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BA133: LECTURE TEN—PORTFOLIO THEORY Homework-- Chapter 6: 13-15; Chapter 7: 1,8,13, 22. I have asked you to skip most of Chapter 6, the portion discussing utility theory, be- cause it is more commonly taught in graduate courses, and there are other topics more relevant to this course—I would rather spend time on those topics. Preface: the best discussion of risk reduction via diversification appears in Burton Malkiel’s A Random Walk Down Wall Street . Malkiel describes an island with only two companies—an umbrella company and a beach resort. When people get up they look out the window and either go to the beach and pay admission, or they avoid the beach and instead buy an umbrella. (Don’t complicate this two asset economy by ask- ing about food or beer). If you lose umbrellas the way I do, you’d understand why you need to buy a new umbrella every time it rains. Both of these companies involve substantial variability in their returns, and it turns out, those returns are perfectly negatively correlated, thus a combination of equal in- vestments in both of them produces a portfolio with virtually no risk, and a very stable return. Malkiel’s introduction to diversification is so well written that when I reviewed the first edition of your text, I advised them to incorporate something similar to Malkiel’s approach. The recommendation influenced the discussion in Chapters 6-7 of this text, and your text’s references to umbrella companies and suntan–lotion vendors are a not too subtle parallel to Malkiel’s efforts. In the real world, professionals engage in the above in varying degrees; they know about diversification. Some managers deliberately underdiversify; others overdiver- sify. Both of them still pay attention to the portfolio risk and return parameters gen- erated and altered by the allocations. Some time back I concluded there is a good analogy extending Malkiel’s approach. I liked weather people to security analysts. If you are a passive investor you will min- imize your portfolio’s risk by combining the beach resort and the umbrella companies in your portfolio as illustrated. In contrast, active managers will try to anticipate whether it rains or is sunny and buy the appropriate stock for that day, but before oth- er portfolio managers buy it. After awhile, managers will start having to get up earli- er to beat the others to outperform them. Soon they will be getting up in the dark, un- able to determine what will happen, and finally will resort to hiring meteorologists to forecast the weather for them. It is trite, but that is what security analysts are sup- posed to do…help forecast the “weather.” End of preface. 1
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Text introduces the concept of hedging, and it seems self explanatory, but you should know the difference between hedging and speculating. Speculators bet their money on a specific outcome, with no provision for being incorrect. A hedger, e.g. would buy the umbrella company, (or vice versa), but put some or half of their money into
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This note was uploaded on 12/06/2011 for the course UGBA 133 taught by Professor Distad during the Summer '08 term at University of California, Berkeley.

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