ch6outline - Chapter 6 Efficient diversification I...

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Chapter 6: Efficient diversification I. Diversification and Portfolio Risk A. Two broad sources of uncertainty 1. The first is the risk that has to do with general economic conditions, such as the business cycle, the inflation rate, interest rates, exchange rates, and so forth 2. Then you must add to these macro factors firm-specific influences, such as a firm’s success in research and development, its management style and philosophy, and so on. 3. Firm-specific factors are those that affect a firm without noticeably affecting other firms 4. In some cases the two effects of different risks are offsetting, which stabilizes portfolio return B. Diversifying into many more securities continues to reduce exposure to firm-specific factors, so portfolio volatility should continue to fall 1. There is no way to avoid all risk. C. When all risk is firm-specific, diversification can reduce risk to low levels D. With all risk sources independent, and with investment spread across many securities, exposure to any particular source of risk is negligible 1. This is just an application of the law of averages 2. The reduction of risk to very low levels because of independent risk sources is sometimes called the insurance principle . E. When common sources of risk affect all firms, however, even diversification cannot eliminate risk F. In figure 6.1B(pg.150), portfolio standard deviation falls as the number of securities increases, but it is not reduced to zero 1. The risk that remains even after diversification is called market risk , risk that is attributable to market-wide risk sources 2. Other names are systematic risk or nondiversifiable risk 3. The risk that can be eliminated by diversification is called unique risk, firm-specific risk, nonsystematic risk, or diversifiable risk G. Figure 6.2(pg.151) shows the effect of portfolio diversification, using data on NYSE stocks 1. The figure shows the average standard deviations of equally weighted portfolios constructed by selecting stocks at random as a function of the number of stocks in the portfolio H. On average, portfolio risk does fall with diversification, but the power of diversification to reduce risk is limited by common sources of risk II. Asset Allocation with Two Risky Assets A. Investors need to decide on the proportion of their portfolios to allocate to the stock versus the bond market
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1. This, too, is an asset allocation decision B. Covariance and Correlation 1. The key determinant of portfolio risk is the extent to which the returns on the two assets tend to vary wither in tandem or in opposition 2. Portfolio risk depends on the correlation between the returns of the assets in the portfolio 3. The performance of stock funds tends to follow the performance of the broad economy 4. In contrast, bond funds often do better when the economy is weak a. This is because interest rates fall in a recession, which means that bond prices rise 5. The variance is the probability-weighted average across all scenarios of the squared deviation between the actual
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ch6outline - Chapter 6 Efficient diversification I...

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