Lecture7 - Portfolio Management Theory (Traditional) AEM...

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AEM 4230 Portfolio Management Theory (Traditional) Risk versus Return ± In the investment management process there is a fundamental tradeoff between risk and return
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Allocating Capital: ± Split investment funds between safe and risky assets Main Issues ± Risk/return tradeoff ± Different degrees of risk aversion will affect allocations between risky and risk free assets Allocating Capital: Risky & Risk Free Assets
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± Greater levels of risk aversion lead to larger proportions of the portfolio in the risk free asset ± Lower levels of risk aversion lead to larger proportions of the portfolio in the risky asset Risk Aversion and Allocation ± Willingness to accept high levels of risk for high levels of returns would result in leveraged combinations Risk Aversion and Allocation
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Utility Function U = E (r) - 0.005 A σ 2 Where U = utility E(r) = expected return on the asset or portfolio A = coefficient of risk aversion σ 2 = variance of returns Role of Portfolio Management ± Use the basic theory to combine securities in a portfolio tailored to the investor’s preferences and needs ± Objective of earning a large return
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A Random Walk Down Wall Street ± Book first published in 1973 by, then Princeton professor, Burton Malkiel ± “A random walk is one in which future steps or directions cannot be predicted on the basis of past action. When the term is applied to the stock market, it means that short-run changes in stock prices cannot be predicted.” ± Idea that stocks already reflect all available information ² Do security prices reflect all available information? ± Grossman & Stiglitz (AER 1980) – investors will have an
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Lecture7 - Portfolio Management Theory (Traditional) AEM...

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