The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

CONSTRUCTING THE PORTFOLIO

Once a portfolio strategy is selected, the next task is to construct the portfolio (i.e., select the specific assets to be included in the portfolio). It is in this phase of the investment management process that the investor attempts to construct an efficient portfolio. An efficient portfolio is one that provides the greatest expected return for a given level of risk, or equivalently, the lowest risk for a given expected return.

To construct an efficient portfolio, the investor must be able to quantify risk and provide the necessary inputs. As explained in Chapter 3, there are three key inputs that are needed: future expected return (or simply expected return), variance of asset returns, and correlation (or covariance) of asset returns. All of the investment tools described in the chapters that follow in this book are intended to provide the investor with information with which to estimate these three inputs.