week 7: portfolio Theory Flashcards
What are the two aims of modern portfolio theory?
MPT aims to create an optimal (or efficient) portfolio that could offer:
The highest return for a given amount of risk (𝜎_P)
The lowest risk for a given amount of return (𝐸(𝑟_P))
what are the three generic parts of the investment decision process?
The Investment Decision Process consists of the following three generic parts:
1) Capital allocation between a risky portfolio and a risk-free asset (i.e., risky vs. risk-free)
2) Asset allocation across broad asset classes (within the risky category), such as Stocks, Bonds, etc.
3) Within each asset class, select individual assets/securities
What is capital allocation?
A straightforward way to control portfolio risk is through the fraction of the portfolio invested in
Risk-free assets (e.g., T-bills)
Risky assets.
i.e., a choice among broad investment classes.
What is the slope of he cpaital allocation line (CAL)?
the slope of he cpaital allocation line (CAL) is the excess return of the risky portfolio P per unit of risk (standard deviation).
Known as the reward-to-volatility or Sharpe ratio (S).
Explain passive vs active investment strategy?
****Passive Investment Strategy
No security analysis; invests in index funds, ETFs, or mutual funds.
Low information costs and management fees.
The Capital Market Line (CML) represents returns using a market portfolio.
Active Investment Strategy
Aims to beat market returns through analysis and expertise.
High information costs and management fees.
The CAL is based on the optimal risky portfolio.
What is the Capital market line (cml)?
The capital allocation line (CAL) provided by a risk-free portfolio F and a fund of common stocks that mimics a broad market index Is called the capital market line (CML).
In other words, the risky portfolio P is a broad market index, e.g., S&P 500 index fund.
The slope of the CML is the Sharpe ratio for the broad market index.
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