Naive Diversification

Question 1

Who developed mean variance portfolio analysis?

Answer 1

Harry Markowitz(1952)

Question 2

According to Rubenstein (2002) what did the development of mean variance analysis mean?

Answer 2

Markowitz’s(1952) work was the birth of modern finance.

Question 3

Single period model

Answer 3

Investment decisions are made for one time period.

Question 4

Investors Aim?

Answer 4

To maximize expected return for a given level of risk (measured by variance)

Question 5

In the mean-variance framework, how is risk measured?

Answer 5

Risk is measured by variance or standard deviation of returns.

Question 6

Efficient frontier

Answer 6

This is where the optimal portfolio lies and no other portfolio offers a higher return for the same risk.

Question 7

How to determine the best combination of assets

Answer 7

Relies heavily on matrix calculations to determine best combination

Question 8

Expected return of the portfolio

Answer 8

The weighted average of the expected returns of the two assets. See ipad for equation

Question 9

Portfolio variance (risk)

Answer 9

Measures how volatile or risky the portfolio is. See ipad for equation.

Question 10

Portfolio standard deviation

Answer 10

This gives the risk in the same units as returns. Making it easier to interpret.

Question 11

What is covariance?

Answer 11

A statistical measure of how two variables are related to one another.

Question 12

If positive covariance?

Answer 12

Means assets rise/fall together

Question 13

If negative Covariance?

Answer 13

One rises, the other falls

Question 14

How to measure covariance?

Answer 14

A standardized measure of covariance is the correlation.

Question 15

Correlation (corr)

Answer 15

Is a standardized version of covariance (unit free so easier to interpret)

Question 16

Where does correlation lie?

Answer 16

Between -1 and 1

Question 17

-1 correlation

Answer 17

Means perfect negative correlation (great for diversification, maximum risk reduction)

Question 18

+1 correlation

Answer 18

Means perfect positive correlation (no diversification so no risk reduction)

Question 19

Zero correlation

Answer 19

no statistically significant linear relationship between two variables

Question 20

What does low correlation mean?

Answer 20

The lower the correlation the larger the risk reduction benefits.

Question 21

For N risky assets

Answer 21

When there are N assets you generalize the two-asset model. Now each asset has its own weight and expected return. See ipad.

Question 22

What does the covariance matrix V contain?

Answer 22

Diagonal: variances of each asset
Off-diagonal: covariances between asset pairs

Question 23

What is a naive diversification strategy?

Answer 23

Investing equally in all assets.
A naïve diversification strategy is when an investor does not use an optimal investment theory to build a portfolio.

Question 24

Why is the 1/N strategy notable?

Answer 24

DeMiguel, Garlpappi, and Uppal (2009) argue its hard to outperform.
For the more N the risk of the portfolio declines

Question 25

What are the components of total risk?

Answer 25

Total risk = systematic risk + unique risk

Question 26

How many stocks are enough for effective naive diversification?

Answer 26

Textbooks: 20 stocks Campbell et al (2001): 50 stocks

Question 27

Why diversify internationally?

Answer 27

Lower correlations between domestic and foreign markets so portfolio risk can be reduced (Solnik, 1974)

Question 28

What happens to correlations during financial crisis?

Answer 28

The increase (Longin and Solnik(1995))

Question 29

What is a major factor in international investing?

Answer 29

The role of currency

Question 30

What are two key factors affecting foreign asset performance?

Answer 30

1. Foreign market performance 2.Currency exchange performance

Question 31

Notable currency regimes in the 20th century?

Answer 31

Gold standard Bretton Woods (fixed exchange rate) Floating exchange rates (post-1970s)

Question 32

What does Modern Monetary Theory (MMT) argue?

Answer 32

Sovereign currencies with floating exchange rates allow greater fiscal flexibility

Question 33

Can currency risk be hedged by investors?

Answer 33

Yes Equity investors: Little benefit Bond investors: Great benefit

Question 34

Who benefits from currency hedging?

Answer 34

According to DMS(2012) there is little benefit for global equity investors but greater benefit for bond investors

Question 35

Why trade currencies?

Answer 35

Markets are huge and liquid and returns can be driven by central bank policies, economic fundamentals, and macro trends.

Question 36

What are three popular currency trading strategies (DMS, 2012)?

Answer 36

1.Value 2.Momentum 3.Carry Trade

Question 37

Value currency strategy

Answer 37

Buy undervalued currencies and sell overvalued ones

Question 38

Momentum currency strategy

Answer 38

Buy currencies that have recently appreciated, sell hose that have depreciated. Assume the trend continues in the short run.

Question 39

Carry trade strategy

Answer 39

Borrow in currency with low interest rate and invest in one with high interest rate.

Question 40

Why are emerging international markets attractive?

Answer 40

Investing increases the risk reduction benefits Lower correlations with developed markets. Offer high average returns but also high volatility

Question 41

How are countries classified into emerging vs developed markets?

Answer 41

By index providers (MSCI, FTSE) or GDP

Question 42

What classifies an emerging market?

Answer 42

GDP per capita of less than $25,000

Question 43

Benefits of investing in an emerging market when you are invested in developed markets?

Answer 43

Diversification

Question 44

What are the risks of international investing?

Answer 44

Political Regulatory Operational Higher costs Currency risks

Question 45

What is the investment horizon?

Answer 45

The length of time an investor expects to hold an investment

Question 46

What role does investment horizon play?

Answer 46

It affects means, variances, correlations, and higher moments like skewness and kurtosis