7 Portfolio Theory

Question 1

What is the adjustment process?

Answer 1

• This is how participants become aware and incorporate new information
• The price movement doesn’t have to be instantaneous for the efficient market hypothesis to hold

Question 2

The Relationship between Risk and Return

Answer 2

• There is a direct relationship between risk and return
  o The higher the risk the higher the return

Question 3

Peoples tolerance to risk

Answer 3

• People vary in their tolerance to risk, but most people do not like risk
  o We assume people will trade off between the two and accept higher risk when there is the demand for the return

Question 4

What is the optimal combination of risk and return

Answer 4

This will be at the highest amount of return for a given risk
Or
The lowest level of risk for an expected return

Question 5

What are the components of return on a stock

Answer 5

Capital Appreciation and Income

Question 6

Why does higher risk give higher returns?

Answer 6

The investors demand the higher returns as they want to be compensated for taking on more risk

Question 7

How can you reduce risk with diversification?

Answer 7

• By investing in two or more assets whose returns do not always move in the same direction at the same time, investors can reduce risk in their investment portfolios
• Returns for individuals stocks are largely independent of each other and approximately normally distributed. A tool for comparing risk and return for

Question 8

What are the limits on diversification benefits

Answer 8

• When the number of assets in a portfolio is large, adding another stock has almost no effect on the standard deviation
• Most risk reduction from diversification may be achieved with 15-20 assets
• Diversification can virtually eliminate risk unique to individual assets, but the risk common to all assets in the market remains

Question 9

Types of risk that can be reduced by diversification

Answer 9

• Firm specific risk relevant for a particular firm can be diversified away and is called diversifiable, unsystematic or unique risk
• Risk that cannot be diversified away is non-diversifiable, or systematic risk. This is the risk inherent in the market or economy
• Firm-specific risk is, in effect, reduced to zero in a diversified portfolio but some systematic risk will always remain.

Question 10

What is unsystematic risk

Answer 10

Risk specific to the company / industry
Can be diversified

Question 11

What is systematic risk

Answer 11

Wider macro economic issues
Cannot be diversified

Question 12

What is the portfolio efficiency frontier

Answer 12

This is the North-Western Boundary of the Feasible set

Question 13

What are the underlying assumptions of portfolio theory

Answer 13

• The characteristics of a project can be captured by just two characteristics
  o Expected return and risk
• All projects are infinitely divisible
• We are concerned with a single period time horizon
• Investors are rational, risk adverse, utility maximisers