Rangkuman Chapter 8

Portfolio Selection For All Investor

Using the Markowitz analysis to select an optimal portfolio of financial assets investors should:
1. Identify optimal risk-return combinations
Portfolio theory is normative, meaning that it tells investors how they should act to
diversify optimally including :
a) Single investment period
b) Liquidity of position
c) Preference based only on a portfolio’s expected return and risk as measured by
variance or standard deviation
2. The attainable set of portfolios
Investor should evaluate portfolios on the basis of their expected returns and risk as
measured by the standard deviation, so the investor must first determine the risk-return
opportunities available to an investor from a given set of securities.

Efficient Portfolios, one that has the smallest portfolio risk for a given level of expected return
or the largest expected return for a given level of risk. Investors can identify efficient portfolios
by specifying an expected portfolio return and minimizing the portfolio risk at this level of
return.

Point A represents the global minimum variance portfolio because no

other minimum-variance portfolio has a smaller risk. The bottom
segment of the minimum- variance frontier, AC, is dominated by
portfolios on the upper
segment, AB. For example, since portfolio X has a larger return than
portfolio Y for the same level of risk, investors would not want to own
portfolio Y.

SELECTING AN OPTIMAL PORTFOLIO OF RISKY ASSETS

1. Indifference Curves, that assume investors are risk-averse. the expected return-risk
combination that will satisfy such an investor’s personal preferences.

2. Each indifference curve represents the combinations of risk and expected return that are
equally desirable to a particular investor. This portfolio maximizes investor utility
because the indifference curves reflect investor preferences, while the efficient set
represents portfolio possibilities.
Important Conclusions about the Markowitz Model
1. referred to as a two-parameter model because investors are assumed to make decisions
on the basis of two parameters, expected return and risk. (mean-variance model)
2. No portfolio on the efficient frontier, as generated, dominates any other portfolio on the
efficient frontier.
3. Investors are not allowed to use leverage. (example ; the issue of investors using
borrowed money along with their own portfolio funds to purchase a portfolio of risky
assets)
4. In practice, different investors, or portfolio managers, will estimate the inputs to the
Markowitz model differently.
5. The Markowitz model remains cumbersome to work with because of the large variance-
covariance matrix needed for a set of stocks.

So, the Alternative Methods of Obtaining the Efficient Frontier by using Single-Index Model
A model that relates returns on each security to the returns on a market index.

An alternative way to use the Markowitz model as a selection technique is to think in terms
of asset classes, such as domestic stocks, foreign stocks of industrialized countries, the
stocks of emerging markets, bonds, and so forth. Using the model in this manner, investors
decide what asset classes to own and what proportions of the asset classes to hold.

The asset allocation decision refers to the allocation of portfolio assets to broad asset
markets; in other words, how much of the portfolio’s funds is to be invested in stocks,
how much in bonds, money market assets, and so forth. Each weight can range from 0 to
100 percent.

ASSET ALLOCATION AND DIVERSIFICATION

For many investors a diversified portfolio consists of two elements: diversifying between
asset categories and diversifying within asset categories. Such an action can provide a truly
diversified portfolio. If investor hold only a diversified stock portfolio, you are making a one-
dimensional bet on asset classes.

SOME MAJOR ASSET CLASSES

1. International Investing, The rationale for this has been that such investing reduces the
risk of the portfolio because domestic and foreign markets may not move together and
potential opportunities in other markets may be greater than those available in their
country.
2. Bonds
3. Treasury Inflation-Indexed Securities (TIPS), pay a base interest rate that is fixed at
the time the bonds are auctioned. However, the principal value of the bonds is adjusted
for inflation. Therefore, the fixed rate of interest is applied semiannually to the inflation-
adjusted principal of the bonds rather than their par value.
4. Real Estate, Investors can easily hold real estate by buying Real Estate Investment
Trusts (REITs).
5. Gold
6. Commodites, a great rise in some recent years, with steel, cooper, oil, cement,
agricultural products, and so forth showing large increases in price.

COMBINING ASSET CLASSES, As an indication of what can be accomplished using asset

classes for an investment program, consider a simple analysis whereby investors diversify
across mutual funds representing different asset classes.
Programs exist to calculate efficient frontiers using asset classes. These programs allow
for a variety of constraints, such as minimum yield and no short selling.

ASSET CLASSES AND CORRELATION COEFFICIENTS

The correlation between asset classes is obviously a key factor in building an optimal
portfolio. Investors would like to have asset classes that are negatively correlated with each
other, or at least not highly positively correlated with each other.

Asset Allocation and the Individual Investor

1. Asset Allocation Using Stocks and Bonds, Most investors own portfolios of stocks or
bonds or a combination of the two. It stands to reason that bonds are the safer of the two
assets, and this in fact is why many investors allocate at least part of their portfolio to
bonds. Bonds historically have provided a lower return than stocks, but with a
considerably lower risk.
2. Some Limitations on Asset Allocation Individual investors, in choosing asset
classes, should be aware that the benefits of asset allocation are not always present.

Asset Allocation and Index Mutual Funds, this asset allocation plan, using only stock and
bond funds, both domestic and international, should be sufficient for many investors. Adding
additional asset classes may add value, but they also increase the overall portfolio risk.

LIFE CYCLE ANALYSIS

Traditionally, recommended asset allocations for investors have focused on the stage of the
life cycle they are in.

The Impact of Diversification on Risk, diversification typically reduces the risk of a

portfolio—as the number of portfolio holdings increases, portfolio risk declines. In fact,
almost half of an average stock’s risk can be eliminated if the stock is held in a well-
diversified portfolio.

SYSTEMATIC AND NONSYSTEMATIC RISK

1. Diversifiable (Nonsystematic) Risk, generally declines as more stocks are added

because we are eliminating the nonsystematic risk or company-specific risk.
2. Nondiversifiable (Systematic) Risk, directly associated with overall movements in the
general market or economy is called systematic risk, or market risk, or non-diversifiable
risk.