Portfolio theory is an important topic in the theory of choice under uncertainty. It
deals with the problem facing an investor who must decide how to distribute an
initial wealth of, say, W0 among a number of single-period investment opportunities,
called securities or assets.
The choice of portfolio will depend on both the investor’s preferences and his
beliefs about the uncertain payoffs of the various securities. A mutual fund is just
a special type of (managed) portfolio.
The chapter begins by considering some issues of definition and measurement.
Section 6.3 then looks at the portfolio choice problem in a general expected utility
context. Section 6.4 considers the same problem from a mean-variance perspective.
This leads on to a discussion of the properties of equilibrium security returns
in Section 6.5.
6.2 Notation and preliminaries
6.2.1 Measuring rates of return
Good background reading for this section is ?.
A rate of interest (growth, inflation, &c.) is not properly defined unless we state
the time period to which it applies and the method of compounding to be used.
2% per annum is very different from 2% per month.
Table 6.1 illustrates what happens to £100 invested at 10% per annum as we
change the interval of compounding. The final calculation in the table uses the
Revised: December 2, 1998