TOPIC 4: Modern Portfolio Theory + CMA Pt.1 Flashcards
(15 cards)
Why is diversification a key principle in portfolio theory?
Because combining assets with low or negative correlations reduces portfolio risk without necessarily reducing expected return.
What’s a Markowitz efficient portfolio?
A portfolio offering the highest expected return for a given level of risk — or the lowest risk for a given return — forming the efficient frontier.
Why do we use mean-variance optimization (MVO)?
To find the optimal combination of assets that minimizes portfolio variance while meeting return goals.
Why is asset allocation more important than stock picking?
Studies show it explains about 90% of portfolio variability over time, and 40% across portfolios — much more than security selection or market timing.
Why might global diversification diminish?
Because markets become more integrated over time, correlations increase (e.g., US-UK from 0.3 in 1960s to 0.9 by 2012).
What is a capital market assumption (CMA)?
Forward-looking estimates of risk, return, and correlations — a key input to MPT and portfolio optimization.
Why are historical CMAs unreliable for future?
Because future conditions may differ from the past, and relationships (like correlations and risk) are not stable over time.
Why is volatility more reliable to extrapolate?
Because volatility shows persistence over time and is a better indicator of future risk than historical return or correlations.
Why do practitioners often apply constraints to MPT portfolios?
To avoid unrealistic weights (like large positions in a single asset), reflect liquidity needs, or match policy guidelines.
What’s a simple risk-based allocation?
Allocating portfolio into “Safe”, “Market Risk”, and “Risky” buckets, and shifting weights based on risk tolerance and conditions.
What’s a Yale Model portfolio?
Equal allocation across a range of asset classes (such as private equity, hedge funds, real estate) to increase diversification and reduce portfolio volatility.
Why can MPT produce concentrated portfolios?
Because the optimizer may “chase” assets with high expected return and low covariance, ignoring diversification benefits — often yielding large weights in few assets.
Why are constraints (like weight limits) applied in practice?
To reflect liquidity, policy, or diversification requirements and to avoid portfolios that are overly concentrated or illiquid.
Why might an equilibrium-risk premium be lower today?
Higher demand for equities has driven prices up and future returns (and risk premium) down — reflecting lower risk or greater liquidity.
What’s a building block approach?
Starting from a base (like government bond yield), adding a risk premium for additional risk — for equities, typically 4% above bond yield — to form expected return estimates.
