Portfolio Theory of Investment helps to choose stocks and other securities in such a manner in given weights to reduce risk and optimize returns. It highlights the advantages of diversification in different stocks and other securities, which are negatively correlated to reduce the overal risk of the portfolio as well optimize returns.
For example say stock A has a mean return of 15% and stock B has a return of 18%. As well, the individual stock A has say 4% standard deviation and Stock B has a standard deviation of say 7%, and they have a negative correlation say – (-0.85) then by combining in given proportions of stock A and Stock B an investor can reduce the overal risk of the portfolio mean return and optimize returns by manipulating the weights of stock a and stock B. The risk is reduced because the stocks returns are negatively correlated and there fore the risk will be less than the weighted average risk of the portfolio.
In effect, Portfolio Theory of Investment explains why the risk is reduced and helps an investor to optimize returms with little information and fundermental analysis of the individual companies. In other words the Portfolio Theory of Investment highlights the importance for an investor not to invest in one stock but to invest in a Portfolio of stock and bonds and Treeasury Bills so that he can minimize risk and maximize his return given his risk preference. As well, Portfolio Theory of Investment can be used if one knows the beta of stocks to calcualte the expected return of equity using the Capital Asset Pricing Model, which is essential to evaluate capital budgeting decision making. That is, Portfolio Theory of Investment is the basis of the Capital Asset pricing Model and is used in modern fianancial management of a company.
In efffect Portfolio Investment Theory is an indispensable theory, which assist an investor to design appropriate portfolios of stocks more than two so that it maximizes reurns and reduces the risk of the portfolio as a whole. As well, It also assist a financial manger to calculate expected rate of equity using the Capital Asse pricing Model to evaluate the value of the Business or to evalaute capital budgeting using appropriate risk adjusted rate of return on equity.