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Unformatted text preview: C h a p t e r 7 C h a p t e r 7 An Introduction to Portfolio Management – Some Background Assumptions – Markowitz Portfolio Theory 72 Some Background Assumptions • As an investor you want to maximize the returns for a given level of risk. • Your portfolio includes all of your assets and liabilities. • The relationship between the returns for assets in the portfolio is important. • A good portfolio is not simply a collection of individually good investments. 73 Some Background Assumptions • Risk Aversion – Given a choice between two assets with equal rates of return, riskaverse investors will select the asset with the lower level of risk – Evidence • Many investors purchase insurance for: Life, Automobile, Health, and Disability Income. • Yield on bonds increases with risk classifications from AAA to AA to A, etc. – Not all Investors are risk averse • It may depends on the amount of money involved: Risking small amounts, but insuring large losses 74 Some Background Assumptions • Definition of Risk – Uncertainty: Risk means the uncertainty of future outcomes. For instance, the future value of an investment in Google’s stock is uncertain; so the investment is risky. On the other hand, the purchase of a sixmonth CD has a certain future value; the investment is not risky. – Probability: Risk is measured by the probability of an adverse outcome. For instance, there is 40% chance you will receive a return less than 8%. 75 Markowitz Portfolio Theory • Main Results – Quantifies risk – Derives the expected rate of return for a portfolio of assets and an expected risk measure – Shows that the variance of the rate of return is a meaningful measure of portfolio risk – Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio 76 Markowitz Portfolio Theory • Assumptions for Investors 1. Consider investments as probability distributions of expected returns over some holding period 2. Maximize oneperiod expected utility, which demonstrate diminishing marginal utility of wealth 3. Estimate the risk of the portfolio on the basis of the variability of expected returns 4. Base decisions solely on expected return and risk 5. Prefer higher returns for a given risk level. Similarly, for a given level of expected returns, investors prefer less risk to more risk 77 Markowitz Portfolio Theory • Using these 5 assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return. 78 Alternative Measures of Risk • Variance or standard deviation of expected return...
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This note was uploaded on 10/10/2011 for the course FINANCE fin4423 taught by Professor Csk during the Fall '11 term at Troy.
 Fall '11
 csk
 Finance

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