Chapter 6 Efficient Diversification 1

Risk and Return Risk and Return In previous chapters, we have calculated returns on various investments. In chapter 5, we used the standard deviation of returns as a measure of total risk. Now, we look at what happens to returns and risk when assets are combined into portfolios. 2

Portfolio Returns Portfolio Returns The return on a portfolio is a __________ ______________________ of the returns on the assets in the portfolio. If 2 or more assets with equal expected returns are combined, the expected return on the portfolio equals the expected return of the individual assets. 3

Portfolio Risk Portfolio Risk In general, the risk (standard deviation) of a portfolio is ____________________ than the risk of the individual assets. This reduction in risk is referred to as ______________________________. Diversification can reduce risk, but cannot eliminate it. 4

Portfolio Risk Portfolio Risk On average, the standard deviation of returns of a single stock is about 35-40%. The standard deviation of returns of the S&P 500 is 20%. By investing in an S&P 500 index, the risk is about half as great as investing in a single stock. You still face the risk of a decline in the market: market risk. 5

Components of Risk Market or systematic risk: risk related to macroeconomic conditions, or of a decline in the overall market Nonsystematic or firm specific risk: risk that is unique to a particular industry or firm Total risk = Systematic + Nonsystematic 6

Market risk Market risk Three terms that are used interchangeably are: ◦____________________________ risk ◦___________________________ risk These refer to the part of risk that __________________ be eliminated by diversification 7

Nonsystematic Risk Nonsystematic Risk Four terms used interchangeably: ◦Nonsystematic risk ◦Firm-specific risk ◦Diversifiable risk ◦Unique risk These refer to the part of risk that ______________ be eliminated by diversification 8

Portfolio Risk Portfolio Risk To maximize the risk reduction benefit of diversification, combine securities whose returns have a low (or negative) ____________________________. 9

Extending Concepts to All Securities The optimal combinations result in lowest level of risk for a given return The optimal trade-off is described as the efficient frontier, or investment opportunity set Portfolios on the efficient frontier _________________________ all other portfolios of risky assets 10

E(r) The minimum-variance frontier of risky assets Efficientfrontier Globalminimumvarianceportfolio Minimumvariancefrontier Individualassets St. Dev. 11

Extending to Include Riskfree Asset The optimal combination becomes linear The optimal portfolio of risky assets (M) combined with the riskless asset will dominate Combinations of the risk-free asset and a risky asset or portfolio of risky assets is referred to as a CAL, or capital allocation line. 12

E(r) CAL (Global minimum variance) CAL (B) CAL (M) B M rf Mrf&M B G M B  ALTERNATIVE CALS 13

Dominant CAL with a Riskfree Investment CAL(M) dominates other lines -- it has the best risk/return tradeoff or the steepest slope. It is referred to as the Capital Market Line, or CML. Regardless of risk preferences combinations of M & rf dominate 14