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 riskfree assets.
2
The portfolio selected maximises utility and determines the amount of borrowing or lending
at the riskfree rate.
Chapter outline
7.1 Introduction
1
This chapter examines investor choice between risky and riskfree assets.
2
Riskfree (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 shortselling, whereby as asset is borrowed and repaid at a
later date.
7.3 Investor preferences and expected utility
1
Assume investors are riskaverse, rational and nonsatiated.
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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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 Meanvariance 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 meanvariance efficient set and the investor’s
indifference curve.
7.7 Riskfree assets
1
Riskfree assets don’t contribute risk to the portfolio, hence linear relationship between
return and risk for the portfolio.
2
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 JASONHALL
 Standard Deviation, Variance, Australia Pty Limited, Nelson Australia Pty Limited, Nelson Australia Pty

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