May 1, 2000 Notes

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May 1, 2000 Notes
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Optimal Portfolio 1 risky, 1 riskless asset
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• When are there are many risky securities, youre
  only interested in efficient portfolios.
• The optimal portfolio is represented by a
  tangency between an indifference curve and the
  locus of efficient portfolios

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Optimal Portfolio many risky assets
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the efficient risky portfolio

• this is in the absence of a riskless asset.
• In the presence of a riskless asset, all the
  portfolios composed of risky assets alone are
  inefficient (except one).

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risk aversion and portfolio choice

• Very risk-averse hold a small amount of risky
  assets,
• the rest in the riskless asset
• Not very risk-averse (highly risk-tolerant)
  hold a large amount of risky assets,
• a small (or negative) amount in the riskless
  asset

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• positive holding of risk-free security
• appropriate for highly risk-averse investor

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• negative holding of risk-free security
• appropriate for the investor with low risk
  aversion (risk-tolerant investor)

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NOTE THIS!

• Both investors hold the same risky assets, and in
  the same relative proportions.

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Contrast popular advice

• bond/stock ratio varies a lot composition of
  risky portfolio depends on risk aversion.

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recommended reading

• An Asset Allocation Puzzle, (Niko Canner, N.
  Gregory Mankiw and David N. Weil)
• American Economic Review March 1997
• conclusion some of these recommended portfolios
  must be inefficient.
• Are investors irrational? Investment advisors?

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• Here is a set of recommendations that is
  consistent with CAPM

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Contrast advice of brokers

• If youre risk-averse concentrate on low-risk
  securities
• utilities, blue chips
• If youre risk-tolerant concentrate on
  high-risk securities
• small-cap stocks, high-tech stocks, biotech stocks