Chapter 8: Portfolio Selection and Asset Allocation

ANSWERS TO END-OF-CHAPTER QUESTIONS

8-1.

The vertical axis of the Efficient Frontier is expected return. The horizontal axis is risk,
as measured by standard deviation.

8-2.

There are many portfolios on the Markowitz efficient frontier, depending on how precise
one wishes to be. For example, an efficient frontier could be calculated using 1
percentage point intervals for expected return, or one-tenth of a percent intervals.
Regardless, there are many portfolios on the efficient frontier.
The Markowitz efficient set consists of those portfolios dominating the feasible set of
portfolios that could be attained. It is described by a curve, as opposed to a straight line.

8-3.

Rational investors seek efficient portfolios because these portfolios promise maximum
expected return for a specified level of risk, or minimum risk for a specified expected
return.

8-4.

Using the Markowitz analysis, an investor would choose the portfolio on the efficient
frontier that is tangent to his/her highest indifference curve. This would be the optimal
portfolio for him/her.

8-5.

An indifference curve describes investor preferences for risk and return. Each
indifference curve represents all combinations of portfolios that are equally desirable to a
particular investor given the return and risk involved. Thus, an investor's risk aversion
would be reflected in his or her indifference curve.
The curves for all risk-averse investors will be upward-sloping, but the shapes of the
curves can vary depending on risk preferences.

8-6.

The efficient frontier shows possibilities; that is, the optimal portfolios that an investor
could own. Indifference curves express preferences, or the tradeoff between expected
return and risk.

8-7.

In recent years, the correlations among stocks of different countries have risen. These
correlations increased significantly starting in 1995. The immediate benefits of risk
reduction by adding stocks with lower correlations has been reduced but not eliminated.

8-8.

Investors should not ignore international diversification. The correlations could become
somewhat lower in the future, although as the world economy becomes more integrated,
this is less and less likely. However, there should always be opportunities for investors
in the stocks of other countries, and they should be looking for these opportunities.

8-9.

The asset allocation decision involves the percentages of ones investable funds to be
placed in each category of financial assets such as stocks, bonds, real estate, and so forth.
It is believed by many to be the most important decision an investor can make, and this is
particularly true for large institutional investors.

8-10. When more asset classes are involved, the efficient frontier often improves. This is
because there are more opportunities for low correlations between asset classes, and even
negative correlations.
8-11.

As we add securities to a portfolio, the total risk of the portfolio declines rapidly, but then
levels off and at some point will not decline a noticeable amount.

8-12. Diversification works extremely well in reducing part of the risk of a portfolio, but it
cannot eliminate all of the risk because diversification cannot eliminate market risk.
There are clearly limits to diversification because it cannot eliminate market risk. The
effects of diversification kick in immediately-normally, two securities are better than
one, three are better than two, etc.
The effects of diversification are both immediate and dramatic.
8-13. No. The evidence suggests an investor can improve his/her position by holding some
percentage of the portfolios assets in stocks.
8-14. No. Modern portfolio theory argues for diversification among asset classes.
8-15. The traditional beliefs about diversification, popularized by Evans and Archer in the
1960s, was that something like 8-16 securities provided most of the diversification
benefits that could be obtained. In round numbers, call it 20 stocks. Malkiels evidence
suggests that many more securities are required to achieve adequate diversification. In
round numbers, call it 50 stocks.
8-16.

Gold can be used as part of an asset allocation plan. This can be accomplished using
ETFs, mutual funds, gold mining stocks, and the ownership of gold bullion.

8-17.

There is no way to know for sure because there is no reference point for this situation.
This is why the correlation coefficient is used in these situations.

8-18.

If the single asset is an ETF or mutual fund holding a broad market index, on a practical
`basis it might be considered efficient.

8-19.

Without borrowing and lending, which is not included in the original Markowitz
analysis, the Markowitz efficient frontier cannot be a straight line.

ANSWERS TO END-OF-CHAPTER PROBLEMS

8-1.

b (12 X 20 X .30) = 72

8-2.

a (50%)(16%) + (50%)(22%) = 19%

8-3.

b Stock X has the lower standard deviation

8-4.

.33 (.75) = 24.75% of total assets