Chapter 17
RISK AND DIVERSIFICATION
• What is risk aversion, and why are
investors, as a group, risk averse?
• What are the general investment
implications of risk aversion?
• Why is standard deviation a good
measure of risk, and how does an
investor compute standard deviations
for both individual securities and
portfolios?
Contemporary Investments: Chapter 17
RISK AND DIVERSIFICATIONCont.
• What is the impact of security
correlations impact portfolio risk?
• What are the benefits of
diversification, and how investors
achieve them?
• What is the meaning of efficient
diversification and modern portfolio
theory
Contemporary Investments: Chapter 17
What is risk aversion?
• Risk aversion
• Risk aversion and expected returns
• Relative risk aversion and expected
returns
Contemporary Investments: Chapter 17
Figure 17.1 – Distribution of Yearly Returns
of Stocks and T-Bills, 1926-2002
Contemporary Investments: Chapter 17
Figure 17.2 – Risk Aversion and
Expected Returns
Contemporary Investments: Chapter 17
Measuring risk and return:
Individual securities
• Measuring returns
– Ex-ante or expected returns
– Ex-post or historical returns
• Measuring risk
– Range
– Number of negative outcomes
– Standard deviation (or variance)
Contemporary Investments: Chapter 17
Calculating standard deviations
and security selection
• Ex-ante or expected risk
• Ex-post or historical risk
• Security selection
Contemporary Investments: Chapter 17
Figure 17.3 – Risk/Return Graph for
Security Selection
Contemporary Investments: Chapter 17
Portfolio risk and return
• Portfolio return.
– Ex-ante portfolio return, ERp
– Ex-post portfolio return, Mp
Contemporary Investments: Chapter 17
Standard deviation of a
two-security portfolio
•
•
•
•
Covariance (COV(A,B))
Correlation coefficient CORR(A,B)
CORR(A,B) = COV(A,B)/ (SDA)(SDB)
Standard deviation for a two-security
portfolio
• Correlation and portfolio standard
deviation
Contemporary Investments: Chapter 17
Figure 17.4 – Two-Security Portfolio
Combinations with
Various Correlations
Contemporary Investments: Chapter 17
Investment opportunity set
for two-security portfolio
• Minimum variance portfolio
• Standard Deviation of an N-Security
Portfolio.
Contemporary Investments: Chapter 17
Figure 17.5 – Two-Security Portfolio
Combinations of Securities A and E
Contemporary Investments: Chapter 17
Diversification
•
•
•
•
•
•
Diversification across securities
Two types of portfolio risk
Mathematical effects of diversification
Diversification across time
Efficient diversification
How to find an efficient frontier
• Implications for Investors
Contemporary Investments: Chapter 17
Figure 17.6 – Example of Diversification
Across Securities
Contemporary Investments: Chapter 17
Figure 17.7 – Efficient Frontier for
Three Stocks
Contemporary Investments: Chapter 17
Figure 17.8 – Full-Market Efficient Frontier
Contemporary Investments: Chapter 17