Lecture Financial markets - Lecture 5: Portfolio diversification and supporting financial institutions. In this chapter you will learn: How risks are spread, covariance with market portfolio, beta, mutual fund theorem, investment companies and their management. | Lecture 5: Portfolio Diversification and Supporting Financial Institutions Portfolio Diversification All that should matter to an investor is the performance of the entire portfolio. Mean and variance of portfolio matter Law of large numbers means that spreading over many independent assets reduces risk, has no effect on expected return. Equally-Weighted Portfolio When Asset Returns are Independent & Same Variance Same dollar value in each asset Rebalancing each period Portfolio expected return equals average of asset expected returns Portfolio standard deviation equals asset standard deviation divided by Square root rule Investment Companies as Providers of Diversification Investment trusts (before 1940s) Mutual funds (especially index funds) Closed end investment companies Unit investment trusts All these institutions can enable small investors to overcome transactions cost and lumpiness problems in achieving diversified portfolios Doubts about Diversification Complete diversification would imply holding much in fixed incomes, real estate, etc. But hasn’t stock market outperformed these? Equity Premium Puzzle Geometric average real stock market return 1871-1997: (Siegel Table 1-1). Geometric average real fixed-income return 1871-1997: (Siegel Table 1-2) Equity premium = Puzzle: Why has equity premium been so high? Dominance of Stocks over Fixed Incomes? No thirty-year period since 1831-1861 when the return on either long-term or short-term bonds exceeded that on equities. (Siegel p. 15) Survey of Institutional Investors, Shiller, 1993 “There is no thirty-year period since 1860 in which US government bonds have outperformed stocks.” Have you heard roughly this claim (even if details, such as the use of 30 years) are different? 1. Yes, often 52% 2. Yes, once or twice 22% 3. No 26% But is Equity Premium Robust? Geometric average US real stock market return 1802-1997: (Siegel Table 1-1) Geometric average real fixed income return . | Lecture 5: Portfolio Diversification and Supporting Financial Institutions Portfolio Diversification All that should matter to an investor is the performance of the entire portfolio. Mean and variance of portfolio matter Law of large numbers means that spreading over many independent assets reduces risk, has no effect on expected return. Equally-Weighted Portfolio When Asset Returns are Independent & Same Variance Same dollar value in each asset Rebalancing each period Portfolio expected return equals average of asset expected returns Portfolio standard deviation equals asset standard deviation divided by Square root rule Investment Companies as Providers of Diversification Investment trusts (before 1940s) Mutual funds (especially index funds) Closed end investment companies Unit investment trusts All these institutions can enable small investors to overcome transactions cost and lumpiness problems in achieving diversified portfolios Doubts about Diversification Complete .
