05-Risk, Return, and CAL

05-Risk, Return, and CAL - Risk, Return and the Capital...

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1 Risk, Return and the Capital Allocation Line Marriott School of Management Bus M 410 Winter 2011 Rob Schonlau Last updated Jan 12, 2011
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Your friends temporarily entrusted $2 million to you to invest. They asked you to invest it in the best possible manner … l Earlier lectures discussed the types of assets you could invest in as well as return and risk measures used to think about financial performance. l But nothing has been said thus far about how to best combine assets into the “optimal” portfolio. This lecture builds on earlier intuition about risk and return and considers a simplified situation where you can only choose between investing in a risk-free asset and a single risky asset and asks the question: how much of your wealth should go into the risk-free asset? How much in the risky asset? Why? 2
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Lecture 5 Outline l Introduce asset allocation choice: How do you model the simple trade-off you face when you decide how much of your wealth to place in a risk-free versus a risky asset? l Introduce the Capital Allocation Line (CAL)
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The asset allocation question restated. . . l How much do you punch the accelerator? How fast do you want to go? How do you make this decision? On some level, you are balancing the expected risk against the expected enjoyment you get from speed. l Greater speed can be thrilling but it can also get pretty ugly. 4
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Human preferences l All else equal, people prefer higher expected returns . Thus given a choice between two investments of the same risk they will choose the one with higher expected return. l
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05-Risk, Return, and CAL - Risk, Return and the Capital...

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