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Brailsford3eSM_Ch07 - Chapter 7 Investor preferences and...

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Copyright © 2006 Nelson Australia Pty Limited Chapter 7 Investor preferences and portfolio concepts Learning objectives After the completion of this chapter, you should be able to: demonstrate how investor preferences can be modelled and analysed understand the importance of portfolio diversification in investment decision making understand the mean variance opportunity set describe portfolio construction methods explain how we model rational investor investment portfolio choice Key points 1 Investors must choose between some combination of risky and risk-free assets. 2 The portfolio selected maximises utility and determines the amount of borrowing or lending at the risk-free rate. Chapter outline 7.1 Introduction 1 This chapter examines investor choice between risky and risk-free assets. 2 Risk-free (risky) assets have certain (uncertain) return across future return states. 3 Examines two popular models of investor choice and diversification concepts. 7.2 Arbitrage profits 1 Arbitrage involves making profit without risk and zero net investment. 2 Investors trading on any arbitrage opportunity will result in such opportunities being quickly eroded. 3 Arbitrage strategy often involves short-selling, whereby as asset is borrowed and repaid at a later date. 7.3 Investor preferences and expected utility 1 Assume investors are risk-averse, rational and non-satiated. 2 Expected utility of wealth used by investors to determine investment choice. 3 If returns are normal and/or investors have quadratic utility, can use mean and variance to approximate investor preference.
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2 Investments: Concepts and Applications Solutions Manual Copyright © 2006 Nelson Australia Pty Limited 7.4 Prospect theory 1 Founded in psychology theory, and is based on gains or losses rather than wealth. 2 Under prospect theory investors predicted to be twice as concerned about losses as about gains. 3 Explains reluctance to dispose of shares in loss position, known as the disposition effect. 7.5 The benefits of diversification 1 Increasing the number of assets in a portfolio diversifies the risk of the portfolio. 2 Variance of the portfolio approaches the average covariance of the assets in the portfolio and the variance of the assets becomes unimportant. 7.6 Mean-variance opportunity set 1 Captures relationship between expected return and variance for large numbers of assets. 2 Two approaches to estimating the opportunity set are the Markowitz and Sharpe approaches. 3 Efficient set is optimal area of opportunity set; maximum return given risk. 4 Optimal portfolio is the tangency point of the mean-variance efficient set and the investor’s indifference curve. 7.7 Risk-free assets 1 Risk-free assets don’t contribute risk to the portfolio, hence linear relationship between return and risk for the portfolio. 2
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Brailsford3eSM_Ch07 - Chapter 7 Investor preferences and...

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