Week 9 Flashcards
How do we calculate the variance of a portfolio?
We multiply the proportion squared invested in an asset by the variance of that asset. Do this for all the assets and add them up. Then, we multiply the number of assets (normally 2) by the covariance of the assets and multiply this by the amount invested in each asset multiplied together… add this on to our equation.
What is the difference between diversifiable (non-systematic) and non-diversifiable (systematic) risk?
Systematic risk involves changes in GDP, inflation, interest rates, etc.
Non-systematic risk involves union action, stuff that affects a limited number of assets, etc. We can eliminate this risk by holding a large number of assets, however, we can not eliminate systematic risk by doing this. Therefore, there is always risk with holding risky assets.
What are the 2 problems with empirical evidence on portfolio diversification?
-Data issues: Not all households share information on their finances and brokerage accounts do not show the complete household portfolio, meaning the surveys are not representative of the whole population.
-Definition issues: Measuring portfolio diversification at one point in time may not be fully accurate as there are different ways of measuring diversification, and households change their investments over time, as the market conditions change.
Summarise the Blume and Friend (1975) paper:
They used tax return incomes and a survey on the financial characteristics of consumers to measure the number of stocks and to measure how closely an individual portfolio could approximate the market portfolio. They found that more than 50% of HH hold no more than 2 stocks, HH with self-employed heads systematically had a more diversified stock portfolio. However, they did not consider that a high level of diversification can be achieved by investing in a limited number of mutual funds.
Summarise the Kelly (1995), All their eggs in one basket, paper:
They aimed to explore the diversification of HH portfolios, split between ordinary and rich investors. They found that for ordinary investors, there is a poor level of diversification at all levels of stock holding and rich investors had a median number of 10 stocks.
Summarise the Calvet, Campbell and Sodini (2007), Down or out paper:
They used Swedish data to examine the efficiency of HH investment decisions. They found that diversification is sought through mutual funds and not individual stock ownership. Only a minority of Swedish HH hold an undiversified portfolio.
Summarise the Goetzmann and Kumar (2008), Equity portfolio diversification, paper:
They used the data of 60,000 individual investors at a large US brokerage house and found that directly held stock portfolios are severely under-diversified. The levels of diversification increase with age, income, wealth, education and sophistication (investors who trade options and engage in short-selling) levels.
Summarise the Abreu and Mendes (2010), Financial literacy and portfolio diversification, paper:
They used Portuguese data of financial knowledge revealed in surveys, investors’ education level and the sources of information commonly used by investors to base their financial choices. They found that diversification increased with the level of specific financial knowledge, education level, etc.
