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The portfolio perspective refers to evaluating individual investments by their contribution to the risk and return of an investor's portfolio. The alternative to taking a portfolio perspective is to examine the risk and return of individual investments in isolation. An investor who holds all his wealth in a single stock because he believes it to be the best stock available is not taking the portfolio perspective — his portfolio is very risky compared to holding a diversified portfolio of stocks. Modern portfolio theory concludes that the extra risk from holding only a single security is not rewarded with higher expected investment returns. Conversely, diversification allows an investor to reduce portfolio risk without necessarily reducing the portfolio's expected return.

In the early 1950s, the research of Professor Harry Markowitz provided a framework for measuring the risk-reduction benefits of diversification. Using the standard deviation of returns as the measure of investment risk, he investigated how combining risky securities into a portfolio affected the portfolio's risk and expected return. One important conclusion of his model is that unless the returns of the risky assets are perfectly positively correlated, risk is reduced by diversifying across assets.

In the 1960s, professors Treynor, Sharpe, Mossin, and Lintner independently extended this work into what has become known as modern portfolio theory (MPT). MPT results in equilibrium expected returns for securities and portfolios that are a linear function of each security's or portfolio's market risk (the risk that cannot be reduced by diversification).

One measure of the benefits of diversification is the diversification ratio. It is calculated as the ratio of the risk of an equally weighted portfolio of $n$ securities (measured by its standard deviation of returns) to the risk of a single security selected at random from the $n$ securities. If the average standard deviation of returns for the $n$ stocks is $25\%$, and the standard deviation of returns for an equally weighted portfolio of the $n$ stocks is $18\%$, the diversification ratio is $18 / 25 = 0.72$. If the standard deviation of returns for an equally weighted portfolio is $25\%$, there are no diversification benefits and the diversification ratio equals one. A lower diversification ratio indicates a greater risk-reduction benefit from diversification.

While the diversification ratio provides a quick measure of the potential benefits of diversification, an equal-weighted portfolio is not necessarily the portfolio that provides the greatest reduction in risk. Computer optimization can calculate the portfolio weights that will produce the lowest portfolio risk (standard deviation of returns) for a given group of securities.

There are three major steps in the portfolio management process:

1. Step 1:Planning. Begins with an analysis of the investor's risk tolerance, return objectives, time horizon, tax exposure, liquidity needs, income needs, and any unique circumstances or investor preferences. This analysis results in an investment policy statement (IPS) that details the investor's investment objectives and constraints. It should also specify an objective benchmark (such as an index return) against which the success of the portfolio management process will be measured. The IPS should be updated at least every few years and any time the investor's objectives or constraints change significantly.
2. Step 2:Execution. Involves an analysis of the risk and return characteristics of various asset classes to determine how funds will be allocated to the various asset types. Often, in what is referred to as a top-down analysis, a portfolio manager will examine current economic conditions and forecasts of macroeconomic variables (GDP growth, inflation, interest rates) to identify the asset classes that are most attractive. The resulting portfolio is typically diversified across asset classes such as cash, fixed-income securities, publicly traded equities, hedge funds, private equity, and real estate, as well as commodities and other real assets. Once the asset class allocations are determined, security analysts use model valuations to identify undervalued securities — this is termed bottom-up security analysis.
3. Step 3:Feedback. Over time, investor circumstances will change, risk and return characteristics of asset classes will change, and the actual weights of the assets in the portfolio will change with asset prices. The portfolio manager must monitor these changes and rebalance the portfolio periodically in response, adjusting the allocations to the various asset classes back to their desired percentages. The manager must also measure portfolio performance and evaluate it relative to the return on the benchmark portfolio identified in the IPS.

Individual investors save and invest for a variety of reasons, including purchasing a house or educating their children. In many countries, special accounts allow citizens to invest for retirement and to defer any taxes on investment income and gains until the funds are withdrawn. Defined contribution pension plans are popular vehicles for these investments.

Many types of institutions have large investment portfolios:

• Endowment — a fund dedicated to providing financial support on an ongoing basis for a specific purpose (e.g., a university endowment).
• Foundation — a fund established for charitable purposes to support specific activities or research. A typical foundation's investment objective is to fund the activity on a continuing basis without decreasing the real (inflation adjusted) value of portfolio assets. Foundations and endowments typically have long investment horizons, high risk tolerance, and (aside from planned spending) little need for additional liquidity.
• Banks — the investment objective is to earn more on loans and investments than the bank pays for deposits. Banks seek to keep risk low and need adequate liquidity to meet investor withdrawals.
• Insurance companies — invest customer premiums to fund customer claims as they occur. Life insurers have a relatively long-term investment horizon, while property & casualty (P&C) insurers have a shorter horizon because claims are expected to arise sooner.
• Investment companies / mutual funds — manage pooled funds in particular styles (index, growth, bond) and may restrict to subcategories (large-cap, energy, speculative bonds) or regions (emerging markets, international bonds, Asian equities).
• Sovereign wealth funds — pools of assets owned by a government. Example: the Abu Dhabi Investment Authority, funded by Abu Dhabi government surpluses, has approximately USD 700 billion in assets.

A defined contribution (DC) pension plan is a retirement plan in which the firm contributes a sum each period to the employee's retirement account. The firm's contribution can be based on years of service, the employee's age, compensation, profitability, or even a percentage of the employee's contribution. In any event, the firm makes no promise regarding the future value of the plan assets. The investment decisions are left to the employee, who assumes all of the investment risk.

In a defined benefit (DB) pension plan, the firm promises to make periodic payments to employees after retirement. The benefit is usually based on the employee's years of service and the employee's compensation at, or near, retirement. For example, an employee might earn a retirement benefit of 2% of her final salary for each year of service. Consequently, an employee with 20 years of service and a final salary of \$100,000 would receive \$40,000 (= \$100,000 × 2% × 20 years) each year upon retirement until death. Because the employee's future benefit is defined, the employer assumes the investment risk. Poor investment performance increases the amount of required employer contributions to the fund.

The asset management industry comprises firms that manage investments for clients. Asset management firms include both independent managers and divisions of larger financial services companies. They are referred to as buy-side firms, in contrast with sell-side firms such as broker-dealers and investment banks.

Full-service asset managers offer a variety of investment styles and asset classes. Specialist asset managers may focus on a particular investment style or a particular asset class. A multi-boutique firm is a holding company that includes a number of different specialist asset managers.

A key distinction is between active and passive management. Active management attempts to outperform a chosen benchmark through manager skill (e.g., fundamental or technical analysis). Passive management attempts to replicate the performance of a chosen benchmark index — including traditional broad market index tracking or a smart beta approach focused on exposure to a particular market risk factor. Passive management represents about one-fifth of assets under management; its share of industry revenue is even smaller because passive fees are lower than active fees.

Asset management firms may also be classified as traditional or alternative. Traditional managers focus on equities and fixed-income securities. Alternative managers focus on private equity, hedge funds, real estate, or commodities. Profit margins tend to be higher for alternatives, so many traditional managers are moving into this area, somewhat blurring the distinction.

Some industry trends:

• The market share for passive management has been growing — driven by lower fees and questions about whether active managers can add risk-adjusted value, especially in efficient developed markets.
• The amount of data available to asset managers has grown exponentially, prompting heavy investment in IT and third-party services to capitalize on information quickly.
• Robo-advisors use computer algorithms to offer advice based on investor requirements and constraints. They appeal to younger investors and those with smaller portfolios, and have lowered the barriers to entry into the industry (including for insurance companies).

Mutual funds are one form of pooled investments (a single portfolio that contains funds from multiple investors). Each investor owns shares representing a portion of the overall portfolio. The total net value of fund assets divided by the number of shares is the net asset value (NAV) per share.

With an open-end fund, investors can buy newly issued shares at the NAV; newly invested cash is invested by the managers in additional portfolio securities. Investors can redeem shares (sell back to the fund) at NAV. All mutual funds charge an ongoing management fee expressed as a percentage of NAV. No-load funds charge no up-front or redemption fees; load funds charge up-front fees, redemption fees, or both.

Closed-end funds are professionally managed pools that do not take new investments or redeem investor shares. Their shares trade like equity (on exchanges or OTC). The portfolio management firm still charges ongoing management fees.

Types of mutual funds:

• Money market funds — invest in short-term debt; provide interest income with very low risk of NAV change. NAVs are typically set to one currency unit, though some have "broken the buck" when securities dropped sharply. Differentiated by types of money market securities and average maturities.
• Bond mutual funds — invest in fixed-income, differentiated by maturities, credit ratings, issuers, and types: government bond funds, tax-exempt bond funds, high-yield bond funds, global bond funds.
• Stock mutual funds — index funds are passively managed to match an index (e.g., S&P 500). Actively managed funds select securities with the goal of beating their benchmark. Actively managed funds have higher fees, higher portfolio turnover, and tend to generate greater tax liabilities than passive index funds.

Other forms of pooled investments:

• Exchange-traded funds (ETFs) — similar to closed-end funds in that purchases and sales are made in the market rather than with the fund. However, ETFs are most often passively managed (closed-end funds are often actively managed). Special redemption provisions for ETFs are designed to keep their market prices very close to NAV (versus closed-end funds whose price can deviate significantly). ETFs can be sold short, purchased on margin, and traded at intraday prices, whereas open-end funds are typically sold/redeemed only daily at closing-NAV. ETF investors pay brokerage commissions and a bid-ask spread; dividends are typically received in cash (open-end funds offer dividend reinvestment). ETFs generally have lower capital gains liability than open-end index funds, because ETF share sales do not force the fund to sell securities.
• Separately managed accounts (SMA) — a portfolio owned by a single investor and managed according to that investor's needs and preferences. No shares are issued.
• Hedge funds — pools of investor funds not regulated to the extent that mutual funds are. Limited number of investors, often sold only to qualified investors with substantial portfolio wealth. Minimum investments are typically high — between \$250,000 and \$1 million.
• Private equity and venture capital funds — invest in portfolios of companies, often with the intention to sell them later in public offerings. Managers of such funds may take active roles in managing the companies in which they invest.