The Power of Diversification
Correlation and Risk Diversification Historical Risk and Correlation Avenues for Diversification
Portfolio of Many Risky Assets
Importance of Correlation in a Portfolio of Many Assets
Portfolio Risk & Portfolio of Two Risky Assets
Portfolio of Two Risky Assets Portfolio Return Portfolio Risk
Utility Theory and Indifference Curves
Indifference Curves An indifference curve plots the combinations of risk–return pairs that an investor would accept to maintain a given level of utility (i.e., the investor is indifferent about the combinations on any one curve because they would provide the same level of overall utility). Indifference curves are thus defined in terms of a trade-off between expected…
Risk Aversion and Portfolio Selection
The Concept of Risk Aversion The concept of risk aversion is related to the behaviour of individuals under uncertainty. Risk Seeking Risk Neutral Risk Averse Risk Tolerance Risk tolerance refers to the amount of risk an investor can tolerate to achieve an investment goal. The higher the risk tolerance, the greater is the willingness to take risk. Thus,…
Other Investment Characteristics
Distributional Characteristics A normal distribution has three main characteristics: its mean and median are equal; it is completely defined by two parameters, mean and variance; and it is symmetric around its mean with: Skewness Skewness refers to asymmetry of the return distribution, that is, returns are not symmetric around the mean. A distribution is said to be…
Historical Return and Risk
Expected return is the nominal return that would cause the marginal investor to invest in an asset based on the real risk-free interest rate (rrF), expected inflation [E(π)], and expected risk premium for the risk of the asset [E(RP)]. The real risk-free interest rate is expected to be positive as compensation for postponing consumption. The…
Applications of the CAPM in Portfolio Construction
Security Characteristic Line Similar to the SML, we can draw a security characteristic line (SCL) for a security. The SCL is a plot of the excess return of the security on the excess return of the market. Security Selection Implications of the CAPM for Portfolio Construction
Beyond CAPM: Limitations and Extensions of CAPM
Limitations of the CAPM Theoretical Limitations of the CAPM Practical Limitations of the CAPM Extensions to the CAPM Theoretical Models Practical Models