What is the risk-return relationship
Higher risk -> higher expected return
What is expected return
Weighted average of possible returns based on probabilities
Does expected return have to be a possible outcome
No, it’s an average over many outcomes
What determines risk in an investment
How spread out (volatile) the returns are
If 2 assets have the same expected return, which is riskier
The one with more volatility (more spread out returns)
Can probabilities be different in risk calculations
Yes, returns are weighted by probabilities
What is a portfolio
A collection of investments
What determines portfolio expected return
Weighted average of individual asset returns
Does correlation affect expected return
No, it only affects risk
What determines portfolio risk (3)
- individual risks
- weights
- correlation between assets
What is correlation (ρ)
Measure of how 2 assets move together (-1 to +1)
What does ρ = +1 mean and ρ= -1 mean, and ρ = 0
+1 = assets move perfectly together
-1 = assets move perfectly opposite
= 0 = no linear relationship between returns
Why is correlation important
It determines how much risk can be reduced
What is diversification
Combining assets to reduce risk
When does diversification work best
When correlation is less than +1
What is true diversification
Holding assets from different industries/sectors
Can diversification eliminate all risk? Or only one type of risk?
No, only unsystematic risk
What is the feasible set
All possible portfolios
What is the efficient frontier
Best portfolios (max return for given risk)
What is the minimum variance portfolio
Portfolio with the lowest possible risk
What is systematic risk
Market risk that affects all assets (cannot be diversified)
What is unsystematic risk
Asset-specific risk (can be diversified away)
Total risk =
systematic + unsystematic risk
Which risk matters for expected return
Systematic risk only
