TAILIEUCHUNG - Charles J. Corrado_Fundamentals of Investments - Chapter 17

CHAPTER 17 Diversification and Asset Allocation Intuitively, we all know that diversification is important for managing investment risk. But how exactly does diversification work, and how can we be sure we have an efficiently diversified portfolio? Insightful answers can be gleaned from the modern theory of diversification and asset allocation. | CHAPTER 17 Diversification and Asset Allocation Intuitively we all know that diversification is important for managing investment risk. But how exactly does diversification work and how can we be sure we have an efficiently diversified portfolio Insightful answers can be gleaned from the modern theory of diversification and asset allocation. In this chapter we examine the role of diversification and asset allocation in investing. Most of us have a strong sense that diversification is important. After all Don t put all your eggs in one basket is a bit of folk wisdom that seems to have stood the test of time quite well. Even so the importance of diversification has not always been well understood. For example noted author and market analyst Mark Twain recommended Put all your eggs in the one basket and WATCH THAT BASKET This chapter shows why this was probably not Twain s best piece of As we will see diversification has a profound effect on portfolio risk and return. The role and impact of diversification were first formally explained in the early 1950 s by financial pioneer Harry Markowitz who shared the 1986 Nobel Prize in Economics for his insights. The primary goal of this chapter is to explain and explore the implications of Markowitz s remarkable discovery. 1 This quote has been attributed to both Mark Twain The Tragedy of Pudd nhead Wilson 1894 and Andrew Carnegie How to Succeed in Life 1903 . 2 Chapter 17 Expected Returns and Variances In Chapter 1 we discussed how to calculate average returns and variances using historical data. We now begin to discuss how to analyze returns and variances when the information we have concerns future possible returns and their probabilities. Expected Returns We start with a straightforward case. Consider a period of time such as a year. We have two stocks say Netcap and Jmart. Netcap is expected to have a return of 25 percent in the coming year Jmart is expected to have a return of 20 percent during the same .

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