At the heart of portfolio management is the idea of getting the maximum return for a given level of risk. Rational investors will try to choose the most efficient portfolio (a combination of assets) for their level of risk tolerance – the portfolio providing the maximum expected return for a given level of variance, or standard deviation, of return.
How much of each asset to allocate in a portfolio, or which type of asset (stocks, bonds, real estate, and so on), is dependent on many factors, such as covariance between the assets and risk appetite of the investor. For instance, diversification of a portfolio by mixing a risky asset with a risk-free asset will reduce the overall risk of the portfolio, but the risk/return trade-off has to be examined. Higher levels of risk aversion will lead to a larger proportion of investment in the risk-free asset.
Today there are many different types of strategy, and portfolio managers may have to adjust a portfolio dynamically in response to changing market conditions.
