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After the completion of the IPS, the next step is its implementation. A variety of quantitative and qualitative portfolio construction approaches are available for this stage. We will focus our attention on the mean-variance approach, as it is the best-known approach, and most of the subsequent developments in this area have attempted to improve on its shortcomings. Some of these approaches are discussed in the next chapter.

Earlier, this chapter discussed how the general expected utility approach could be used to represent preferences in terms of moments of a portfolio's return distribution. In particular, we noted that optimal portfolios could be constructed by selecting the weights such that the following function is maximized:

(1.12)

where μ is the expected return on the portfolio, λ is a parameter that represents the risk-aversion of the asset owner, and σ² is the variance of the portfolio's return. The next section provides a more detailed description of this portfolio construction technique and examines the solution under some specific conditions. Later sections will discuss some of the problems associated with this portfolio optimization technique and offer some of the solutions that have been proposed by academic and industry researchers.