Overview
Portfolio Management introduces the theoretical foundations of modern portfolio theory (MPT), the Capital Asset Pricing Model (CAPM), and the investment management process. While this topic carries a relatively small exam weight at Level I, it integrates concepts from across the curriculum and becomes the central focus of Levels II and III.
Modern Portfolio Theory
Harry Markowitz (1952) showed that investors should evaluate portfolios by their expected return and variance, not individual securities in isolation. Diversification reduces risk because assets are not perfectly correlated.
Portfolio expected return: E(Rp) = Σ wᵢ × E(Rᵢ)
Portfolio variance: σ²p = Σᵢ Σⱼ wᵢwⱼ Cov(Rᵢ, Rⱼ)
The efficient frontier represents the set of portfolios offering the highest expected return for each level of risk. No rational investor should hold a portfolio inside (below) the efficient frontier.
The Capital Asset Pricing Model (CAPM)
CAPM extends MPT by assuming a risk-free asset. The Capital Market Line (CML) shows risk-return combinations available by combining the market portfolio with the risk-free asset. Every investor holds the same market portfolio (the tangency portfolio) and adjusts their overall risk by varying the weight in the risk-free asset.
Beta (β) measures a security’s systematic (non-diversifiable) risk relative to the market: β = Cov(Rᵢ, Rₘ) / Var(Rₘ)
The Security Market Line (SML) is CAPM’s pricing equation: E(Rᵢ) = Rf + βᵢ × [E(Rₘ) − Rf]
Securities plotting above the SML are undervalued (positive alpha); those below are overvalued.
Risk Measures and Portfolio Construction
Systematic risk (market/beta risk) cannot be diversified away; investors are compensated for bearing it. Unsystematic risk (idiosyncratic) is eliminated through diversification; investors receive no premium for it.
Total risk = Systematic risk + Unsystematic risk σ²ᵢ = β²ᵢ × σ²ₘ + σ²ₑᵢ
The investment policy statement (IPS) is the foundation of the portfolio management process. It documents the client’s risk tolerance, return objectives, time horizon, liquidity needs, tax situation, legal constraints, and unique circumstances. All portfolio decisions should flow from the IPS.