7.4 Portfolio theory
Figure 7.2
The risk /return
profiles of three
securities, A, B
and C
Each of the three points represents the expected return, plotted against the riskiness of that
return, for three independent securities.portfolio. Further diversification means that the investor will have to pay higher
dealing charges to establish the portfolio and then will have more cost and/or work
in managing it.
If systematic risk must be borne by investors because it is caused by economy-wide
factors, it seems likely that some securities are more susceptible to these factors than
are others. For example, a high street food supermarket would seem likely to suffer
less as a result of economic recession than would a manufacturer of capital goods
(business non-current assets, such as machines used to manufacture motor vehicles).
Since it seems that we can eliminate specific risk very cheaply and easily, is there
any reward, in terms of higher returns, for bearing it? Is the level of systematic risk
attaching to the returns from all securities the same? These questions and several oth-
ers relating to them will now be examined.7.4 Portfolio theory
If we assume both that security returns are symmetrically distributed about their
expected value and that investors are risk averse, then we can completely describe
securities by their expected values (or means) and standard deviations and so repres-
ent them graphically, as in Figure 7.2.