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3. 2. and their utility curves demonstrate diminishing marginal utility of wealth. For a given risk level.1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period. Investors minimize one-period expected utility. investors prefer higher returns . so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only. 4. 5. Investors estimate the risk of the portfolio on the basis of the variability of expected returns. Investors base decisions solely on expected return and risk.

RELATIONSHIP BETWEEN DIVERSIFICATION AND RISK Standard Deviation of Return Unsystematic (diversifiable) Risk Total Risk Standard Deviation of the Market Portfolio (systematic risk) Systematic Risk Number of Stocks in the Portfolio .

EFFICIENT FRONTIER The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk. Frontier will be portfolios of investments rather than individual securities – Exceptions being the asset with the highest return and the asset with the lowest risk . or the minimum risk for every level of return.

a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola). .Efficient Frontier Expected Return Googl 100% investment in security e No points plot above with highest E(R) the line Points below the efficient frontier are dominated All portfolios on the line are efficient Coca cola 100% investment in minimum variance portfolio Standard Deviation Figure shows the efficient frontier for just two stocks .

Formulas Portfolio Return Where. of securities in the portfolio Portfolio Risk 2 2 2 p xA A x 2 B 2 B 2xA xB AB A B Interactive Risk Total Risk Risk from A Risk from B . E(Rp)=expected return on portfolio xi=weight of securities i in the portfolio E(Ri)=Expected return on securities i n= No.

136 .Example Assume the following statistics for Stocks A.232 . B.195 The correlation coefficients between the three stocks are: Stock A Stock B Stock C Stock A Stock B Stock C 1.10 .286 0.000 -0.000 0. and C Stock A Stock B Stock C Expected return Standard deviation .132 1.14 .605 1. Which combinations of the three stocks accomplish this objective? Which of those combinations achieves the least .000 An investor seeks a portfolio return of 12%.20 .

50% in C: (.Solution: Two combinations achieve a 12% return: 1) 50% in B.8)(10%) = 12% . 80% in C: (.5)(14%) + (.2)(20%) + (.5)(10%) = 12% 2) 20% in A.

0046 .50) (.50)( .50) (.0095 .0185) (.50)(.0380) 2(.0080 .136)(.0061 .Solution (cont’d): Calculate the variance of the B/C combination: x x 2 x A xB AB A B 2 p 2 A 2 A 2 B 2 B (.195) 2 2 .605)(.

80) (.232)(.20) (.80)(. Solution (cont’d): Calculate the variance of the A/C combination: x x 2 x A xB AB A B 2 p 2 A 2 A 2 B 2 B (.195) 2 2 .132)(.0284 .0022 .0019 .20)(.0538) (.0243 .0380) 2(.

. Thus.Solution (cont’d): Investing 50% in Stock B and 50% in Stock C achieves an expected return of 12% with the lower portfolio variance. the investor will likely prefer this combination to the alternative of investing 20% in Stock A and 80% in Stock C.

CONCLUSION Various portfolio combinations may result in a given return The investor wants to choose the portfolio combination that provides the least amount of variance .

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