The Basics of the Optimal Portfolio Theory

Optimal portfolio theory finds the optimal set of hypothetical portfolios that reside within the space of the x and y axes, the portfolio frontier space. It is a mathematical concept very similar to utility theory.

In its conception, the theory used three asset classes that served to make up a hypothetical portfolio. Those three asset classes were cash, stocks and bonds. Keep in mind that more than three could be used; however, for simplicity, three are chosen. 

The theory contains three major variables: allocation percentages, rate of return and volatility. To better understand this, it is best to imagine an x- and a y-axis where the x-axis represents risk (volatility) and the y-axis represents reward (rate of return). Any real portfolio can be measured comparatively to the optimal portfolio line. Only portfolios on this hypothetical line are optimal.

With that said, we can say that this is a financial management theory used for the selection and comparison of portfolios. New investors need not worry about the math of the theory. It serves one better to know basic cartesian math concepts, such as the x-axis and y-axis. Further explorations would involve calculus as well.

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