Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

Portfolio Approach to Investing

Portfolio Approach to Investing

Investors have to ensure their investments achieve their future needs. Irrespective of what the future financial goals are, a portfolio approach to investment decision making is important. It enables an investor to create a diversified investment portfolio.

Portfolio Diversification

The benefits of a diversified portfolio are best summarized by the anecdotal wisdom of “don’t put all your eggs in one basket”. If a portfolio is too heavily allocated to one individual security, and that security fails for some reason, an investment portfolio can be reduced to zero. Diversification allows investors to spread some of the downside risk associated with any one investment position without necessarily decreasing the expected rate of return.

Reducing Risk

Diversified portfolios have a lower portfolio risk or volatility (as measured by standard deviation) than any one individual position within the portfolio. Due to the statistical relationship or interactions between individual portfolio positions (correlation), the overall volatility is lowered by including multiple positions within a portfolio.

Composition Matters

Each individual security has a historic risk and return profile. By combining securities within a portfolio, we can produce a risk and return profile for the portfolio itself. Through examination of different portfolios – allocating different percentages to the underlying securities – we can determine the portfolio composition that produces the best risk-return profile.

Downside Protection

Portfolio diversification is not an absolute failsafe for investors. During times of market turmoil, a diversified portfolio may not protect an investor from losses. The reduction in risk as a result of portfolio diversification comes about due to the uncorrelated nature of the individual portfolio holdings. However, this correlation is not fixed and when markets are stressed, as was the case during the 2007-2008 financial crisis, previously uncorrelated assets can become correlated.  This is known as contagion and in 2008, global assets experienced price declines. This proved that portfolio diversification is not as effective as the mathematical models had previously suggested.

The Modern Portfolio Theory

Although adopting a portfolio approach to investing seems intuitive, there is a theory behind it. The diversification concept follows the work of Harry Markowitz’s 1952 publication and is known as Modern Portfolio Theory (MPT). The principle concept is that investors should not only hold portfolios but also focus on the relationship among the individual securities within the portfolio. MPT has its limitation but continues to be a cornerstone for portfolio managers.


A portfolio approach to investing provides which of the following benefits?

A. The highest investment returns

B. Protection against investment losses

C. A reduction in risk during normal market conditions


The correct answer is C.

A diversified portfolio reduces risk without compromising investment returns. However, it does not completely protect an investor against investment losses during times of market turmoil.

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons

    Sergio Torrico
    Sergio Torrico
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.