a. describe the portfolio approach to investing;
Why should investors take a portfolio approach instead of investing in individual stocks? Why not put all your eggs in one basket?
Portfolio theory is used to maximize an investment's expected rate of return for a given level of risk, or minimize the level of risk for a given expected rate of return.
For the purpose of investing, risk is defined as the variation of the return from what was expected (volatility). It is represented by a measure such as standard deviation.
Diversification is used to reduce a portfolio's overall volatility. By building a portfolio out of many unrelated (uncorrelated) investments total volatility (risk) is minimized. The idea is that most assets will provide a return similar to their expected return and will offset those in the portfolio that perform poorly. The diversification ratio
is the ratio of the standard deviation of an equally weighted portfolio to the standard deviation of a randomly selected security.
- The composition of a portfolio matters a great deal. Different portfolios have different risk-return trade-offs.
- Portfolio diversification does not necessarily provide the same level of risk reduction during times of severe market turmoil as it does when the economy and markets are operating normally.
- The modern portfolio theory says that the value of an additional security to a portfolio ought to be measured with its relationship to all of the other securities in the portfolio.
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