shares of the Portfolio?
On a general level, investment managers and academic economists have long been aware of the necessity of taking returns as well as risk into account: "all your eggs should not be placed in the same basket". This is where the idea of holding a portfolio of shares comes from. Modern portfolio theory (MPT), or portfolio theory, was introduced by Harry Markowitz with his paper "Portfolio Selection" which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection. Portfolio theory explores how risk averse investors construct portfolios in order to optimise expected returns for a given level of market risk. The theory quantifies the benefits of diversification. Out of a universe of risky assets, an efficient frontier of optimal portfolios can be constructed. Each portfolio on the efficient frontier offers the maximum possible expected return for a given level of risk. An example of this can be seen below.
The Efficiency Frontier
The green region corresponds to the achievable risk-return space. …
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- Why Is the Risk of a Portfolio of Shares Normally Lower than the Average Risk of the Shares of the Portfolio?
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