Modern portfolio theory relies on diversification to minimize individual security risk in a portfolio. The idea is that by holding a large number of different securities, no individual security can seriously affect the performance of the portfolio and the investor is left with only systemic risk, which is the risk that the entire sector or market will decline. It is possible to hedge against systemic risk, but it cannot be fully mitigated without giving up a significant portion of the potential returns.
Asset allocation is the second part of reducing risk. An investor can hold 200 different securities in his portfolio, but if they are all in one sector, he will be seriously exposed to the systemic risk of the individual sector.
To mitigate the systemic risk of a sector, investors look to allocate different portions of their portfolio into different sectors and asset classes. For example, a portfolio might be composed of 10 percent blue chip stocks, 10 percent mid-cap stocks, 10 percent small-cap stocks, 10 percent international stocks, 10 percent in real estate, 10 percent in gold, 10 percent in corporate bonds, 10 percent in government bonds, 10 percent in oil and 10 percent in cash.
By allocating funds among different asset classes, the investor is going to experience less volatility caused by the varying performance of the investments in each class.
After asset allocation and diversification are determined, the variance of each security is examined. Variance is the rate at which the value of an investment fluctuates around an average. The greater the variance, the greater the risk associated with the investment.
Using an investment's variance, its beta can be calculated. Beta is a useful measure of how much variance exists for an individual security compared to an existing portfolio or benchmark. An investment's beta is an easy way to see if adding the security to an existing portfolio will reduce the risk associated with the portfolio or will increase the risk.
A beta of less than one will lower the risk, while a beta of greater than one will increase the risk.
Using Portfolio Analysis to Fix a Portfolio
The different tools used in portfolio analysis are useful only to the extent that they can help an investor achieve her goals. If an analysis finds that there is too high a concentration in a given asset class or not enough diversification within an asset class, an investor can take steps to correct the situation with the ultimate goal of building a portfolio that optimizes returns while minimizing risk.