Portfolio Construction and Management
Risk, return and diversification
Asset allocation is the dominant driver of a portfolio's risk and return profile. Diversification works because imperfectly correlated assets offset one another; combining assets with correlation below +1 reduces volatility without necessarily reducing expected return. Modern portfolio theory maps this into the efficient frontier - portfolios offering the highest expected return for each level of risk. Adding a risk-free asset produces the capital market line; CAPM then prices risk through beta, and alpha measures return in excess of that predicted by beta. Total risk splits into systematic (market-wide, undiversifiable) and unsystematic (company-specific, diversifiable) components.
Building and monitoring
Strategic allocation sets long-term weights reflecting objectives and risk tolerance; tactical allocation makes shorter-term deviations. Rebalancing restores target weights and enforces a disciplined sell-high/buy-low behaviour. Benchmarks must be appropriate to the mandate, and performance should be judged against them over a suitable period. Time-weighted returns measure manager skill by removing the effect of cash flows; money-weighted returns reflect the investor's actual experience. Sharpe ratio uses total risk (standard deviation); Treynor uses beta; the information ratio compares active return with tracking error.
Trap: holding many funds does not guarantee diversification if they share the same holdings or high correlation. Beta is not a measure of total risk.
Rule of thumb: beyond roughly 20–30 well-spread equity holdings, most company-specific risk has been diversified away; the remaining risk is market risk.
Example: Sharpe = (portfolio return − risk-free rate) ÷ standard deviation. A 9% return, 3% risk-free and 12% volatility gives 0.5.