Ch 11 Flashcards
Two assumptions about investors
- Investors prefer more return to less return
2. Investors prefers less risk to more risk
Expected return
Average return on a risky asset expected in the future
Risk premium
Difference between returns on a risky investment and a risk free investment
Projected/ expected risk premium
Difference between the expected return on a risk investment and the certain return on a risk free investment
Risk premium formula
Expected return (Rj) - risk free rate (Rf)
Portfolio
Groups of assets suck as stocks and bonds held by and investor
Portfolio weights
Percentage of a portfolios total value invested in a particular asset
Standard deviation _____ as number of securities increases
Declines
Diversification
The process of spreading an investment across assets and thereby forming a portfolio
Principle of diversification
Says spreading an investment a cross many assets will eliminate some of the risk
Diversifiable risk
Risk that can be eliminated by diversification
Nondiversifiable risk
The minimum level of risk that cannot be eliminated by simply diversifying
Time diversification fallacy
Although stocks are more volatile in any given hrs, over time this volatility cancels itself out
Correlation
Extent to which the returns on two assets move together
Positively correlated
Returns on two assets move up and down together
Negatively correlated
Returns on two assets move opposite of each other
Correlation coefficient
Ranges from -1 to 1, 1 is perfect positive correlation, 0 is incorrelated,
Asset allocation
How an investor spreads portfolio dollars among assets
Investment opportunity
Collection of possible risk-return combinations available from portfolios of individual assets
Dominated/ inefficient portfolios
Given their level of risk, the expected return is inadequate compared to some other portfolio of equivalent risk
Efficient Portfolio
A portfolio that offers the highest return for its level of risk
Markowitz efficient frontier
Ten set of portfolios with the maximum return for a given standard deviation
Primary reason Markowitz is not extended to large collections of individual assets
The inputs into the analysis are expected returns on assets, standard deviations on all assets, and correlations between every pair of assets
Why is diversification important
Portfolios with many investments usually produce a more consistent and stable total return than portfolios with one investment
