Sharpe Ratio:

The idea of the ratio is to see how much additional return you are receiving for the additional volatility of holding
the risky asset over a risk-free asset - the higher the better.

The Sharpe ratio is a risk-adjusted measure of return that is often used to evaluate the performance of a
portfolio. The ratio helps to make the performance of one portfolio comparable to that of another portfolio by
making an adjustment for risk.

For example, if manager A generates a return of 15% while manager B generates a return of 12%, it would appear
that manager A is a better performer. However, if manager A, who produced the 15% return, took much larger
risks than manager B, it may actually be the case that manager B has a better risk-adjusted return.

To continue with the example, say that the risk free-rate is 5%, and manager A's portfolio has a standard
deviation of 8%, while manager B's portfolio has a standard deviation of 5%. The Sharpe ratio for manager A
would be 1.25 while manager B's ratio would be 1.4, which is better than manager A. Based on these calculations,
manager B was able to generate a higher return on a risk-adjusted basis.

To give you some insight, a ratio of 1 or better is considered good, 2 and better is very good, and 3 and better is
considered excellent.

Diversification:

A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind
this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns
and pose a lower risk than any individual investment found within the portfolio.

Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of
some investments will neutralize the negative performance of others. Therefore, the benefits of diversification
will hold only if the securities in the portfolio are not perfectly correlated.

Unsystematic risk:

Company- or industry-specific (factors) hazard that is inherent in each investment. Unsystematic risk, also known
as “nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," can be reduced through
diversification. By owning stocks in different companies and in different industries.
Systematic risk:

The risk inherent to the entire market or an entire market segment. Systematic risk, also known as
“undiversifiable risk,” “volatility” or “market risk,” affects the overall market, not just a particular stock or
industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated
through diversification, only through hedging or by using the right asset allocation strategy.

Markowitz Portfolio Theory/Modern Portfolio Theory:

A theory on how risk-averse investors can construct portfolios to optimize or maximize expected return based
on a given level of market risk, emphasizing that risk is an inherent part of higher reward.

MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a
collection of investment assets that has collectively lower risk than any individual asset. This is possible,
intuitively speaking, because different types of assets often change in value in opposite ways. For example, to
the extent prices in the stock market move differently from prices in the bond market, a collection of both types
of assets can in theory face lower overall risk than either individually.

More technically, MPT models an asset's return as a normally distributed function (or more generally as an
elliptically distributed random variable), defines risk as the standard deviation of return, and models a portfolio
as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets'
returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce
the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient.

An investor can reduce portfolio risk simply by holding combinations of instruments that are not perfectly
positively correlated. In other words, investors can reduce their exposure to individual asset risk by holding a
diversified portfolio of assets. Diversification may allow for the same portfolio expected return with reduced
risk.

Efficient Frontier:

The “Efficient Frontier” is a modern portfolio theory tool that shows investors the best possible return they can
expect from their portfolio, given the level of risk that they’re willing to accept.

A set of optimal portfolios that offers the highest expected return for a defined level of risk or the lowest risk for
a given level of expected return. Portfolios that lie below the efficient frontier are sub-optimal, because they do
not provide enough return for the level of risk. Portfolios that cluster to the right of the efficient frontier are also
sub-optimal, because they have a higher level of risk for the defined rate of return.
Capital Market Line:

The method to determine the best position on the efficient frontier line is the capital market line
(CML). The capital market line is, graphically, a tangent line that can be drawn on a graph, connecting
the return of risk-free-asset with the efficient market frontier. An investor is only willing to accept
higher risk if the return rises proportionally. The CML shows where the most efficient portfolio lies on
the efficient frontier line.
 Formulae

Rates of Return: Single Period:

HPR = Holding Period Return

 
HPR  P1 P0 D1
P0 P0 = Beginning price

P1 = Ending price

D1 = Dividend during period one

E (r )   p ( s )r ( s )
s • p(s) = Probability of a state

• r(s) = Return if a state occurs

• s = State
 2   ps r s   E r 2
s

𝑐𝑜𝑣(𝐴, 𝐵) = ∑ 𝑝(𝑠) ∗ [𝑟𝐴 (𝑠) − 𝐸(𝑟𝐴 )] [𝑟𝐵 (𝑠) − 𝐸(𝑟𝐵 )]

𝐴𝑙𝑙 𝑆𝑡𝑎𝑡𝑒𝑠

Expected Value of Portfolio (A , B)

EP[r] is given by

EP[r]=wAEA[r]+wBEB[r]

EP[r]=wAEA[r]+wBEB[r]+wCEC[r]+wDED[r]+…………