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Portfolios (The Capital Market Line (Investors hold an optimum portfolio…
Portfolios
The Capital Market Line
Investors hold an optimum portfolio of shares along the efficient frontier - combination of maximum amount of shares.
Investments are not restricted to risky securities (shares) - risk free borrowing and lending exists
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The capital market line shows a linear risk return relationship when portfolios are combined with risk free investment
Investments are available along CML from risk free to the point of tangency with the efficient frontier.
The market portfolio indicates the optimal combination of risky shares given the existence of risk free investment
Investors are able to move along the CML by changing proportions of market portfolio and RF investments
The result of a linear relationship trade-off between risk and return, a straight line between 2 investment options
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Risk loving investors will position themselves closer to the market portfolio by investing more money here
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Envelope Curve
The risk- return behaviour of a portfolio of shares can be mapped out - this map is known as the envelope curve.
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It is possible to calculate the most efficient (risk minimising) combination of shares i.e. best return for level of risk
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Portfolio calculations
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Step 3
Calculate the mean returns and standard deviation of a 2 share portfolio given the correlation or co-variance between shares
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Diversification
Many shares move in opposite directions and so the fortunes of one company (share price rise) are the misfortunes of another company (share price decrease).
Unsystematic risk can be diversified away by holding a large amount of shares to spread and reduce risk.
Unless returns of a portfolio are perfectly positively correlated - then diversification reduces risk
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Utility curves
Utility curves
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The capital market line shows the most efficient investments available i.e. combination of risk free and market portfolio
Investors will make the most efficient investment by matching their own indvidual utility curves to the Capital Market Line
Where a personal utility curve (risk-return attitude) meets the Capital Market Line then this represents the most efficient investment section
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A portfolio of 2 or more shares reduces standard deviation (risk) compared to individual shares - produces average returns but less than (weighed) average risk
Any combination of investment in each share will reduce overall risk to return - an optimum mix can be achieved or found by trying different % amounts of each share
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The risk reduction is achieved by holding the whole market portfolio of shares or at least a collection of shares with high negative correlation