6. Markowitz Portfolio Theory

Question 1

Why are investors’ utility curves important in portfolio theory?

Answer 1

• They indicate the desired tradeoff by investors between risk and return.
• The efficient frontier indicates which portfolio is preferable for the given investor (see notes)
• Because utility curves differ one should expect different investors to select different portfolios on the efficient frontier

Question 2

Explain how an investor chooses an optimal; portfolio. Will this choice always be a diversified portfolio, or could it be a single asset?

Answer 2

• The optimal portfolio is the “point of tangency between his/her set of utility curves and the efficient frontier”
• This will always be a diversified portfolio because almost all the portfolios on the frontier are diversified except for the two end points (minimum variance port. and maximum return port.)

Question 3

Draw a hypothetical graph of an efficient frontier of U.S common stocks. Add U.S. bonds and international stocks and bonds.

Answer 3

(see notes for curve)

• Hypothetical graph has a curved shape (risky assets). Adding bonds will generate a new frontier that is shifted up to the left (as we expect bonds to be less correlated with stocks, therefore more diversification)
• International stocks and bonds further shifts the frontier up and left

Question 4

Covariance of returns

Answer 4

A measure of the degree to which two variables “move together” relative to their individual mean values of time

Question 5

Correlation Coefficient

Answer 5

Standardised measure of association

Question 6

Portfolio risk vs individual security risk

Answer 6

Portfolio risk is always less than the weighted average of the risk of the individual securities in the portfolio unless securities included have perfect correlation (i.e. the closer the correlation to -1.00, the better)