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The Role of Portfolio Theory in Risk Management and Investment
Decision Making
1

2

Syahriatul Mahmudah , Widi Lstiyas Rini , Aditya Maulana Majid

3

Departemen of Magister Manjamen, Institut Teknologi dan Bisnis Widya Gama Lumajang, Indonesia1,2,3
Corresponding Author: widilistiyas@gmail.com

ARTICLE INFO

ABSTRACT

Date of entry:
27 April 2024

This article discusses the important role of portfolio theory in the
context of risk management and investment decision making.
Portfolio theory, introduced by Harry Markowitz in 1952, has
become a major foundation in the world of finance. The basic
concept of this theory regarding asset diversification to achieve a
desired level of return with acceptable risk, provides a strong
scientific foundation in risk management and investment decision
making. In this article, we review the basic concepts of portfolio
theory, diversification strategies, and their application in
managing risk holistically. In addition, this article also discusses
how portfolio theory helps investors make more informed
investment decisions by analyzing risks and returns rationally.
Based on previous research, we also explore the contribution of
portfolio theory in creating company value and provide practical
guidance for investors in forming efficient portfolios. Thus, this
article provides a more comprehensive understanding of the
relationship between risk, investment, and company value as well
as the importance of portfolio theory in achieving financial goals.

Revision Date:
20 May 2024
Date Received:
28 May 2024

Keywords: Investment Decision Makin, Portifolio Theory, Risk
Management.
Cite this as: xxx

INTRODUCTION
Portfolio theory, which was first introduced by Harry Markowitz in 1952, has become the main
foundation in risk management and investment decision making. This theory's basic concept of
diversifying assets to achieve a desired level of return with acceptable risk provides a strong
scientific foundation in the world of finance.(Liestyowati et al., 2023)One of the main pillars of
portfolio theory is diversification, which aims to reduce risk by spreading investments across
different assets(Nurid, 2017). In this context, portfolio theory helps manage risk by avoiding
reliance on the performance of individual stocks and reducing the impact of significant price
fluctuations(Management, 2023). Risk management is a crucial aspect of investing, and portfolio
theory provides guidance in identifying, assessing and managing risks systematically. This
framework involves not only diversification, but also effective risk mitigation strategies to protect
capital(Siregar & Amalia, 2020). Risk management involves a series of steps such as risk
identification, risk assessment, development of mitigation strategies, and monitoring(Septyanto,
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2013). Portfolio theory provides insight into how to integrate these components in an investment
context(Yunita Wulan Dewi & Sri Darma, 2019).
Investment decisions involve asset selection, portfolio allocation, and configuration of financial
instruments. In this case, portfolio theory provides a rational risk and return analysis guide, helping
investors make informed investment decisions(Halimah, 2020). The close relationship between
portfolio theory and risk management can be seen through portfolio diversification(Prastika,
2022). Diversification not only reduces specific risks, but also helps manage systematic risk or
market risk by dealing with market fluctuations more resiliently( et al., 2021). Market Influence
and Investor Behavior: Portfolio theory not only takes market factors into account, but also takes
into account investor behavior. The gap between rational and irrational behavior is the focus in
investment decision making, which is integrated with the concept of portfolio theory. Portfolio
evaluation through performance measurement is an integral part of investment decision making.
Portfolio theory provides metrics such as the Sharpe ratio and Jensen index to evaluate portfolio
performance in a more measurable manner(Putra & Yadnya, 2016).
With ever-changing market dynamics, portfolio theory continues to evolve to understand and adapt
to changes in the investment environment(Mardhiyah, 2017). Innovation in financial instruments is
also a focus for understanding how to best exploit opportunities and manage risks. Factor models,
such as models that consider specific and systematic risk factors, are also closely related to
portfolio theory. The integration of factor models strengthens risk analysis and investment decision
making in more complex contexts(Agil et al., 2023). Previous research entitled The Effect of
Portfolio Diversification on Risk Management and Investment Performance: Analysis of
Individual Investors.(Liestyowati et al., 2023)details the impact of portfolio diversification on risk
management and investment performance among individual investors in Jakarta, Indonesia, using
a sample of 110 investors through a structured survey. Overall, this research presents findings that
can provide valuable insights in the context of investment decision making and risk management
at the individual level. In the analysis of research results, it can be seen that portfolio
diversification plays a central role in reducing investment risk. The significant negative correlation
with standard deviation and beta confirms that diversification strategies are effective in managing
market volatility and risk. These results are in line with the principles of Modern Portfolio Theory,
where spreading investments across multiple asset classes is considered a smart approach to
achieving these goals.
The Influence of Risk Management, Intellectual Capital and Profitability on Company
Value(Halimah, 2020). This research aims to empirically test the influence of risk management,
intellectual capital and profitability on company value, with a focus on food and beverages
companies listed on the Indonesia Stock Exchange during the 2015-2018 period. The research
finding that risk management variables have a positive effect on company value shows the
importance of good risk management in improving company performance. This is consistent with
literature that identifies risk management as a key factor in the formation of corporate value.
Corporate Governance as a Risk Management Mechanism to Increase Company Value(Triyuwono
et al., 2020). This research aims to examine the relationship between corporate governance, risk
and company value with a focus on companies listed on the Indonesia Stock Exchange (BEI)
during the 2013-2018 period. Research findings state that corporate governance has a positive and
significant influence on risk. Meanwhile, risk has a positive and significant influence on company
value. This point shows the important role of corporate governance in shaping the level of risk and
value of the company.
Based on the analysis of previous research above which examines factors such as portfolio
diversification, risk management, intellectual capital, and corporate governance on company value,
several concepts and findings can be found that can contribute to the novelty of the research title
"The Role of Portfolio Theory in Risk Management and Investment Decision Making.” Which can
provide novelty by emphasizing that portfolio theory is not only a framework for diversification,
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but can also play a role in holistic risk management and provide a stronger basis for making smart
investment decisions. The integration of corporate governance concepts can also provide a new
dimension in understand how company policies can shape risk management and overall company
value. Thus, the title broadens the scope of portfolio theory and provides a more comprehensive
understanding of the relationship between risk, investment, and company value.

METHODS
This research uses the literature study research method, an approach carried out by analyzing and
synthesizing relevant literature in a particular research field. Literature studies aim to develop an
in-depth understanding of the research topic, identify conceptual frameworks, and evaluate
existing findings. Literature studies help researchers to understand the development of knowledge
in a particular field (Webster, 2014). By detailing the steps of topic identification, selection of
information sources, data search and collection, literature analysis and synthesis, researchers can
form a strong conceptual framework for future research.

RESULTS AND DISCUSSION
Based on the results of a review of 6 journals and 1 book, it was found that the role or influence of
Portfolio theory on risk management and decision making is as follows:
In the first journal, the concept of modern portfolio theory is explained which is based on the
understanding that most investors tend to avoid risk. This theory teaches how to combine shares in
a portfolio to achieve maximum profits with a certain level of risk or gain profits with minimal
risk. A strategy to reduce risk in investment is to diversify shares to form a portfolio. Portfolio
refers to a collection of financial assets in one unit that is managed or owned by an investor,
investment company, or institutionfinance(Anggraini, 2013). The basis of this portfolio theory is
the recognition that generally investors in securities, or financial assets, do not invest all their
capital in one type of stock, but rather allocate it to various types of stock. In other words, the
principle of diversification is the main focus for parainvestors(Herdiyana, 2009). In this literature
study, the journal authors explore the use of Management Information Systems (MIS) as a tool for
forming optimal portfolios. Portfolio theory is applied in the investment context to design optimal
portfolios, and one of the techniques used is the Single Index Model (SIM). SIM is an approach
where all aspects related to the calculation of securities are consolidated through a formula known
as a single index model. In this journal, it is stated that through this calculation, investors can more
easily make decisions within the framework of a single index model, which is a method for
identifying securities that can form an optimal portfolio. This model is an effort to simplify the
Markowitz model, which considers various aspects so that the results can provide better assistance
for investors in decision making. Therefore, being a careful and informed investor involves the
application of portfolio theory as well as its implementation in investment practice.
Then from further literature sources, there are 2 journals that apply optimal portfolio formation to
analyze decision making with case studies in the banking sector and a compass index of 100. In
the second journal, the results of trial calculations show that there are 9 out of 35 banking shares
that have the optimal portfolio category and from this category produces a return of 0.364% with a
risk of 1.005%. Meanwhile, the same third journal uses a quantitative approach with the type of
research, namely descriptive. This journal has the results that there are 13 company shares out of
34 stock samples that have an optimal portfolio composition with a portfolio return of 2.79% per
month and a risk level of 1.23% per month. The fourth journal, which is slightly different from
other literature journals, discusses the role of portfolios in the context of investment portfolio
diversification as an important strategy in reducing the impact of biased behavior. This has a
relationship in matters related to decision making, especially in the context of investment and risk
management for both companies and MSMEs. Biased behavior is a person's tendency to make
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decisions that may be irrational and influenced by certain experiences, emotions and personal
beliefs. By diversifying your portfolio or spreading your investments across various assets, fatal
risks caused by behavioral biases such as overconfidence and loss aversion can be easily
considered and reduce their tendency.
Thenin the literature source of the book entitled "Investment Management and Portfolio theory" in
the Portfolio theory chapter it is explained that the form of basic assumptions begins by assuming
that the rate of return on securities in the future can be estimated, right, one can evaluate how risk
tendencies might arise by considering variations in the distribution of returns . Within the
framework of certain assumptions, portfolio theory produces a linear relationship between risk and
return. In this context, the higher the risk associated with an investment or loan, the greater the
expected rate of return to compensate for that risk. In Markowitz's theory, portfolios are related to
investors' estimates of expected risks and returns, which are measured statistically to construct
investment portfolios. In its implementation, investors generally diversify their investment
portfolio by combining various securities, in other words, they form a portfolio. The meaning of
this statement is that in Markowitz's theory, the concept of portfolio is closely related to the
perception or estimate that an investor has regarding the level of risk and expected return from
investment. This theory views a portfolio as a collection of financial assets that are arranged in
such a way based on statistical estimates of risk and return. In practice, investors generally
implement a diversification strategy in their investment portfolio, namely by combining various
types of securities. By carrying out this diversification, they create a portfolio that can help reduce
investment risk and increase potential returns.
Furthermore, in the fifth journal, it explains that the existence of a portfolio can ensure investors'
choices and decisions can help achieve financial goals that have been set more consistently and
can link investors' investments with these goals. Then apart from that, the journal states that
portfolio diversification is the basic idea for investors to avoid the possibility of large losses by not
placing all their assets in just one property. Portfolio diversification is a crucial strategy in
achieving balance in a portfolio; This step involves allocating funds to different asset classes to
reduce dependence on one type of investment. Making smart investment decisions also involves
applying projections, risk management, and portfolio engineering strategies(Arvianita, 2021). And
the sixth journal explains research by Liestyowati, et alemphasizes the vital role of portfolio
diversification in the context of individual investors in Jakarta, Indonesia. This research highlights
several key aspects and the existence of a negative correlation between the level of diversification
and risk indicators, such as standard deviation and beta, this confirms the success of diversification
in managing idiosyncratic and systematic risks. Investors who diversify their portfolios tend to
experience more stable and less volatile investment results. In contrast to the general view that
diversification is detrimental to investment results, our analysis shows that diversification has a
significantly positive impact on investment performance (ROI). This emphasizes the importance of
creating an efficient portfolio to optimize the trade-off between investment risk and return.
Differences in diversification levels based on age and risk tolerance highlight the importance of
adopting a personally tailored investment strategy. Younger investors, with longer investment
horizons and higher risk tolerance, tend to diversify more aggressively, while older investors may
choose a more conservative approach.
From the results of a literature review of 7 sources consisting of 6 journals and 1 book regarding
the role of portfolio theory and its implementation, it can be seen that portfolio theory in business,
namely investment, has a very significant influence.
The Role of Portfolio Theory
Portfolio theory plays a central role in risk management, decision making, and value creation in
the investment context. The basic concept of this theory shows that investors tend to avoid risk,
and a stock diversification strategy in a portfolio is the key to achieving the goal of maximum
profits with measurable risk. Application of portfolio theory through tools such asManagement
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information systems and models such as the Single Index Model (SIM) provide the basis for
designing optimal portfolios. Through a single index model, investors can more easily make
decisions by identifying the securities that form an optimal portfolio, providing a simplification of
the Markowitz model. In decision making, portfolio theory offers the view that forming an optimal
portfolio helps investors make smarter investment decisions. Portfolio diversification is not only a
strategy to manage investment risk, but is also a solution to reduce the impact of biased behavior
such as overconfidence and loss aversion. A diversification strategy is considered a crucial step in
achieving balance in a portfolio, which involves allocating funds to different asset classes.
In addition, portfolio theory contributes to creating company value. Through portfolio
diversification, companies can achieve financial goals more consistently, while implementing this
theory in investment practice helps create added value for companies and investors. The research
results show that portfolio diversification has a significantly positive impact on investment
performance (ROI), creating more stable and less volatile investment results. The importance of
personally tailored investment strategies is also highlighted in the context of portfolio theory. The
correlation between diversification level, investor age, and risk tolerance emphasizes the need to
adapt portfolio strategies according to investor characteristics and preferences. Thus, portfolio
theory is not only a conceptual guide, but also provides practical direction for forming efficient
portfolios, managing risk, and achieving financial goals more consistently.
The Role of Portfolio Theory in Risk Management
Portfolio theory plays an important role in investment decision making by providing a systematic
framework for understanding how investors can achieve their financial goals with acceptable risk.
By understanding the concepts of diversification, asset allocation, and risk measurement, investors
can build a portfolio that is balanced between risk and expected return. Portfolio theory also helps
investors to understand that no single asset is risk-free, but by investing in a diversified manner,
risk can be reduced significantly. In addition, portfolio theory also provides a basis for
understanding the relationship between risk and return, as well as how to choose the optimal
combination of assets to achieve investment goals. By using the principles of portfolio theory,
investors can make investment decisions that are more informed and better suited to their risk
profile and investment objectives.
The Role of Portfolio Theory in Investment Decision Making
Portfolio Theory plays an integral role in investment decision making by providing a
comprehensive framework for investors. By highlighting the importance of risk diversification,
this theory encourages investors to spread their investments across multiple assets, thereby
reducing the negative impact of a single price change. Additionally, portfolio theory helps
investors understand the complex relationship between risk and return, enabling them to choose
the optimal combination of assets according to their investment goals and risk tolerance. It also
helps in determining appropriate asset allocation in a portfolio and provides a framework for
analyzing portfolio performance as well as managing risks systematically. By applying the
principles of portfolio theory, investors can make more informed investment decisions and be
more effective in achieving their financial goals.

CONCLUSION
From the results of research using literature studies, it can be concluded that portfolio theory plays
a very important role in risk management and investment decision making. The basic concepts of
portfolio theory, such as asset diversification and risk measurement, provide a strong foundation
for investors to achieve their financial goals with acceptable risk. Portfolio diversification is the
key to reducing investment risk and creating added value for companies and investors.
In addition, portfolio theory provides systematic guidance in understanding the relationship
between risk and return, as well as in selecting the optimal combination of assets. By applying the
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principles of portfolio theory, investors can make more informed and effective investment
decisions. Thus, portfolio theory is not only a conceptual framework, but also provides practical
direction for forming efficient portfolios, managing risk, and achieving financial goals more
consistently

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