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INTRODUCTION TO PORTFOLIO MANAGEMENT

 Concerned with the risk reducing role played by individual assets in an investment portfolio of
several assets

MEANS AND STANDARD DEVIATIONS OF TOTAL RETURN

 Return and risk of an asset are commonly measured in terms of the mean and standard deviation
of total return
 Mean: return one expects to obtain on average
 Standard deviation: measure of dispersion, in this case total volatility of return
o The return one experiences will fall within 1 SD to either side of the mean about 68% of
the time, within 2 SD 95% of the time and within 3 SD 99.7% of the time
 Mean and SD of return for a given asset can be computer from historical returns, however they
may or may not reflect the probability distribution of future returns

INVESTING IN ONLY ONE ASSET

 Dominated assets occur when other options have either a higher expected return or a lower SD
than any other asset
 The choice among undominated assets is dictated by the degree to which the investor is
personally willing to trade less return for less risk

PORTFOLIOS OF A RISKLESS AND A RISKY ASSET

 F = fraction investment in the risky asset


 1-F = fraction invested in cash
 E(a), E(b), E(c), E(d) = expected returns on assets A, B, C, D
 S(a), S(b), S(c), S(d) = standard deviations of return on assets A, B, C, D
 Expected return of a portfolio of cash and another asset (B) is: E = (1-F)*E(a) + f*E(b)
 Portfolio expected return is the weighted average of all the expected returns of the assets in the
portfolio
 If F = 1 (all our money is in B) then expected return of the portfolio = expected return of B, if F =0
(all our money is in cash) then expected return of the portfolio = expected return of cash
 Formula for standard deviation of a portfolio of cash and asset B = F*(standard deviation of B)
o Ex. if we invest half our money in B, we are only subject to ½ the risk

PORTFOLIOS OF TWO RISKY ASSETS

 F = fraction invested in B
 1-F = fraction invested in C
 Expected return of the portfolio = F*E(b) + (1-F)*E(c)
 Formula for portfolio SD = square root(F^2*S(b)^2+2F(1-F)RS(b)S(c)+(1-F)^2S(c)^2)
o Where R is the correlation between the returns on B and the returns on C – measure of
the degree to which the returns on 2 assets fluctuate together
o If the correlation = 1 meaning the assets are perfectly correlated, the formula can be
manipulated to = F*S(b) + (1-F)*S(c)
 If one holds equal amounts of risky assets that are not perfectly correlated, the expected return
of the portfolio will be the average of the expected returns of the assets in the portfolio, however
the SD will be less than the average of the SD in the portfolio
o Diversification leads to a reduction in risk without any sacrifice in expected return