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Chapter 2

CFIN501- Chapter 2- Diversification and Risky Asset Allocation.docx

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FIN 501
Edward Blinder

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CFIN501 Chapter 2 Diversification and Risky Asset AllocationExpected Return and VariancesExpected ReturnsExpected return average return on a risky asset expected in the futureRiskpremiumexpectedreturnriskfreerateExpected return on a security or other assetsum of the possible returns multiplied by their probabilitiesCalculating the varianceCalculate variance of returns on two stocksoDetermine the squared deviations from the expected return oMultiply each possible squared deviation by its probability oAdd both stepsPortfoliosPortfoliogroup of assets such as stocks and bonds held by an investorPortfolio return and portfolio risk obvious relevancePortfolio weightsList percentages of the total portfolios value that are invested in each portfolio assertsPortfolio weightpercentage of a portfolios total value invested in a particular assetasset1PortfolioweightofassetsPortfolio Expected ReturnsCalculate expected return more directlysave ourselves workER05R050RoEX PNfWorks no matter how many assets there areREnERxRxRxP1122nonassets in portfoliooxpercentage of our money in asset iiPortfolio VarianceVariance on a portfolio is not generally a simple combinations of variance of the assets in the portfolioIf recession or boom happens and return is the same zero variance and no riskFinancial alchemyoTake 2 quite risky asset and by mixing them just rightcreate a riskless portfoliooCombining assets into portfoliossubstantially alter the risks faced by an investorDiversification and Portfolio RiskThe Effect of Diversification Another Lesson From Market HistoryCopp and Clearlyexamined diversification characteristics of the Canadian portfolios by forming portfolios of 222 randomly chosen Canadian stocksTable 27 column 3standard deviations for a portfolio of one security is 1347oRandomly select a Canadian stock listed on Toronto stock exchange and put all your money into it your standard deviation return would be almost the sameoStandard deviation declines as the number of securities increaseFoundation of diversification effectrandom selection of stocksoResulting portfolio represents different sectors market caps and other featuresInvesting in the same company industrysimilar to having all your eggs in one basketCrash of 2008 seemingly unrelated asset categories tend to move togetherdownoDiversification is generally a good thingdoesnt always work as we might hopeThe Principle of Diversification1
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