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Chapter 6

Chapter 6. Efficient Diversification. In previous chapters, we have calculated returns on various investments. In chapter 5, we used the standard deviation of returns as a measure of total risk. Now, we look at what happens to returns and risk when assets are combined into portfolios .

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Chapter 6

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  1. Chapter 6 Efficient Diversification

  2. In previous chapters, we have calculated returns on various investments. • In chapter 5, we used the standard deviation of returns as a measure of total risk. • Now, we look at what happens to returns and risk when assets are combined into portfolios. Risk and Return

  3. The return on a portfolio is a weighted average of the returns on the assets in the portfolio. • If 2 or more assets with equal expected returns are combined, the expected return on the portfolio equals the expected return of the individual assets. Portfolio Returns

  4. In general, the risk (standard deviation) of a portfolio is lowerthan the risk of the individual assets. • This reduction in risk is referred to as diversification. • Diversification can reduce risk, but cannot eliminate it. Portfolio Risk

  5. On average, the standard deviation of returns of a single stock is about 35-40%. • The standard deviation of returns of the S&P 500 is 20%. • By investing in an S&P 500 index, the risk is about half as great as investing in a single stock. • You still face the risk of a decline in the market: market risk. Portfolio Risk

  6. Market or systematic risk: risk related to macroeconomic conditions, or of a decline in the overall market • Nonsystematic or firm specific risk: risk that is unique to a particular industry or firm • Total risk = Systematic + Nonsystematic Components of Risk

  7. Three terms that are used interchangeably are: • Market risk • Systematic risk • Nondiversifiable risk These refer to the part of risk that cannot be eliminated by diversification Market risk

  8. Four terms used interchangeably: • Nonsystematic risk • Firm-specific risk • Diversifiable risk • Unique risk These refer to the part of risk that can be eliminated by diversification Nonsystematic Risk

  9. To maximize the risk reduction benefit of diversification, combine securities whose returns have a low (or negative) correlation. Portfolio Risk

  10. An efficient portfolio is one that offers: • The lowest risk for a given expected return • Or, the highest expected return for a given risk level Efficient Portfolio

  11. The optimal combinations result in lowest level of risk for a given return • The optimal trade-off is described as the efficient frontier, or investment opportunity set • Portfolios on the efficient frontier dominate all other portfolios of risky assets Extending Concepts to All Securities

  12. The minimum-variance frontier of risky assets E(r) Efficient frontier Individual assets Global minimum variance portfolio Minimum variance frontier St. Dev.

  13. The optimal combination becomes linear • The optimal portfolio of risky assets (M) combined with the riskless asset will dominate • Combinations of the risk-free asset and a risky asset or portfolio of risky assets is referred to as a CAL, or capital allocation line. Extending to Include Riskfree Asset

  14. ALTERNATIVE CALS CAL (M) CAL (B) E(r) B B M M CAL (Global minimum variance) G rf s M rf&M B

  15. CAL(M) dominates other lines -- it has the best risk/return tradeoff or the steepest slope. It is referred to as the Capital Market Line, or CML. Regardless of risk preferences combinations of M & rf dominate Dominant CAL with a Riskfree Investment

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