Selection of a Stock Portfolio

Selection of a Stock Portfolio

Selection of a Stock Portfolio

Selection of a Stock Portfolio

Itmight appear that the selection of a portfolio would follow obviouslyand easily from the prior process of valuing securities.

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That this is not true is evident from reflection on the behaviorof investors. Almost all choose to hold groups of common stocks ratherthan the single stock which offers the greatest expected return. Thissuggests that "attractiveness" does not consist exclusively of expectedreturn. If that were all that mattered, investors would put as muchof their resources as possible into the single security offering the greatest expected return.

Since 1952, investors have come to understand much better another dimension of attractiveness and the reasons why the rational and professional management of portfolios consists of much more than thelisting of securities in order of the magnitude of their expected returns.The great event in 1952 was the publication by Harry Markowitzof his now celebrated article "Portfolio Selection."Markowitz's greatcontribution was to analyze the implications of the fact that investors,though seeking high expected returns, generally wish to avoid risk.Since there is overwhelming evidence that risk aversion characterizesmost investors and especially most large investors, rationality in portfolio management demands that account be taken not only of expectedreturns for a portfolio but also of the risk that is incurred.

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Althoughthe expected return on a portfolio is directly and obviously relatedto the expected returns on the component securities, it is not possibleto deduce the riskiness of a portfolio simply by knowing the riskinessof individual securities. The riskiness of portfolios depends not onlyon the attributes of securities considered individually but also on theinterrelationships among them. It is primarily for this reason that portfolio management is a separate subject.

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