SU UGBA 133 LECTURE 11 PORTFOLIO THEORY 2

SU UGBA 133 LECTURE 11 PORTFOLIO THEORY 2 - BA 133...

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BA 133 PORTFOLIO THEORY, CONTINUED, LECTURE ELEVEN CHAPTER 8: Homework: 1, 4, 9a, 13, 14, 18-20. Diversification and Portfolio Risk: Much written on this since the pioneer papers in the early 1970s…back then the papers concluded that most of the diversifiable risk could be eliminated by a portfolio contain- ing 12-18 stocks, depending on whose paper you read (numerous examples, e.g. Archer and Evans’s article in the Journal of Finance , years ago). The Figure in your text, 8.2 on p. 209 looks impressive showing that most of the risk that can be eliminated via diversification is achieved within twenty or so stocks, and very little additional risk reduction is accomplished at 1,000 stocks. The chart is an ex- cerpt from an article by Meir Statman, a finance professor at Santa Clara. What you might also notice is the tendency for sigma to remain near 19%; a big stand- ard deviation—more recently the volatility has declined to the 15 % level. The primary caveat is all of those studies, including Statman’s selected stocks ran - domly . BUT: no active manager selects stocks randomly . They select stocks within industries, and there may only be ten or fifteen industries in those portfolios. Some managers use five or six industries, concentrating their positions in the six or so stocks they like within each of those five or six industries. Because of the non-randomness, empirical evidence reveals that it takes many more stocks, perhaps hundreds, to eliminate the unique risk, because of the industry concen- trations, and non-random selection. In fact, these portfolios will still probably have risk that could otherwise be eliminated by more efficient diversification. Most successful active portfolio managers aren’t always interested in eliminating diversifiable risk…why? If you have to pay brokerage commissions and collect a management fee, you cannot beat the index/benchmark using a well diversified portfolio. Your portfolio is either the market or something very close to it. Recall: total portfolio risk can be separated into categories, risk that can be eliminated by diversification and risk that remains in the portfolio, regardless of diversification at- tempts. Terminology: Diversifiable risk comes with many names, all of which are used interchangeably, in- cluding: unique, firm-specific, non-systematic, and unsystematic risk to name a few.
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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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SU UGBA 133 LECTURE 11 PORTFOLIO THEORY 2 - BA 133...

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