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Chapter 6
The return on a portfolio
is a weighted average of
the returns on the assets in the portfolio.
If 2 or more assets with equal expected returns are
combined, the expected return on the portfolio equals
the expected return of the individual assets.
Portfolio Risk
In general, the risk (standard deviation) of a portfolio
is lower than the risk of the individual assets. This
reduction in risk is referred to as diversification.
Diversification can reduce risk, but cannot eliminate it.
On average, the standard deviation of returns of a
single stock is about 3540%.The standard deviation of
returns of the S&P 500 is 20%. By investing in an
S&P 500 index, the risk is about half as great as
investing in a single stock. You still face the risk of a
decline in the market: market risk.
Components of Risk
Market or systematic risk: risk related to
macroeconomic conditions, or of a decline in the
overall market. Nonsystematic or firm specific risk:
risk that is unique to a particular industry or firm
Total risk = Systematic + Nonsystematic
Market risk
Three terms that are used interchangeably are:
Market risk, Systematic risk, Nondiversifiable risk
These refer to the part of risk that cannot be eliminated
by diversification
Nonsystematic Risk
Four terms used interchangeably:Nonsystematic risk;
Firmspecific risk; Diversifiable risk;Unique risk
These refer to the part of risk that can be eliminated by
diversification
Portfolio Risk
To maximize the risk reduction benefits of
diversification, combine securities whose returns have
a low (or negative) correlation.
Efficient Portfolio
offers:
The lowest risk for a given expected return
Or
, the highest expected return for a given risk level
Extending Concepts to All Securities
The optimal combinations result in lowest level of risk
for a given return. The optimal tradeoff is described
as the
efficient frontier
, or
investment opportunity set
.
Portfolios on the efficient frontier dominate all other
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This note was uploaded on 10/22/2010 for the course FIN 331 taught by Professor Pinto,k during the Fall '08 term at N. Arizona.
 Fall '08
 Pinto,K

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