FNCE 625 – Investment Analysis and Management
Skaur12
ch08.pptxInvestments: Analysis and Management
Fourteenth Edition
Gerald R. Jensen and Charles P. Jones
Chapter 8
Portfolio Selection
Building a Portfolio
Diversification is key to risk management
Asset allocation most important single decision
Using Markowitz Principles
Step 1: Identify optimal risk-return combinations using the Markowitz analysis
Inputs: Expected returns, variances, covariances
Step 2: Choose the final portfolio based on your preferences for return relative to risk
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Portfolio Theory
Optimal diversification takes into account all available information
Assumptions in portfolio theory
A single investment period (one year)
Liquid position (no transaction costs)
Preferences based only on a portfolio’s risk and expected return
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The Efficient Frontier
Efficient Frontier – represents the set of all mean/variance efficient (optimal) portfolios
Optimal portfolio has maximum return for a given level of risk or minimum risk for a given level of return
Portfolios on the efficient frontier dominate all other portfolios
No portfolio on the efficient frontier dominates another portfolio on the frontier
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Efficient Portfolios
Efficient frontier or Efficient set (curved line from A to B)
Global minimum variance portfolio (represented by point A)
Portfolios on A B dominate all other possible portfolios
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Selecting an Optimal Portfolio of Risky Assets 1
Portfolio weights are the output from Markowitz analysis
Assume investors are risk averse
Indifference curves (I Cs) determine individual’s optimal portfolio
I C, description of preferences for risk and return
I C reflects portfolio combinations that are equally desirable
I Cs match investor preferences with portfolio possibilities
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The Optimal Portfolio
Goal is to achieve highest (most N W) attainable curve
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Selecting an Optimal Portfolio of Risky Assets 2
International diversification unlikely to offer as much risk reduction as in the past
Markowitz portfolio selection model
Assumes investors use only risk and return to decide
Generates a set of equally “good” portfolios
Does not address the issues of borrowed money or risk-free assets
Cumbersome to apply
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Selecting Optimal Asset Classes
Another way to use Markowitz model is with asset classes
Allocation of portfolio to asset types
Asset class, rather than individual security, is most important for investors
Can be used when investing internationally
Different asset classes offer various returns and levels of risk
Correlation coefficients may be quite low
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Asset Allocation 1
Includes two dimensions
Diversifying across asset classes
Diversifying within asset classes
Asset classes include:
Equities – foreign and domestic
Bonds – foreign, domestic, and government
Treasury Inflation-Protected Securities (T I P S)
Alternative assets – real estate, commodities, private equity, hedge funds, etc.
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Asset Allocation 2
Correlation among asset classes must be considered
Correlations change over time
For investors, allocation depends on
Time horizon
Risk tolerance
Diversified asset allocation does not guarantee against loss
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Commodity Funds
Commodities:
Precious metals, industrial metals, livestock, grains, oil products, etc.
Types of commodity funds:
Bullion – hold physical asset
Synthetic – use derivative security
Equity – hold equities of firms engaged in business
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Asset Allocation 3
Index Mutual Funds, E T Fs and E T Ns
Cover various asset classes: domestic and foreign stocks (all investment styles), alternative assets (e.g. real estate, commodities), bonds of all types
Life Cycle Analysis
Varies asset allocation based on investor age
Life-cycle funds (target-date funds) vary allocation as investor ages
No one “correct” approach to allocation
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Systematic & Unsystematic Risk 1
The variance (risk) of a portfolio, or a single security, consists of both systematic risk and unsystematic risk
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Systematic & Unsystematic Risk 2
Systematic risk is not diversifiable
Systematic risk - risk of an overall movement in the market
nondiversifiable systematic market risk
Unsystematic risk is diversifiable
Unsystematic risk - risk of an event that is unique to the asset or a small group of assets
diversifiable unsystematic unique risk
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Portfolio Risk and Diversification
Number of securities in portfolio
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Copyright
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