Portfolio Selection
FIN221: Lecture 4 Notes
Chapter 19
Portfolio Selection
Chapter 19 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University
Portfolio Selection
• Diversification is key to optimal risk management • Analysis required because of the infinite number of portfolios of risky assets • How should investors select the best risky portfolio? • How could riskless assets be used?
Building a Portfolio
• Step 1: Use the Markowitz portfolio selection model to identify optimal combinations • Step 2: Consider riskless borrowing and lending possibilities • Step 3: Choose the final portfolio based on your preferences for return relative to risk
Portfolio Theory
• Optimal diversification takes into account all available information • Assumptions in portfolio theory
– A single investment period (one year) – Liquid position (no transaction costs) – Preferences based only on a portfolio’s expected return and risk
An Efficient Portfolio
• Smallest portfolio risk for a given level of expected return • Largest expected return for a given level of portfolio risk • From the set of all possible portfolios
– Only locate and analyze the subset known as the efficient set
• Lowest risk for given level of return
Selecting an Optimal Portfolio of Risky Assets
• Assume investors are risk averse • Indifference curves help select from efficient set
– Description of preferences for risk and return – Portfolio combinations which are equally desirable – Greater slope implies greater the risk aversion
Selecting an Optimal Portfolio of Risky Assets
• Markowitz portfolio selection model
– Generates a frontier of efficient portfolios which are equally good – Does not address the issue of riskless borrowing or lending – Different investors will estimate the efficient frontier differently
• Element of uncertainty in application
The Single Index Model
• Relates returns on each security to
Chapter 19
Portfolio Selection
Chapter 19 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University
Portfolio Selection
• Diversification is key to optimal risk management • Analysis required because of the infinite number of portfolios of risky assets • How should investors select the best risky portfolio? • How could riskless assets be used?
Building a Portfolio
• Step 1: Use the Markowitz portfolio selection model to identify optimal combinations • Step 2: Consider riskless borrowing and lending possibilities • Step 3: Choose the final portfolio based on your preferences for return relative to risk
Portfolio Theory
• Optimal diversification takes into account all available information • Assumptions in portfolio theory
– A single investment period (one year) – Liquid position (no transaction costs) – Preferences based only on a portfolio’s expected return and risk
An Efficient Portfolio
• Smallest portfolio risk for a given level of expected return • Largest expected return for a given level of portfolio risk • From the set of all possible portfolios
– Only locate and analyze the subset known as the efficient set
• Lowest risk for given level of return
Selecting an Optimal Portfolio of Risky Assets
• Assume investors are risk averse • Indifference curves help select from efficient set
– Description of preferences for risk and return – Portfolio combinations which are equally desirable – Greater slope implies greater the risk aversion
Selecting an Optimal Portfolio of Risky Assets
• Markowitz portfolio selection model
– Generates a frontier of efficient portfolios which are equally good – Does not address the issue of riskless borrowing or lending – Different investors will estimate the efficient frontier differently
• Element of uncertainty in application
The Single Index Model
• Relates returns on each security to