B.2 Portfolio Theory I-1.pptx

B.2 Portfolio Theory I-1.pptx - 1 Outline Portfolio Theory...

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1 Outline: Portfolio Theory I Portfolio diversification Sources: ρ and N Systematic (market) risk Unsystematic (firm-specific) risk Constructing portfolios of risky assets (N=2) Portfolio weights Portfolio expected return Portfolio expected variance Correlation and diversification, again Construct new portfolios from two risky securities Efficient frontier
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Venti Portfolio Theory 2 Portfolio Basics Portfolio: A collection of investment assets. Two steps: Asset Allocation: Choice among broad classes. Security Selection: Which securities to hold within each class Diversification : combining assets in a portfolio in such a way as to minimize the overall portfolio risk. Two sources: : Look for asset pairs that have offsetting risks N : Hold large numbers of assets For now, think of risk as volatility – we will get more specific later
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Venti Portfolio Theory 3 Offsetting Risks ( ) extreme case:  = -1 What is the variance of a two asset portfolio when the two assets are perfectly negatively correlated?
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Venti Portfolio Theory 4 Offsetting Risks ( ) Many hedge funds describe their investment strategies as “long-short” They try to keep equal investments in: Long positions (positive correlation with overall market) Short positions (negative correlation with overall market) Because long positions balance short positions, they will be market neutral.
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Holding Large Number of Assets (N) Venti Portfolio Theory 5 Increasing the number of securities in a portfolio can substantially reduce the variability of returns without an offsetting reduction in expected returns. To understand how and why holding a large number of securities lowers portfolio risk (portfolio variance), we need to be more specific about what we mean by “risk.” Every security has two kinds of risk, but only one affects portfolio variance The other is “diversified away” by holding large numbers of securities.
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Venti Portfolio Theory 6 Types of Risk There are only two types of risk, but many names for them: systematic risk (or undiversifiable risk or market risk) unsystematic risk (or diversifiable risk or firm-specific risk or idiosyncratic risk or unique risk)
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