CHAPTER 12

CHOOSING AN INVESTMENT PORTFOLIO

Objectives

« To un dersta nd the process of pers onal in vest ing in theory and in practice.

« To build a qua ntitative model of the tradeoff betwee n risk and reward.

Outline

The Process of Pers onal Portfolio Selecti on

The Trade-off betwee n Expected Retur n and Risk Efficie nt Diversificati on with Many Risky Assets

Summary

* There is no sin gle portfolio selecti on strategy that is best for all people.

« Stage in the life cycle is an imp orta nt determ inant of the optimal compositi on of a pers on

assets and liabilities.

*

Time horizons are important in portfolio selection. We distinguish among three time horizons: the planning horizon, the decision horizon, and the trading horizon. *

In mak ing portfolio selecti on decisi ons, people can in gen eral achieve a higher expected rate of retur n only by expos ing themselves to greater risk. *

One can sometimes reduce risk without loweri ng expected return by diversify ing more completely either within a give n asset class or across asset classes. * The power of diversificati on to reduce the risk in ess of an in vestor ' scpw r efodti m depe nds on the

among the assets that make up the portfolio .In practice, the vast majority of assets are positively correlated with

each other because they are all affected by com mon econo mic factors. Con seque ntly, one

' s ability to red

through diversification among risky assets without lowering expected return is limited. * Although in principle people have thousands of assets to choose from, in practice they make their choices from a menu of a few final

products offered by financial intermediaries such as bank accounts, stock and bond mutual fun ds, and real estate. In desig ning and produc ing the menu of assets to offer to their customers these

in termediaries make use of the latest adva nces in finan cial tech no logy.12.1 12.2 12.3 s optimal portfolio of