MIDTERM (Investment management)
It suggests that by spreading investments across different asset classes, you can reduce overall portfolio risk without sacrificing potential returns.
Diversification
Markowitz Portfolio Theory recognizes the inherent tradeoff between risk and return. It provides a framework for investors to identify portfolios that offer the highest expected return for a given level of risk.
Risk Return Tradeoff
The theory acknowledges that asset returns are not independent and may be correlated. Understanding these correlations is vital to building an efficient portfolio that minimizes risk and maximizes returns.
Correlation
Considering their individual risk tolerance and investment goals. It offers the best balance of risk and return for the individual.
Optimal Portfolio
Is a widely used measure of risk that quantifies the volatility of returns. Higher standard deviation indicates greater volatility and risk.
Standard Deviation
Provides a probabilistic estimate of the maximum potential loss an investment can experience over a specified period. It is a useful tool for risk management.
Value at Risk
measures the systematic risk of an asset relative to the overall market.
Beta
considers both risk and return by measuring the risk-adjusted return of an investment. It helps investors compare different investments based on their efficiency.
Sharpe Ratio
The anticipated return on an investment, calculated as the weighted average of the possible returns, considering their probabilities.
Expected Return
Past performance of the investment or similar investments can provide insights into potential future returns.
Historical Data
Current economic conditions, interest rates, and other market factors can influence expected returns.
Market Conditions
Financial analysts may provide forecasts and recommendations based on their research and market analysis.
Analyst Forecast
First, determine the expected return for the investment by considering different possible returns and their respective probabilities.
Calculate Expected Return
Next, calculate the difference between each possible return and the expected return. These differences represent deviations from the expected outcome.
Determine Deviations from Expected Return
Square each deviation to account for both positive and negative deviations. Then, calculate the weighted average of these squared deviations, using their probabilities as weights.
Square Deviations and Calculate Weighted Average
Finally, take the square root of the variance to obtain the standard deviation, which represents the volatility of the investment's returns.
Calculate Standard Deviation
Determine the variance for each investment in the portfolio using the method outlined in the previous section.
Calculate Individual Investment Variances
Covariance measures the relationship between the returns of different investments in the portfolio. It reflects how their returns move together.
Calculate Covariance
Calculate the weighted average of the individual variances, taking into account the proportion of each investment in the portfolio.
Calculate Weighted Average Variance
Add the weighted average variance to the sum of covariance terms for all investment pairs, representing the total variance of the portfolio.
Calculate Portfolio Variance
Diversification is effective when investments are not perfectly correlated. If investments move independently, their individual risks can offset each other within the portfolio.
Correlation and Diversification
Diversification helps reduce unsystematic risk, which is specific to individual investments. It cannot eliminate systematic risk, which is inherent to the overall market.
Benefits of Diversification
Investing in different asset classes like stocks, bonds, real estate, and commodities.
Asset Class Diversification
Spreading investments across various sectors within an asset class, such as technology, healthcare, and energy.
Sector Diversification
Investing in securities from different countries to reduce exposure to single-country risks.
Geographic Diversification
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