This has led the investors to think about collective investment to set off the risk from one investment with the return from another investment. This was formally called portfolio and many theories have been developed thereafter to facilitate portfolio management. This paper discusses some of the important concepts of modern portfolio management. The paper takes a descriptive approach where all the concepts are described in such a way how they are useful for investors.
Investors always seek for an optimal investment portfolio where the returns are more and risk is less. This can be met through Portfolio Theory. The Theory helps in developing an optimal portfolio that will enable an investor to optimize market risk and generate more return from the business. Thus Portfolio theory is an approach to manage risk and return. The Theory has got much relevance in of financial management literature as many investors found them effective means of increasing the return at a given risk level. The theory is basically applied to the stock market and is based on the idea that there are basically two kinds of risk: (a) diversifiable or relevant risk (risk associated with events occurring in individual companies such as strikes, new marketing programs, lawsuits and new inventions (b) non diversifiable or market risk (risk associated with factors that affect all companies such as inflation, war and recession (Elton, 1999). The careful construction of portfolio of securities helps investors to reduce the diversifiable risk to zero and optimize the market risk. However the market risk cannot be eliminated as it is uncontrollable one. And to the investment managers it helps to meet the current financial goals of their company. Portfolio Theory also states that every project of a company should be appraised for risk involved and return expected, so that it can help the company to accept a project where the success rate and returns are higher (Gruber, 1987).
Diversification: Diversification is considered to be the core principle of Portfolio Theory. It is a portfolio strategy or a technique that enables an investor to reduce portfolio risk (relevant risk and market risk) by investing in combination of instruments such as stock, mutual funds, cash, bonds and real estate which are moving in different direction. In other words it can be told as the strategy that reduces the exposure of investors to individual asset risk by holding a diversified portfolio of assets. It can be well summed up with the phrase "Don't put all of your eggs in one basket" (Glink, p. 78, 2001). Take examples suppose an investment is made by the investor only in the stock issued by the single company. Unfortunately a serious downturn happens to the stock issued by single company then the portfolio of the investor will decline ultimately. So the better way for an investor is to split his investments of stocks in two different companies so that the investor can reduce the potential risk of his portfolio. The other way to reduce risk is to include cash, bond and stock in the portfolio that is to develop an asset allocation strategy for the portfolio.