Portfolio selection The variance of a weighted sum is V(R)=∑a2V(X小+2 aiajoij If we use the fact that the variance of R, is o then V(R)=∑∑ Let R: be the return on the i "security. Let u be the expected value of R,; oi, be the covariance between R, and R, (thus oi is the variance of Ri. Let X, be the percentage of the investor's assets which are al located to the i security. The yield(R)on the portfolio as a whole is R=∑RX The R,(and consequently R)are considered to be random variables. 7 The Xi are not random variables, but are fixed by the investor. Since the X: are percentages we have EXi=1. In our analysis we will ex clude negative values of the X(i.e, short sales); therefore Xi20 for ll The return(R)on the portfolio as a whole is a weighted sum of ran- dom variables(where the investor can choose the weights). From our discussion of such weighted sums we see that the expected return E from the portfolio as a whole is X and the variance is XiX any two events(a and B), whe to be consistent in every detail considered. We should be in part subjective
The Journal of finance For fixed probability beliefs (ui, o the investor has a choice of vari- ous combinations of E and v depending on his choice of portfolio X1,..., XN. Suppose that the set of all obtainable (e, n) combina tions were as in Figure 1. The E-v rule states that the investor would (or should)want to select one of those portfolios which give rise to the (E, V combinations indicated as efficient in the figure; i. e, those with minimum V for given E or more and maximum E for given V or less. There are techniques by which we can compute the set of efficient rtfolios and efficient(E, v) combinations associated with given u attainable E, V combinations and oii. We will not present these techniques here. We will, however illustrate geometrically the nature of the efficient surfaces for cases in which N(the number of available securities) is small The calculation of efficient surfaces might possibly be of practical use. Perhaps there are ways, by combining statistical techniques and the judgment of experts, to form reasonable probability beliefs (ui, a. We could use these beliefs to compute the attainable efficient combinations of (E, v). The investor, being informed of what(E, V combinations were attainable, could state which he desired. We could then find the portfolio which gave this desired combination