The collapse in 2000 of the stock market has opened all of our eyes to the risks inherent to investing. In this case, how to control the risk and measure it needs to take into consideration. The pioneer of this field is Markowitz. Markowitz states that investment risk may be reduced by combining assets with less than perfect correlations into a portfolio. And he developed the investment technique which is still widely used today. With the development of portfolio theory, some other kinds of models come into being. Such as the capital asset pricing model (CAPM), arbitrage pricing theory (APT) and new equilibrium theory (NET). And many evidence shows that they do can diversify specific risk. Now in the following the principle how to use these techniques would be introduced:
Maybe some investors focused on identifying the securities which can offer the best opportunities for gain with least risk and then construct a portfolio consisting of these securities. Compared with this advice, Markowitz detailed mathematics of diversification; he suggested that investors should pay more attention on selecting portfolios based on the whole risk-reward characteristics instead of merely compiling portfolios from securities that each individually has attractive risk-reward characteristics. In this case, investors should select portfolios not individual securities. When we do investment, expected values, standard deviations and correlations always mentioned. Based on them, it is easy to calculate the expected return and volatility of any portfolio constructed with those securities. Moreover, we can select certain ones of the entire universe of portfolios will optimally balance risk and reward. An efficient frontier of portfolios can be made with those components, and then the investor ...