Brief Review on Asset Selection and Portfolio Construction: Diversification, Risk and Return

Abstract

This paper covers the rationale behind Modern Portfolio Theory and discusses the assumptions of the Capital Asset Pricing Model. The investor’s preference regarding financial instruments, expected return and level of risk are essential to determining the composition of the portfolio. The practice of diversification provides a solution by, the allocation of wealth into selected securities which cumulatively offer, a portfolio that produces a desirable return with minimal variance. Taking into account the investor’s level of risk aversion, allows that efficient diversified portfolio to maximize his utility. The key parameter of portfolio construction, denominated by the Greek letter beta, is systematic risk which is undiversifiable. Estimating the efficient diversified portfolio’s performance is dependent on that single coefficient. The risk-return trade off relationship derived from beta, provides the framework for the pricing of assets held in competitive markets. An empirical study illustrating diversification, risk preference and asset pricing provides practical assessment of the concepts developed in the paper.