Chapter 5

Portfolio Construction

Good management is better than good income.

—Portuguese proverb

A portfolio consists of a collection of assets. The portfolio itself is an asset, too, since it is a collection of assets. The return to the portfolio is a weighted average of the returns to the underlying assets. For example, consider a portfolio of two assets, X and Y. Suppose that the amounts invested in X and Y are $1,000 and $500, respectively. Then X comprises of the value of the portfolio and Y comprises of the portfolio's value. The weights, w_i, are therefore and . Note that the weights sum to unity. If the returns to X and Y are known and denoted at r_x and r_y, then the return to the portfolio is .