Portfolio Theory: Concepts & Terms

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Written By
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Written By
Dan Buckley
Dan Buckley is an US-based trader, consultant, and part-time writer with a background in macroeconomics and mathematical finance. He trades and writes about a variety of asset classes, including equities, fixed income, commodities, currencies, and interest rates. As a writer, his goal is to explain trading and finance concepts in levels of detail that could appeal to a range of audiences, from novice traders to those with more experienced backgrounds.

A portfolio is a collection of financial investments like stocks, bonds, cash equivalents, fund units, etc., held by investment companies, hedge funds, or individual investors.

The concept of a portfolio stems from the theory of diversification, which proposes that a trader/investor can reduce risk by putting their funds in different kinds of investments/trades/returns streams.


Key Takeaways – Portfolio Theory

  • Portfolio Diversification: A well-constructed portfolio holds a variety of investments and trades to reduce risk, based on the principle that spreading investments across different assets and asset classes lowers the impact of a single investment’s poor performance on the overall portfolio.
  • Portfolio Manager’s Role: A portfolio manager is responsible for creating and managing investment portfolios aligned with investors’ goals and risk tolerance, either for institutions or individual clients, using active or passive strategies.
  • Risk and Return: The risk-return relationship is a core concept in investment management. Investors seek higher returns but must balance this with the associated risk. The ideal is to find a portfolio that optimizes this trade-off while considering individual preferences and investment objectives.


Portfolio Manager

A portfolio manager is a financial professional responsible for trading or investing money.

The portfolio manager’s goal is to construct the best portfolio that aligns with the investor’s risk tolerance and investment objectives.

Portfolio managers may work for financial institutions or they can manage personal portfolios for individual investors (e.g., such as a financial advisor).


Investment Management

Investment management is the process of managing money and assets, including buying, selling, and overseeing investments.

It involves professional management of various securities and assets to meet specific investment goals.

Active Management

Active management refers to a strategy where the portfolio manager makes specific investments with the goal of outperforming an investment benchmark index.

Managers who use this strategy have complete freedom to make decisions that deviate from benchmark indexes.

Passive Management (Buy and Hold)

In contrast, passive management, also known as “buy and hold,” is an investment strategy where a manager aims to mirror the performance of a specific index by buying all the securities in the index.

This approach is often associated with lower costs because it requires less active management.

Index Fund

An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that the fund can track a specified basket of underlying investments.

Index funds are popular for their broad market exposure, low operating expenses, and low portfolio turnover.

Core & Satellite

The core and satellite approach to portfolio construction is a method of portfolio management, often used in conjunction with other investment strategies.

The “core” is a large, stable, and conservative portion of a portfolio, while the “satellite” is a smaller, more risk-oriented portion of the portfolio.

It’s analogous to the barbell approach to portfolio management (part of it in “safe” assets, the other in riskier assets).

Smart Beta

Smart beta refers to an investment strategy that uses alternative index construction rules instead of traditional market capitalization-based indices.

Smart beta strategies aim to deliver a better risk and return trade-off than traditional market cap-weighted indices by using factors like volatility or dividends.

Expense Ratio

The expense ratio is a measure of what it costs an investment company to operate a mutual fund, expressed as a percentage of the fund’s total assets.

For example, an expense ratio of 0.55% means that for every $10,000 invested, $55 is lost in fees per year.

A lower expense ratio is generally preferable for investors, as the expenses are withdrawn from the fund, affecting the return investors receive.

However, it just boils down to the value the manager provides.


Investment Style

Different portfolio managers and investors have different investment styles, generally categorized as active or passive, growth or value, and so on.

Value Investing

Value investing is an investment strategy that involves picking stocks that appear to be trading for less than their intrinsic or book value.

Value investors actively ferret out stocks they think the stock market is underestimating.

Contrarian Investing

Contrarian investing is an investment style in which investors purposefully go against prevailing market trends by selling when others are buying, and buying when most traders/investors are selling.

For example, contrarian investors may believe that people who say the market is going up further are more likely to be fully invested and be short on further purchasing power.

Growth Investing

Growth investing involves investing in companies that exhibit signs of above-average growth, even if the share price appears expensive in terms of metrics such as price-to-earnings or price-to-book ratios.


CANSLIM is a strategy developed by investor William J. O’Neil, which selects growth stocks using a combination of both fundamental and technical analysis.

Here’s the meaning of each letter in the CANSLIM acronym:

  • C – Current Earnings: Focus on companies with recent and accelerating earnings growth.
  • A – Annual Earnings: Look for companies with a history of strong annual earnings growth.
  • N – New Products or Services: Companies with innovative products or services often have growth potential.
  • S – Supply and Demand: Stocks with increasing demand and limited supply tend to perform well.
  • L – Leader or Laggard: Invest in leading stocks within leading industries rather than weaker performers.
  • I – Institutional Sponsorship: Stocks with support from institutional investors are more likely to succeed.
  • M – Market Direction: Timing is important; invest when chep or during uptrends in the overall market.

Index Investing

Index investing is a passive strategy that attempts to generate similar returns as a broad market index.

Investors use this strategy to avoid the significant fees and long-term underperformance that can come with active investing or trading.

Magic Formula Investing

Magic formula investing is a disciplined investing strategy that teaches people a simple and effective way to manage their money.

It was designed by Joel Greenblatt, a Columbia Business School adjunct professor and hedge fund manager.

Momentum Investing

Momentum investing is a factor investing strategy in which investors buy securities that have shown high returns over the past three to twelve months, and sell those that have shown poor returns over the same period.

Quality Investing

Quality investing is an investment strategy based on a set of clearly defined fundamental criteria.

Quality investors look for stocks that have characteristics such as stable earnings, high return on equity, low debt, and sustained competitive advantages.

Style Investing

Style investing refers to the strategy of making investment decisions based on trends in the investment market.

These trends can include macroeconomic trends, geographical trends, or sector trends.

Factor Investing

Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns.

Common factors include size, value, momentum, quality, and volatility.


Investment Strategy

Investment strategy refers to the rules, procedures, and guidelines that guide an investor’s selection of an investment portfolio.

Typically, the strategy will be designed around the investor’s risk-return tradeoff: some investors will prefer low-risk investments with lower returns, while others will accept higher risk for the chance of higher returns.

Benchmark-Driven Investment Strategy

A benchmark-driven investment strategy is one where the manager selects securities with the goal of outperforming a benchmark index.

This can be achieved by actively selecting stocks or by using a passive investment strategy.

Liability-Driven Investment Strategy

A liability-driven investment strategy, on the other hand, is focused on meeting a series of predetermined liabilities, regardless of how the underlying investments perform.

This strategy is typically employed by pension funds and insurance companies.


Financial Risk Management in Investment Management

Financial risk management in investment management is the practice of using financial techniques and instruments (e.g., options) to manage exposure to risk.

It involves the identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.


Investor Profile

An investor profile or style defines an individual’s preferences in investment decisions, such as risk tolerance and investment horizon.

Investors are often categorized as conservative, moderate, or aggressive.


Rate of Return on a Portfolio/Investment Performance

The rate of return on a portfolio or investment performance refers to the gain or loss made on an investment over a set period of time, expressed as a percentage increase over the original investment cost.

Performance can be evaluated in absolute terms or compared to a market benchmark.


Risk-Return Ratio

The risk-return ratio, also known as reward-to-variability ratio, is a measure used by investors to compare the expected returns of an investment to the amount of risk undertaken to capture these returns.

Often, these are expressed as a Sharpe Ratio, Sortino Ratio, Treynor Ratio, Information Ratio, among others.

Risk–Return Spectrum

The risk-return spectrum (also known as the risk-return tradeoff) refers to the relationship between the amount of return gained on an investment and the amount of risk that must be undertaken in that investment.

The greater the potential return one might seek, the greater the risk that one generally assumes.


Risk Factor

In finance, a risk factor is a variable that can increase the risk associated with trading/investing.

These can be macroeconomic variables such as GDP or inflation, or other financial variables such as interest rates or market volatility.


Portfolio Optimization

Portfolio optimization is the process of choosing the best portfolio from a set of portfolios according to some objective.

The objective typically maximizes factors such as expected return, and minimizes costs like financial risk.



Diversification is the risk management strategy that mixes a wide variety of investments within a portfolio to minimize the impact that any one security will have on the overall performance of the portfolio.


Asset Classes

Asset classes are categories of investments that have similar characteristics and are subject to the same laws and regulations.

They include equities (stocks), fixed income (bonds), cash and cash equivalents, real estate, commodities, futures, and other financial derivatives.

Exter’s Pyramid

Exter’s Pyramid is a model used in economics to represent the liquidity of different types of assets.

At the top of the pyramid are the most illiquid assets (like derivatives and non-monetary/illiquid commodities), while at the bottom are the most liquid (like gold and cash).


Asset Allocation

Asset allocation refers to the investment strategy of balancing risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance, and investment horizon.

Tactical Asset Allocation

Tactical asset allocation is a dynamic strategy that actively adjusts a portfolio’s asset allocation.

The goal of this strategy is to improve the risk-return ratio by adjusting the asset allocation to take advantage of market or economic conditions.

Global Tactical Asset Allocation

Global tactical asset allocation is a type of asset allocation strategy that includes international investments.

The aim is to take advantage of shifting investment opportunities across the globe.

(Most traders/investors are biased toward their own domestic equities markets.)

Strategic Asset Allocation

In contrast, strategic asset allocation sets targets for asset allocation and then periodically rebalances the portfolio back to those targets over time, regardless of what the market conditions might be.

Dynamic Asset Allocation

Dynamic asset allocation is a strategy that frequently adjusts the mix of assets as markets rise and fall, and as the economy strengthens and weakens.

It is a mix between tactical and strategic asset allocation.


Sector Rotation

Sector rotation is an investment/trading strategy involving the movement of investment assets from one sector of the economy to another.

Investors use this strategy in an attempt to beat the market and increase portfolio returns.

For example, if a trader believes that the economy will slow, they can buy (a) defensive sector(s) of the equities market like utilities or consumer staples and shift away from a cyclical sector like consumer discretionary.


Correlation & Covariance

Correlation and covariance are statistical measures that describe how two different investments move in relation to each other.

Understanding these measurements helps traders/investors to diversify their portfolios effectively.

(We discuss this in more detail here.)

Covariance Matrix

A covariance matrix is a mathematical tool that provides a systematic way of measuring how much different groups of numbers vary together.

It’s used in portfolio theory to estimate the variance of the returns of a portfolio.

Correlation Matrix

A correlation matrix is another statistical tool that measures the relationship between different variables.

In finance, it is used to understand the correlation between different investments in a portfolio.


Risk-Free Interest Rate

The risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss.

This rate is important in finance because it is used in pricing models like the Capital Asset Pricing Model (CAPM).



Leverage in finance refers to the use of borrowed funds in purchasing an asset, with the expectation that the income from the asset or asset price appreciation will be more than the cost of borrowing.


Utility Function

In finance, the utility function is used to represent a user’s preference for certain goods and services over others.

For investors, utility functions can be used to understand their preference for different investments given the trade-off between risk and return.


Intertemporal Portfolio Choice

Intertemporal portfolio choice refers to the allocation of investment in different periods of time.

Investors have to decide not only how to allocate their investments among different assets, but also how to distribute these investments over time.


Portfolio Insurance

Portfolio insurance is a strategy that uses financial derivatives to cushion investors against the risk of losses.

The strategy often involves the purchase of put options to guard against a potential drop in the value of a portfolio of assets they hold.

Constant Proportion Portfolio Insurance

Constant Proportion Portfolio Insurance (CPPI) is a type of portfolio insurance strategy where the investor sets a floor on the dollar value of their portfolio, then structures asset allocation around that floor.


Quantitative Investment/Quantitative Fund

Quantitative investment involves the use of mathematical and statistical models to make investment decisions.

A quantitative fund is a fund that relies on algorithm-based trading strategies, often making use of complex mathematical models to execute strategies predicated on speed and accurate calculations, such as statistical arbitrage.


Uncompensated Risk

Uncompensated risk is the portion of investment risk that can be eliminated through diversification.

Theoretically, by holding a well-diversified portfolio, investors should not expect to be compensated for the additional risk they bear for holding only one security (or holding a non-diversified selection of assets).