The modern portfolio theory was introduced by Harry Markowitz with the publication of his paper Portfolio Selection in the Journal of Finance in 1959 and is called Markowitz portfolio theory (MPT). It is now the major guidance for portfolio allocation decisions for mutual funds, pension funds, and nearly any entity seeking to maximize investment portfolio returns and minimize risks. By exploring how risk-averse investors can construct optimal portfolios through consideration of the trade-off between market risk and expected returns, Markowitz presents the benefits of diversification. Out of a variety of risky investments, an investor can compile an effective portfolio of investments, each of which will offer the maximum possible expected return for a given level of risk. Investors are therefore supposed keep one of the optimal portfolios on the effective level and the rest to adjust to the market risk. The latter is reached through the leverage or de-leverage of that portfolio with positions in a risk-free investment such as government bonds.
[...] If the investor is sitting around waiting for a good time to invest, and is willing to pounce on good (high expected return) investments, he would prefer to have a lot of money to invest when the good opportunity comes around. It turns out that the dividing line in the standard (CRRA) model is logarithmic utility or a risk aversion coefficient of 1 - investors more risk averse than this want assets whose prices go up when expected returns decline, and vice versa. [...]
[...] Hedging demands address whether your overall allocation to stocks, or to specific portfolios, should be higher or lower as a result of return predictability, in order to protect you against reinvestment risk. A long-term bond is the simplest example. Suppose you want to minimize the risk of your portfolio ten years out. If you invest in apparently safe short-term risk-free assets like Treasury bills or a money-market fund, your ten-year return is in fact quite risky, since interest rates can fluctuate. [...]
[...] It involves assembling, and then holding, a broadly diversified portfolio of common stocks deliberately designed to mimic the behavior of a specific benchmark index, such as the Standard & Poor's 500 Price Index 500). Compared to active management, index investing is somewhat new and far less common. Since the 1980s, when index funds fully came into their own as a legitimate alternative strategy, proponents of both approaches have waged combat to determine which one will ultimately yield the higher investment return. [...]
[...] Absent the hedging motive, of course, the optimal allocation to stocks would be zero with no expected return premium. Almost a 2 percent negative stock return premium is necessary to dissuade Campbell and Vicera's investors from holding stocks. At the average (roughly 6 percent) expected return, of the roughly 130 percent of wealth that the risk aversion 4 investors want to allocate to stocks, nearly half is due to hedging demand. Thus, hedging demands can importantly change the allocation to stocks. [...]
[...] By holding a large number of stocks representing many industries and many sectors of the market, investors hope to create a warm blanket of protection against the horrific loss that could occur if they had all their money in one arena that suffered some disaster. In a normal period (so the thinking goes), some stocks in a diversified fund will go down and others will go up, and let's keep our fingers crossed that the latter will compensate for the former. [...]
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