Reading 52: Portfolio Risk and Return: Part I Flashcards
Characterize portfolios of many risky assets.
As more and more assets are added to a portfolio, the contribution of each individual asset’s risk to portfolio risk diminishes. The covariance among the assets in the portfolio accounts for the bulk of portfolio risk.
Describe relative money-weighted and time-weighted portfolio returns based on performance after funds have been deposited.
Which is the standard in the investment management industry?
Money-weighted returns will be higher than time-weighted returns when the period following a deposit has high returns, and lower when the period following a deposit has low returns.
The standard is the time-weighted return.
Contrast the time-weighted rate of return from the money-weighted rate of return.
The time-weighted rate of return is not affected by cash withdrawals or contributions to the portfolio.
The time-weighted rate of return averages the holding period returns over time.
List ways in which investors can diversify.
Investing in asset classes.
Using index funds.
Investing among countries that focus on different industries.
Not investing a significant portion in employee stock plans.
Only adding a security if its Sharpe ratio is greater than the Sharpe ratio of the portfolio times the correlation coefficient.
Only adding a security if the benefit is greater than the associated costs.
Adding insurance by purchasing put options or adding an asset class that has a negative correlation with the assets.
What must be understood about the two-asset portfolio standard deviation formula?
The maximum value for portfolio standard deviation will be obtained when the correlation coefficient equals +1.
Portfolio standard deviation will be minimized when the correlation coefficient equals −1.
If the correlation coefficient equals zero, the second part of the formula will equal zero, and portfolio standard deviation will lie somewhere in between.
What does the minimum-variance frontier represent in portfolios?
The lowest level of risk for each level of expected return. Investors aim to maximize expected return for each level of risk.
What is the holding period yield (HPY), the money-weighted rate of return, and the time-weighted rate of return?
The holding period yield is the return earned on an investment over the entire investment horizon.
The money-weighted rate of return is the internal rate of return of an investment. It accounts for the timing and amount of all the dollar flows into and out of the portfolio.
The time-weighted return is the compounded rate of growth of an investment over a stated measurement period.
Describe and give the formula for the geometric mean return.
R={[(1+R1)×(1+R2)×…×(1+Rn)]1/n}−1
The geometric mean return accounts for compounding of returns, and does not assume that the amount invested in each period is the same. The geometric mean is lower than the arithmetic mean (due to the effects of compounding) unless there is no variation in returns, in which case they are equal.
How are annualized returns calculated?
Rannual=(1+rperiod)n−1
where:
r = Return on investment n = Number of periods in a year
Explain the components of indifference curves worth noting for risk-adverse investors.
They are upward sloping. This means that an investor will be indifferent between two investments with different expected returns only if the investment with the lower expected return entails a lower level of risk as well.
They are curved, and their slope becomes steeper as more risk is taken. The increase in return required for every unit of additional risk increases at an increasing rate because of the diminishing marginal utility of wealth.
What is the outcome if an investor combines the risk-free asset with portfolios further up the efficient frontier?
The investor keeps attaining better portfolio combinations.
Describe and give the formula used to calculate arithmetic or mean return.
The arithmetic or mean return is a simple average of all holding period returns.
R=R1+Ri2+⋯RiTT=1T∑Tt=1RiT
