11. Diversification and Risky Asset Allocation. Diversification. Intuitively, we all know that if you hold many investments Through time, some will increase in value Through time, some will decrease in value It is unlikely that their values will all change in the same way
Diversification and Risky Asset Allocation
To get the most out of this chapter, spread your study time across:
1. How to calculate expected returns and variances for a security.
2. How to calculate expected returns and variances for a portfolio.
3. The importance of portfolio diversification.
4. The efficient frontier and importance of asset allocation.
Note that the second spreadsheet is only for Starcents. What would you get for Jpod?
In the formula: E(RP) = expected portfolio return
wi = portfolio weight in portfolio asset i
E(Ri) = expected return for portfolio asset i
Note that the portfolio weight in Jpod = 1 – portfolio weight in Starcents.
ps = probability of state of economy, s
E(Rp,s) = expected portfolio return in state s
E(Rp) = portfolio expected return
Where: xA = portfolio weight of asset A
xB = portfolio weight of asset B
such that xA + xB = 1.
(Important: Recall Correlation Definition!)
Uh,is this decision a wise one?