Reading 44 : Portfolio Risk and Return (P.1)
- Describe the implications of combining a risk-free asset with a portfolio of risky assets
2. Explain the capital allocation line (CAL) and the capital market line (CML)
- The line of possible portfolio risk and return combinations given the risk-free rate and the risk and return of a portfolio of risky assets ⇒ Capital Allocation Line.
- Each investor has different expectations about the expected returns of, standard deviations of, or correlation between risky asset returns ⇒ each investor will have a different optimal risky asset portfolio & CAL.
- Assumption under modern portfolio theory (and CAPM) that investors have homogeneous expectations (have same risk, return, correlation) ⇒ have some optimal risky portfolio & CAL. In this case, that portfolio must be the market portfolio.
- Under assumption of homogeneous expectation: CAL ⇒ Capital Market Line (CML)
3. Explain systematic and non systematic risk, including why an investor should not expect to receive additional return for bearing non_systematic risk
- The risk that is eliminated by diversification is called unsystematic risk.
- The risk that remains cannot be diversified away and is called the systematic risk (nondiversifiable risk or market risk)
- Total risk = Systematic risk + Unsystematic risk
- 12-18 stocks in portfolio to achieve 90% of the maximum diversification possible. Another study indicated it took 30 securities.
- Systematic Risk is relevant in Portfolios
To sum up, unsystematic risk is not compensated in equilibrium because it can be eliminated for free through diversification. Systematic risk is measured by the contribution of a security to the risk of a well-diversified portfolio, and the expected equilibrium return on an individual security will depend only on its systematic risk.