Optimal Risky Portfolios

In Chapter 7 we discussed the capital allocation decision. That decision governs how an investor chooses between risk-free assets and "the" optimal portfolio of risky assets. This chapter explains how to construct that optimal risky portfolio. We begin with a discussion of how diversification can reduce the variability of portfolio returns. After establishing this basic point, we examine efficient diversification strategies at the asset allocation and security selection levels. We start with a simple example of asset allocation that excludes the risk-free asset. To that effect we use two risky mutual funds: a long-term bond fund and a stock fund. With this example we investigate the relationship between investment proportions and the resulting portfolio expected return and standard deviation. We then add a risk-free asset to the menu and determine the optimal asset allocation. We do so by combining the principles of optimal allocation between risky assets and risk-free assets (from Chapter 7) with the risky portfolio construction methodology Moving from asset allocation to security selection, we first generalize asset allocation to a universe of many risky securities. We show how the best attainable capital allocation line emerges from the efficient portfolio algorithm, so that portfolio optimization can be conducted in two stages, asset allocation and security selection. We examine in two appendixes common fallacies relating the power of diversification to the insurance principle and to investing for the long run.

208 PART II Portfolio Theory

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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