Portfolio theory

Portfolio theory is a theory of the relationship between risk and return. In portfolio theory, the total risk is divided in two types of risk, market risk and unique risk.

Market risk can not be diversified away by buying a stock portfolio with many different stocks. There is a direct relationship between risk and return according to portfolio theory. If we want a higher return on our portfolio, we must accept a higher risk.

The market portfolio is a portfolio of stocks where the unique risk has been diversified away. The market portfolio includes all the shares on the market.

According to portfolio theory, the market portfolio gives the best ratio between return and risk. The market portfolio is the most efficient portfolio to hold for an equity investor. That's why people say that you not should put all your eggs in one basket.