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Chapter 12

Chapter 12. Choosing an Investment Portfolio. Objectives. To understand the process of personal portfolio selection in theory and in practice To build a quantitative model of the trade-off between risk and reward. Contents. The Process of Personal Portfolio Selection

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Chapter 12

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  1. Chapter 12 Choosing an Investment Portfolio

  2. Objectives • To understand the process of personal portfolio selection in theory and in practice • To build a quantitative model of the trade-off between risk and reward

  3. Contents • The Process of Personal Portfolio Selection • The Trade-Off between Expected Return and Risk • Efficient Diversification with Many Risky Assets

  4. Portfolio Selection A process of trading off risk and expected return to find the best portfolio of assets and liabilities

  5. Portfolio Selection • The Life Cycle • Time Horizons • Risk Tolerance

  6. The Life Cycle In portfolio selection the best strategy depends on an individual ‘s personal circumstances: • Family status • Occupation • Income • Wealth

  7. Time Horizons • Planning Horizon: The total length of time for which one plans • Decision Horizon:The length of time between decisions to revise the portfolio • Trading Horizon: The minimum time interval over which investors can revise their portfolios.

  8. Risk Tolerance The characteristic of a person who is more willing than the average person to take on additional risk to achieve a higher expected return

  9. Correlated Common Stock • The next slide shows statistics of two common stock with these statistics: • mean return 1 = 0.15 • mean return 2 = 0.10 • standard deviation 1 = 0.20 • standard deviation 2 = 0.25 • correlation of returns = 0.90 • initial price 1 = $57.25 • Initial price 2 = $72.625

  10. Formulae for Minimum Variance Portfolio

  11. Formulae for Tangent Portfolio

  12. Example: What’s the Best Return given a 10% SD?

  13. Achieving the Target Expected Return (2): Weights • Assume that the investment criterion is to generate a 30% return • This is the weight of the risky portfolio on the CML

  14. Achieving the Target Expected Return (2):Volatility • Now determine the volatility associated with this portfolio • This is the volatility of the portfolio we seek

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