How Do You Reduce Investment Risk Using Portfolio Theory?
Portfolio theory is used to maximize an investment portfolio’s expected rate of return for a given level of risk. Portfolio theory is used with the understanding that with higher levels of risk come higher expected returns. For the purpose of investing, risk is defined as the variation of the return from what was expected (volatility). The following guide will provide some brief information on how to apply portfolio theory and reduce risk for a given expected rate of return. Diversification is used to reduce a portfolio’s overall volatility. By building a portfolio out of many unrelated (uncorrelated) investments total volatility (risk) is minimized. The idea is that most assets will provide a return similar to their expected return and will offset those in the portfolio that perform poorly. Asset Classes: Combining various assets classes with various levels of risk together in the same portfolio, an investor is able to control the exposure to risk for a particular investment portfolio
