Chapter 4 Portfolio Theory Flashcards
Risk tolerance
Investors ability and willingness to accept risk
Risk capacity
the amount of risk an investor should take based on resources, goals, and time horizon
Life cycle theory
As individuals move from one phase of the life cycle to another their financial planning goals and objectives may change impacting their risk tolerance
Equity glide path
gradual decrease in equity allocation over the life cycle
R-squared
measure of how well diversified portfolio is
calculated by squaring the correlation coefficient
correlation of -1
considered a perfect hedge and will provide an expected return no higher than the risk free rate (tbill rate)
Weighted return
multiply assets % of portfolio by the expected return
Standard deviation
measures all of the risk associated with price variations in a security - both systematic and non systematic
higher standard deviation implies a higher variability of returns and therefore risk
find
weight of fund a squared x standard deviation squared
weight of fund b squared x standard deviation squared
2 x weight of a x weight of b x standard deviation of a x standard deviation of b x correlation
add those together
find square root
shift + for square
shift - for square root
m+
rm
Efficient frontier
suggests the optimal portfolio for a given risk tolerance and expected return
Capital market line (CML)
shows the expected return at a given level of risk for a portfolio that combines a risk free asset with the market portfolio
Security Market Line
the combination of a risk free asset, the market return and beta forms the security market line
risk premium
return on market - risk free rate of return
Beta
non diversifiable risk of the portfolio
CAPM/SML Equation
risk free return + beta(return on market - risk free return)
Capital asset pricing model
designed to predict investor behavior assuming all investors are rational, can borrow and lend at the risk free rate of return, no taxes or costs
