Week 1
The minimum variance of a portfolio with a perfect negative correlation is 0.
Indifference curves represent a trade-off between two variables: risk and return.
Two characteristics indifference curves:
1. The investor is indifferent between all possible portfolios on this curve.
2. The curve that is most northwest is the curve that offers the greatest utility to the
investor.
We find the optimal complete portfolio to be the tangency point between an indifference
curve (representing what is desirable) and the capital allocation line (representing what is
possible).
Main reasons why Markowitz Portfolio Selection Model might be challenging to implement
empirically:
- The large number of parameters.
- Errors in the estimation of covariance matrix.
How does an index model help in solving those challenges?
- An index model accounts in a tractable way for sources of risk and decomposes
uncertainty into systematic and idiosyncratic risk.
- The procedure drastically decreases the number of estimates needed for portfolio
construction.
Skewness: how asymmetric are returns?
Upside potential: right-skewed (we want this)
Downside potential: left-skewed
Behavioural biases:
Framing: An individual may act risk averse in terms of gains but risk seeking in terms of
losses.
Mental accounting: Specific form of framing in which people segregate certain decisions.
Regret avoidance: individuals who make decisions that turn out badly have more regret
when that decision was more unconventional.
Affect and feelings: affect is a feeling of “good” or “bad” that consumers may attach to a
potential purchase or investors to a stock.
Prospect theory = loss aversion: losses and gains are not experienced symmetrically. A loss
causes more pain than a gain causes joy.
The minimum variance of a portfolio with a perfect negative correlation is 0.
Indifference curves represent a trade-off between two variables: risk and return.
Two characteristics indifference curves:
1. The investor is indifferent between all possible portfolios on this curve.
2. The curve that is most northwest is the curve that offers the greatest utility to the
investor.
We find the optimal complete portfolio to be the tangency point between an indifference
curve (representing what is desirable) and the capital allocation line (representing what is
possible).
Main reasons why Markowitz Portfolio Selection Model might be challenging to implement
empirically:
- The large number of parameters.
- Errors in the estimation of covariance matrix.
How does an index model help in solving those challenges?
- An index model accounts in a tractable way for sources of risk and decomposes
uncertainty into systematic and idiosyncratic risk.
- The procedure drastically decreases the number of estimates needed for portfolio
construction.
Skewness: how asymmetric are returns?
Upside potential: right-skewed (we want this)
Downside potential: left-skewed
Behavioural biases:
Framing: An individual may act risk averse in terms of gains but risk seeking in terms of
losses.
Mental accounting: Specific form of framing in which people segregate certain decisions.
Regret avoidance: individuals who make decisions that turn out badly have more regret
when that decision was more unconventional.
Affect and feelings: affect is a feeling of “good” or “bad” that consumers may attach to a
potential purchase or investors to a stock.
Prospect theory = loss aversion: losses and gains are not experienced symmetrically. A loss
causes more pain than a gain causes joy.
