Risk Aversion and Asset Allocation Flashcards

1
Q

What is Risk Aversion?

A

An investor’s unwillingness to make a risky investment unless investment generates additional return

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2
Q

What is Risk premium?

A

added reward/incentive for taking risk

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3
Q

What is Risk tolerance?

A

opposite of risk aversion

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4
Q

Why Are Investors Risk-Averse?

A
  • Risk aversion a result of diminishing marginal utility

- Diminishing marginal utility: decreased gain in utility for each additional dollar

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5
Q

What is a Utility score?

A
  • mechanism for ranking risky investments
  • Trade-off between expected returns and standard deviations (i.e., risk)
  • Score based on investor’s level of risk aversion
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6
Q

What are the parts of the Utility formula?

A

A = risk aversion parameter (degree of risk aversion).
•All else being equal, the higher the A, the lower the U (utility).
•The higher the U, the more desirable the investment.
•The higher the E(r) (expected return), the higher the U.
•The higher the σ (standard deviation), the lower the U.
•The higher the A, the greater the investor’s desire to avoid high σ.

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7
Q

What does it mean to be indifferent?

A
  • Investor has no preference between investments.

- Indifference arises when utility scores are equal

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8
Q

What is preference?

A

When an investor chooses one investment over another, based on utility score and risk aversion.

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9
Q

What is dominance?

A

When all investors, regardless of risk aversion, would opt for a given investment.

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10
Q

What is asset allocation?

A
  • Refers to allocation of investment capital among various asset classes ◦E.g., cash, stocks, bonds, commodities, real estate
  • Simplified model: risk-free investments and risky securities
  • Overall investment risk derived from proportion of risk-free vs. risky holdings
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11
Q

How do you assemble the Optimal

Investment Portfolio?

A
  • Asset allocation:

- Creation of optimal risky portfolio

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12
Q

What are the two broad asset classes?

A

Risk-free securities (f): e.g., bank account, Treasury bill, money market account

Risky assets (P): e.g., stocks, bonds, commodities, real estate, stock portfolio, bond portfolio, mutual fund, and so on

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13
Q

What is a portfolio weight?

A

Share of capital invested in a given asset class.

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14
Q

How do you choose the best combination?

A
  • Best for investor: combination with highest U.
  • Portfolio weight of P based on risk aversion (A).
  • Must know E(r) and σ to calculate U.
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15
Q

What is leverage?

A

borrowing money to invest.

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16
Q

What are some active investing tactics?

A

market timing: Shifting money between risk-free assets and risky portfolio depending on market trends

security selection: Giving more weight to certain securities in risky portfolio in expectation that their returns will rise

17
Q

What are some passive investing strategies?

A
  • Allocating capital between risk-free assets and risky portfolios based on investor’s risk-aversion level
  • No market timing or security selection
18
Q

What does slope measure?

A

measure of risk premium per unit of risk.