Portfolio Theory

Portfolio Theory – some salient points

  • Risk of the average is not equal to the average of the risk
  • shifting the efficient frontier to North west , the portfolio can be optimised to an extent
  • efficient frontier :- standard way of showing return and risk relationship
  • Expand the universe of investible asset classes to produce a new efficient frontier
  • correlation
  • strategic asset allocation ( defined by objectives ) and tactical asset allocation ( depends upon investment policy )
  • Rebalance Portfolio if financial markets have different expected returns
  • MPT ( modern Portfolio Theory ) by Markowitz in 1952 – portfolio needs to be diversified
  • Distribution of returns ( can be derived by change in prices )
  • Metric used for measuring dispersion – standard deviation ( from the average )
  • scatter plot for measuring correlation ( -1 to 1 ) – measure for dependence
  • Three measures :- Expected return , standard deviation and Correlation
  • optimal Portfolio creation need the above three measures only
  • variance = STD * STD
  • covariances – correlation * std1 * std2 – can take any value
  • Value appreciation vs. risk undertaken ( risk / return trade off )
  • efficient frontier : highest return at a specific level of risk

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