Investments Analysis and Management 13th Edition Jones Test Bank

Investments Analysis and Management 13th Edition

Jones Test Bank

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File: Ch.08, Chapter 8: Portfolio Selection

Multiple Choice Questions

1. According to the Markowitz model, rational investors will seek efficient

portfolios because these portfolios are optimal based on:

a. expected return.
b. risk.
c. expected return and risk.
d. transactions costs.

Ans: c
Difficulty: Easy
Ref: Building a Portfolio Using Markowitz Principles

2. Under the Markowitz model, investors:

a. are assumed to be risk-seekers.

b. are not allowed to use leverage.
c. are assumed to be institutional investors.
d. are always better off if they select portfolios consisting of multiple securities.

Ans: b
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

3. Which of the following is not an assumption of Markowitz portfolio theory?

a. A single investment period

b. Investor preferences are based only on expected return and risk
c. Low transactions costs
d. The availability of a risk-free asset

Ans: d
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

4. The Markowitz model assumes that investors are “risk averse”, which means that
they:

a. will not take a “fair gamble.”

b. will take a “fair gamble.”
c. will take a “fair gamble” fifty percent of the time.
d. will never assume investment risk.

Ans: a
Difficulty: Easy
Ref: Building a Portfolio Using Markowitz Principles

Chapter Eight 94
Portfolio Selection
5. An indifference curve shows:

a. the one most desirable portfolio for an investor.

b. all combinations of portfolios that are equally desirable to an investor.
c. all combinations of portfolios that are equally desirable to all investors.
d. the one most desirable portfolio for all investors.

Ans: b
Difficulty: Difficult
Ref: Building a Portfolio Using Markowitz Principles

6. Which of the following statements regarding indifference curves is not true?

a. Investors have a finite number of indifference curves.

b. The greater the slope of the indifference curve, the greater the risk aversion of the
investor.
c. The indifference curves for all risk-averse investors will be upward sloping.
d. Indifference curves cannot intersect.

Ans: a
Difficulty: Difficult
Ref: Building a Portfolio Using Markowitz Principles

7. The optimal portfolio for a risk-averse investor:

a. cannot be determined.
b. occurs at the point of tangency between the highest indifference curve and the
highest expected return.
c. occurs at the point of tangency between the highest indifference curve and the
efficient set of portfolios.
d. occurs at the point of tangency between the highest expected return and lowest-
risk efficient portfolio.

Ans: c
Difficulty: Difficult
Ref: Building a Portfolio Using Markowitz Principles

8. The efficient set of portfolios represents:

a. investor preferences, whereas indifference curves reflect portfolio possibilities.

b. portfolio possibilities, whereas indifference curves reflect investor preferences.
c. investor risk, whereas indifference curves reflect portfolio return.
d. portfolio return, whereas indifference curves reflect investor preferences.

Ans: b
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

Chapter Eight 95
Portfolio Selection
9. According to the Markowitz model, an efficient portfolio is one that has the:

a. largest expected return for the smallest level of risk.

b. largest expected return and zero risk.
c. largest expected return for a given level of risk.
d. smallest level of risk.

Ans: c
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

10. Portfolios lying on the upper right portion of the efficient frontier are likely to be
chosen by:

a. aggressive investors.
b. conservative investors.
c. risk-averse investors.
d. defensive investors.

Ans: a
Difficulty: Difficult
Ref: Building a Portfolio Using Markowitz Principles

11. A portfolio which lies below the efficient frontier is described as:

a. optimal.
b. unattainable.
c. dominant.
d. dominated.

Ans: d
Difficulty: Easy
Ref: Building a Portfolio Using Markowitz Principles

12. The optimal portfolio is the efficient portfolio with the

a. lowest risk.
b. highest risk.
c. highest utility.
d. least investment.

Ans: c
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

Chapter Eight 96
Portfolio Selection
13. Indifference curves for a risk-averse individual:

a. will be the same as the indifference curves for any other risk-averse individual.
b. have a negative slope.
c. frequently intersect.
d. are convex.

Ans: d
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

14. In the past 20 years, the benefits of international diversification have:

a. increased.
b. decreased.
c. disappeared.
d. become more volatile.

Ans: b
Difficulty: Moderate
Ref: The Global Perspective - International Diversification

15. Different investors estimate the inputs to the Markowitz model differently
because:

a. every investor has his/her own risk/return preferences.

b. every investor has access to different information about securities.
c. there is an inherent uncertainty in security analysis.
d. there is a random selection process used by individual investors.

Ans: c
Difficulty: Difficult
Ref: Some Important Conclusions About the Markowitz Model

16. Which of the following is not true regarding Markowitz portfolio theory? The
Markowitz model:

a. is considered a three-parameter model.

b. implies that no portfolio on the efficient frontier dominates any other portfolio on
the efficient frontier.
c. is cumbersome to work with due to the large variance-covariance matrix needed
for a set of stocks.
d. generates an entire set, or efficient frontier, of portfolios.

Ans: a
Difficulty: Moderate
Ref: Some Important Conclusions About the Markowitz Model

Chapter Eight 97
Portfolio Selection
17. Which of the following is true regarding the Markowitz model?

a. It fully addresses the use of leverage.

b. The inputs to the model are the portfolio asset weights.
c. An investor’s optimal portfolio occurs where the investor’s indifference curve is
tangent to the efficient frontier.
d. Markowitz diversification is inefficient diversification.

Ans: c
Difficulty: Moderate
Ref: Some Important Conclusions About the Markowitz Model

18. As a measure of market risk, the beta for the S&P 500 is generally considered to be:

a. -1.0.
b. 1.0.
c. 0.
d. impossible to determine.

Ans: b
Difficulty: Easy
Ref: Alternative Methods of Obtaining the Efficient Frontier

19. Which of the following portfolios cannot be on the efficient frontier?

a. A: expected return of 10 percent; standard deviation of 8 percent

b. B: expected return of 18 percent; standard deviation of 13 percent
c. C: expected return of 38 percent; standard deviation of 38 percent
d. D: expected return of 15 percent; standard deviation of 14 percent

Ans: d
Difficulty: Moderate
Ref: Alternative Methods of Obtaining the Efficient Frontier

20. Asset allocation is one of the most widely used applications of:

a. the Capital Asset Pricing Model.

b. random diversification.
c. passive portfolio approach.
d. modern portfolio theory.

Ans: d
Difficulty: Easy
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

Chapter Eight 98
Portfolio Selection
21. Because of increasing correlation between U.S. markets and foreign markets,
most professional investors now recommend:

a. zero exposure to foreign markets for the foreseeable future.

b. replacing foreign stock exposure with U.S. Treasury bonds.
c. maintaining some reasonable exposure to foreign markets.
d. replacing foreign stock exposure with sovereign debt from investment grade
countries.

Ans: c
Difficulty: Difficult
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

22. The only asset class to provide systematic protection against inflation is:

a. bonds.
b. real estate.
c. foreign stocks.
d. TIPS.

Ans: d
Difficulty: Easy
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

23. Which of the following statements is true regarding TIPS?

a. As inflation changes, the interest rate on the bond is adjusted.

b. The correlation between TIPS and the S&P 500 Index has often been negative.
c. TIPS are more volatile than regular Treasury bonds of similar maturity.
d. The return on TIPS is often lower than the inflation rate.

Ans: b
Difficulty: Difficult
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

24. Based on recent history, an investor would have a lower risk level with a portfolio
consisting of:

a. all stocks.
b. all bonds.
c. some stocks and some bonds.
d. Impossible to tell.

Ans: c
Difficulty: Moderate
Ref: Asset Allocation and the Individual Investor

Chapter Eight 99
Portfolio Selection
25. Systematic risk is also called:

a. diversifiable risk.
b. market risk.
c. random risk.
d. company-specific risk.

Ans: b
Difficulty: Easy
Ref: The Impact of Diversification on Risk

26. Which of the following statements about diversification is most accurate? The
purpose of diversification is to:

a. increase a portfolio’s expected return.

b. reduce a portfolio’s non-diversifiable risk.
c. reduce a portfolio’s systematic risk.
d. reduce a portfolio’s total risk.

Ans: d
Difficulty: Moderate
Ref: The Impact of Diversification on Risk

27. Which of the following would not be considered a source of systematic risk?

a. A hostile takeover
b. An increase in inflation
c. A decrease in GDP
d. A panic on Wall Street

Ans: a
Difficulty: Moderate
Ref: The Impact of Diversification on Risk

28. An index commonly used as a proxy for developed market international equities
is the:

a. MSCI EAFE Index.

b. MSCI Emerging Markets Index.
c. Russell 1000 Index.
d. FTSE NAREIT Index.

Ans: a
Difficulty: Moderate
Ref: The Global Perspective - International Diversification

Chapter Eight 100

Portfolio Selection
29. Which of the following best approximates the typical correlation between the
S&P 500 and the MSCI EAFE Index?

a. -50%
b. 0%
c. 25%
d. 70%

Ans: d
Difficulty: Moderate
Ref: The Global Perspective – International Diversification

30. Bob holds a portfolio of 20 stocks from different industries, whereas Sharon holds
only one stock in her portfolio. Assuming they each add a stock to their portfolio,
which of the following is most likely? Relative to Bob’s portfolio, Sharon’s
portfolio will experience the:

a. larger increase in total risk.

b. larger increase in return.
c. larger decrease in total risk.
d. larger decrease in market risk.

Ans: c
Difficulty: Moderate
Ref: The Impact of Diversification on Risk

31. Gordon holds a portfolio of U.S. equities and is considering adding several
alternative ETFs that are tied to different asset classes. Adding which of the
following ETFs would produce the largest reduction in the risk of Gordon’s
portfolio?

a. A real estate ETF

b. An emerging markets ETF
c. An EAFE ETF
d. A U.S. bond ETF

Ans: d
Difficulty: Moderate
Ref: The Global Perspective – Diversification

Chapter Eight 101

Portfolio Selection
32. Based on the historic evidence, which of the following is the most supported
reason for adding gold to a portfolio of U.S. stocks?

a. To increase the portfolio’s expected return.

b. To reduce the portfolio’s risk.
c. To increase the portfolio’s expected return and reduce its risk.
d. To increase the portfolio’s expected return and maintain its risk.

Ans: b
Difficulty: Moderate
Ref: The Impact of Diversification on Risk

True/False Questions

1. Because of its complexity, the Markowitz model is no longer used by institutional

investors.

Ans: False
Difficulty: Easy
Ref: Building a Portfolio Using Markowitz Principles

2. When using the Markowitz model, aggressive investors would select portfolios on
the left end of the efficient frontier.

Ans: False
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

3. Markowitz derived the efficient frontier as an upward-sloping straight line.

Ans: False
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

4. A major assumption of the Markowitz model is that investors base their decisions
strictly on expected return and risk.

Ans: True
Difficulty: Easy
Ref: Building a Portfolio Using Markowitz Principles

5. Under the Markowitz model, the risk of a portfolio is measured by the standard
deviation of the portfolio returns.

Ans: True
Difficulty: Moderate
Ref: Building a Portfolio Using Markowitz Principles

Chapter Eight 102

Portfolio Selection
6. Asset allocation explains less than 50 percent of the variance in quarterly returns
for a typical pension fund.

Ans: False
Difficulty: Moderate
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

7. A well-diversified portfolio will typically consist of a mix of small, mid, and large
cap stocks, both U.S. and foreign, as well as corporate and U.S. Treasury bonds,
real estate, and commodities.

Ans: True
Difficulty: Moderate
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

8. It would be impossible to combine an asset allocation plan with Markowitz

analysis.

Ans: False
Difficulty: Moderate
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

9. Real estate has never been shown to be positively correlated with the performance
of stocks.

Ans: False
Difficulty: Moderate
Ref: Selecting Optimal Asset Classes - The Asset Allocation Decision

10. Based on recent research, it seems reasonable that approximately 10 securities are
needed to ensure adequate diversification.

Ans: False
Difficulty: Moderate
Ref: The Impact of Diversification on Risk

11. Academic research shows asset allocation decisions explain approximately 90%
of the variation in returns in a portfolio, whereas individual security analysis,
including “stock picking,” explains only about 10%.

Ans: True
Difficulty: Moderate
Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision

Chapter Eight 103

Portfolio Selection
12. The Markowitz model does not depend on the assumption of normally distributed
security returns.

Ans: False
Difficulty: Difficult
Ref: Building a Portfolio Using Markowitz Principles

Short-Answer Questions

1. Explain what is efficient about the efficient frontier.

Answer: Any portfolio on the efficient frontier offers the highest return for any
given level of risk or the lowest risk for any given level of return.
Difficulty: Easy

2. What variable is manipulated to determine efficient portfolios, and why are the
other variables not changed at will?

Answer: Security weights. Other variables are characteristics of the individual

securities, not a portfolio decision.
Difficulty: Easy

3. Discuss the importance of the asset allocation decision for portfolio performance.

Answer: Deciding what percentage of portfolio funds will be invested in each

country and each class of assets (e.g., bonds and stocks) is referred to as
the asset allocation decision and accounts for more than 90 percent of the
variance in quarterly returns for large pension funds.
Difficulty: Moderate

4. Distinguish between systematic and unsystematic risk. What are two other names
for each? Give examples of each.

Answer: Systematic risk is also called market risk or nondiversifiable risk (e.g.,
inflation, war). Unsystematic risk is also called nonmarket (unique) risk
or diversifiable risk (e.g. poor product design, law suit).
Difficulty: Moderate

5. Suppose you interview two different portfolio managers about their efficient sets
of portfolios. Is it possible, or even probable, that they would have two different efficient
sets? Why?

Answer: Yes. Two different managers are likely to estimate inputs to the model
differently and come out with different answers.
Difficulty: Difficult

Chapter Eight 104

Portfolio Selection
Investments Analysis and Management 13th Edition Jones Test Bank

Problems

1. Given the following information, calculate the expected return of Portfolio ABC.
Expected return of stock A = 10%, Expected return of stock B = 15%, Expected
return of stock C = 6%. 40 percent of the portfolio is invested in A, 40 percent is
invested in B and 20 percent is invested in C.

Solution: Expected return of the portfolio = .10 (.40) + .15 (.40) + .06 (.20) =
.112 = 11.2%
Difficulty: Moderate

2. Assume ABC are all positively correlated. A fourth stock is being considered for
addition to the portfolio, either stock D or stock E. Both D and E have expected
returns of 12%. If stock D is positively correlated with ABC, and E is negatively
correlated with ABC, which stock should be added to the portfolio? Why?

Solution: Add stock E. The expected return of the portfolio would be the same
with either stock and by adding E, the overall risk of the portfolio would
be lowered.
Difficulty: Moderate

Chapter Eight 105

Portfolio Selection

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