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Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons

chapter 8 investment

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127 views

Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons

chapter 8 investment

Uploaded by

jcpinoy ballisbuhay
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Chapter 8

Charles P. Jones, Investments: Analysis and Management,


Twelfth Edition, John Wiley & Sons

8-1
 Diversification is key to optimal risk
management
 Asset allocation is most important single

decision
 Using Markowitz Principles

◦ Step 1: Identify optimal risk-return combinations


using the Markowitz efficient frontier analysis
 Estimate expected returns, variances and
covariances
◦ Step 2: Choose the final portfolio based on your
preferences for return relative to risk

8-2
 Optimal diversification takes into account all
available information
 Assumptions in portfolio theory

◦ A single investment period (one year)


◦ Liquid position (no transaction costs)
◦ Preferences based only on a portfolio’s expected
return and risk

8-3
 Smallest portfolio risk for a given level of
expected return
 Or largest expected return for a given level of

portfolio risk
 From the set of all possible portfolios

◦ Only locate and analyze the subset known as the


efficient set

8-4
 Efficient frontier or
Efficient set (curved
line from A to B)
B  Global minimum
x
variance portfolio
E(R) (represented by
A point A)
y
 Portfolios on AB
C dominate those on
Risk =  AC

8-5
 Portfolio weights are only variable that can
change in Markowitz analysis
 Assume investors are risk averse
 Indifference curves help select from efficient

set
◦ Description of preferences for risk and return
◦ Portfolio combinations which are equally desirable
◦ Match investor preferences with portfolio
possibilities

8-6
 International diversification unlikely to offer
as much risk reduction as it has in the past
 Markowitz portfolio selection model

◦ Assumes investors use only risk and return to


decide
◦ Generates a set of equally “good” portfolios
◦ Does not address the issues of borrowed money or
risk-free assets
◦ Cumbersome to apply

8-7
 Another way to use Markowitz model is with
asset classes
◦ Allocation of portfolio assets to asset types
 Asset class rather than individual security decisions
likely most important for investors
◦ Can be used when investing internationally
◦ Different asset classes offers various returns and
levels of risk
 Correlation coefficients may be quite low

8-8
 Includes two dimensions
◦ Diversifying between asset classes
◦ Diversifying within asset classes
 Asset classes include
◦ International equities
◦ Bonds
◦ Treasury Inflation-Indexed Securities (TIPS)
◦ Real estate
◦ Gold
◦ Commodities

8-9
 Correlation among asset classes must be
considered
 Correlations change over time
 For individual investors, allocation depends
on
◦ Time horizon
◦ Risk tolerance
 Diversified asset allocation doesn’t
necessarily provide benefits or guarantee
against loss

8-
10
 Index Mutual Funds and ETFs
◦ Investors can buy funds covering various asset
classes
 Domestic large-cap stocks, domestic small-cap stocks
 International stocks
 Bond funds
 Life Cycle Analysis
◦ Varies asset allocation based on age of investor
◦ Life-cycle funds (target-date funds) hold various
asset classes and the allocation changes as investor
ages
 No one “correct” approach to allocation

8-
11
Impact of Diversification on Risk
 Total risk = systematic (nondiversifiable) risk
+ nonsystematic (diversifiable) risk
◦ Systematic risk is market risk and common to
virtually all securities
◦ Nonsystematic risk is company-specific risk
 Total risk can go no lower than systematic
risk
 Both risk components can vary over time
 Affects number of securities needed to diversify

8-
12
p %
Total risk
35
Diversifiable (nonsystematic) risk

20
Nondiversifiable (systematic) risk

0
10 20 30 40 ...... 100+
Number of securities in portfolio
Copyright 2013 John Wiley & Sons, Inc.
All rights reserved. Reproduction or translation of this
work beyond that permitted in section 117 of the 1976
United States Copyright Act without express
permission of the copyright owner is unlawful. Request
for further information should be addressed to the
Permissions Department, John Wiley & Sons, Inc. The
purchaser may make back-up copies for his/her own
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Publisher assumes no responsibility for errors,
omissions, or damages caused by the use of these
programs or from the use of the information herein.

8-
14

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