Financial Markets, Banking, and Monetary Policy

CHAPTER 6 Principles of Portfolio Selection and Efficient Markets

WHAT YOU WILL LEARN IN THIS CHAPTER

• Investors make investment decisions along two separate dimensions: expected return and risk.
• Measurement of expected return and risk have precise specifications.
• The desire to lower risk leads to the careful building of portfolios.
• Individual investments are viewed in terms of their ability to reduce the risk of the portfolio—or variability of the overall returns on the portfolio.
• An asset will be a good candidate for a portfolio if its returns move in a contrary fashion to the returns on the other assets in the portfolio.
• Some may be attractive for the portfolio even though, looked at just by themselves, they are highly risky.
• The principles of portfolio choice are not only utilized by portfolio managers, but also regulators of commercial banks and other financial institutions responsible for ensuring financial soundness of these institutions.
• The presence of savvy investors seeking high returns results in financial markets being efficient in the sense that current prices of financial assets tend to embody all relevant information bearing those assets’ values.
• This implies that it is highly unlikely an investor can get above-market returns by seeking to pick winners in the market (if they, indeed, are winners, their prices already reflect this).
• For this reason, many investors choose to place their assets in a diversified portfolio that represents the market.
• These diversification ...