Un-Intimidating Portfolio Theory and Statistics

Abstract

This paper introduces the necessary statistical background for portfolio theory in an intuitive manner. By using two asset portfolio examples, the financial concept of diversification emerges along with the statistical concepts of covariance and correlation. Further, an algorithm is produced for generating an efficient frontier for a two asset portfolio. When introducing the risk free security as a third asset in the portfolio, a similar algorithm produces the weights for the two risky asset "tangency portfolio" and correspondingly a capital allocation line. By understanding these basic concepts, the student is prepared to take on the challenge of more rigorous multi-asset portfolios.

Keywords: Statistics, Portfolio Theory, Capital Allocation Line, Pedagogy

JEL Classification: G10, G11