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16-Diversification II

16-Diversification II - Efficient Diversification II BKM...

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Efficient Diversification II BKM: Chapter 6

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Diversification & Many Risky Assets 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 1 2 3 4 5 6 Number of Assets in Portfolio Standard Deviation of Portfolio
Diversification In any portfolio, what fluctuations are “cancelled out”? Simple two-stock example: B B A A p p DELL MSFT r w r w r r r r + = = = = portfolio on return Dell on return Microsoft on return

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Portfolio Variance w MSFT × w DELL ×
Components of MSFT

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Components of Dell
Remaining Components w MSFT × w DELL ×

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Portfolio Variance w MSFT × w DELL ×
Vanishing Components w MSFT × w DELL ×

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Diversification Portfolio Rule #3 The component of the stock return that is independent of the portfolio return is always “off-set” or “canceled out” in a portfolio.
Diversification t MSFT t p MSFT MSFT t MSFT e r b a r , , , + + = Remaining Component Vanishing Component t DELL t p DELL DELL t DELL e r b a r , , , + + = Remaining Component Vanishing Component

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Example Arbitrary Portfolio: 30% in A, 70% in B
Example E[r A |r P ]=a A +b A r

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