10 - Alternatively the efficient portfolio is that which...

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Define the terms feasible set and efficient set . Often investors have a combination of different stocks. Such a combination of stocks is called a “portfolio”. One of the reasons why we would like to hold a combination of different stocks is to reduce the risk-return trade off by exploiting the situation where correlations between the returns of different stocks is less than one. To see how a portfolio may reduce the return-risk trade off, it is constructive to plot the expected return against the standard deviation of portfolio for different weights. The curve that plots the expected returns and standard deviation for all possible mixes of the two chosen stocks is called the feasible set (Fabozzi & Drake, 2009). A portfolio is made up of a group of individual assets held in combination. An efficient portfolio is that portfolio which provides the highest expected return for any degree of risk.
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Unformatted text preview: Alternatively, the efficient portfolio is that which provides the lowest degree of risk for any expected return. Portfolio can contain more than two risky assets. When there are more than two risky assets in the portfolio, the feasible set is no longer a line. It will be an area. A portfolio with many risky assets, the upper boundary of the feasible set is called the efficient set . Given two randomly chosen stocks will most probably have different expected returns as well as different standard deviation. The latter represent the statistical properties of stock returns over a given period of time expressed as the probability of deviations from the mean. In our case the mean is the average return expected. We can interpret it as the risk that the expected return will not materialize....
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This note was uploaded on 10/15/2011 for the course FIN 550 taught by Professor Smith during the Spring '11 term at Berklee.

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