Portfolio Construction, Risk and Return
Core mechanics
Expected portfolio return is the weighted average of asset expected returns. Risk is usually measured by standard deviation of returns, split into systematic risk (market-wide, captured by beta) and unsystematic risk (company-specific, removable by diversification). Correlation determines how much diversification is achieved: the lower the correlation, the greater the risk reduction for a given pair of assets. Combining assets produces the efficient frontier - the set of portfolios offering the highest expected return for each level of risk.
The practical process
Asset allocation is the dominant driver of long-run outcomes. Construction starts from the client's objectives, time horizon, attitude to risk, capacity for loss and liquidity needs, then selects a strategic allocation, a rebalancing policy and a monitoring process. Risk-adjusted performance is often compared using the Sharpe ratio, (Rp - Rf) / standard deviation.
Traps
- Diversification removes unsystematic risk only; market risk remains.
- Adding more holdings does not reduce risk if they are highly correlated.
- Volatility is not the same as permanent loss of capital.
- Higher expected return never guarantees higher realised return.
- A risk questionnaire measures attitude, not capacity for loss; both must be assessed.
- Rebalancing is contrarian - it sells what has risen and buys what has fallen.
Worked example
A 60/40 portfolio with expected equity return 8% and bond return 3% has an expected return of (0.6 x 8) + (0.4 x 3) = 6.0%. If the risk-free rate is 2% and portfolio standard deviation is 10%, the Sharpe ratio is (6 - 2) / 10 = 0.4 - that is, 0.4 units of excess return per unit of volatility.