Podcast
Questions and Answers
Which asset is considered 'dominated'?
Which asset is considered 'dominated'?
What type of investor would prefer Asset C according to the text?
What type of investor would prefer Asset C according to the text?
Which asset would be best suited for an investor not overly risk-averse and not quite risk-neutral according to the text?
Which asset would be best suited for an investor not overly risk-averse and not quite risk-neutral according to the text?
What aspect should an investor consider when choosing among undominated assets?
What aspect should an investor consider when choosing among undominated assets?
Signup and view all the answers
In portfolio optimization, which combination does the text suggest by allowing investment in cash (asset A) and another asset?
In portfolio optimization, which combination does the text suggest by allowing investment in cash (asset A) and another asset?
Signup and view all the answers
What is the primary reason for preferring assets closer to X and further away from Y as mentioned in the text?
What is the primary reason for preferring assets closer to X and further away from Y as mentioned in the text?
Signup and view all the answers
How does holding both assets in a portfolio affect the standard deviation compared to holding them individually?
How does holding both assets in a portfolio affect the standard deviation compared to holding them individually?
Signup and view all the answers
In a perfectly negatively correlated scenario (R = -1), what happens to the means and standard deviations of the combined assets B and C?
In a perfectly negatively correlated scenario (R = -1), what happens to the means and standard deviations of the combined assets B and C?
Signup and view all the answers
How is risk affected when investing in a portfolio of risky assets B and C if they are imperfectly correlated?
How is risk affected when investing in a portfolio of risky assets B and C if they are imperfectly correlated?
Signup and view all the answers
What happens to the risk level at point Z on the graph in Figure 5 when judiciously choosing the fraction of money invested in asset B?
What happens to the risk level at point Z on the graph in Figure 5 when judiciously choosing the fraction of money invested in asset B?
Signup and view all the answers
How does diversification impact expected return in a portfolio?
How does diversification impact expected return in a portfolio?
Signup and view all the answers
What mathematical formula represents the standard deviation of a portfolio combining assets B and C, considering their correlation and fractions invested?
What mathematical formula represents the standard deviation of a portfolio combining assets B and C, considering their correlation and fractions invested?
Signup and view all the answers
What is the primary focus of portfolio theory?
What is the primary focus of portfolio theory?
Signup and view all the answers
In the context of portfolio theory, what does the mean represent?
In the context of portfolio theory, what does the mean represent?
Signup and view all the answers
How does standard deviation relate to total return in portfolio theory?
How does standard deviation relate to total return in portfolio theory?
Signup and view all the answers
What did Harry Markowitz formalize in 1952 that became a cornerstone of modern financial theory?
What did Harry Markowitz formalize in 1952 that became a cornerstone of modern financial theory?
Signup and view all the answers
For a bell-shaped distribution of total return, how often would one expect the actual return to fall within two standard deviations of the mean?
For a bell-shaped distribution of total return, how often would one expect the actual return to fall within two standard deviations of the mean?
Signup and view all the answers
What role does diversification play in an investment portfolio according to portfolio theory?
What role does diversification play in an investment portfolio according to portfolio theory?
Signup and view all the answers
Study Notes
Portfolio Theory
- Portfolio theory is concerned with the risk-reducing role played by individual assets in an investment portfolio of several assets.
- Harry Markowitz formalized the benefits of diversification in 1952 and was awarded the Nobel Prize in economics for this work.
Means and Standard Deviations of Total Return
- The return and risk of an asset are commonly measured in terms of the mean and standard deviation of total return.
- Total return represents income plus capital gains or losses.
- The mean is the return one expects to obtain on average.
- Standard deviation is a measure of dispersion, in this case total volatility of return.
Properties of Standard Deviation
- For bell-shaped distributions, the return one actually experiences will fall within:
- One standard deviation to either side of the mean about 68% of the time.
- Two standard deviations about 95% of the time.
- Three standard deviations about 99.7% of the time.
Diversification
- Holding both assets in a portfolio leads to a reduction in risk without sacrificing expected return.
- Diversification can be illustrated graphically, showing the combination of assets B and C.
- When B and C are perfectly negatively correlated (R = -1), the portfolio can have zero risk by choosing the right fraction of money invested in B.
Undominated Assets
- Assets are said to be dominated if they have lower expected returns and higher standard deviations than others.
- In a graph of expected returns vs. standard deviations, dominated assets can be easily ruled out.
- The choice among undominated assets depends on the investor's risk tolerance.
Portfolios of a Riskless and a Risky Asset
- A portfolio of a riskless asset (e.g., cash) and a risky asset can reduce risk without sacrificing expected return.
- The optimal choice of assets depends on the investor's risk tolerance.
Studying That Suits You
Use AI to generate personalized quizzes and flashcards to suit your learning preferences.
Description
Learn about the benefits of holding a diversified portfolio in finance. Understand how combining assets can lead to lower risk without sacrificing expected return. Explore the concept graphically and discover the impact of correlation on portfolio outcomes.
