Here are the key points to remember in this chapter

» Risk and Return in a portfolio depend on the risk and return of the securities comprising the portfolio.

» Negatively correlation securities balance out the risk, thus reducing portfolio risk.

» Opportunity set is the set of choices that a person can afford to make in an "arms length transaction".

» Indifference curves represent a set of situations that an investor is indifferent between. The investor would be neutral between points on the same indifference curve - but may have choices between points on different indifference curves.

» The point of tangency between the opportunity set and indifference curve represents an investment option that the investor is able and willing to choose.

» Utility analysis helps in understanding investors' risk orientation.

» A risk averse investor would reject a fair gamble. The second order derivative of such an investor's utility function would be negative.

» Risk can be viewed in absolute or relative terms. These are mathematically measureable.

» How does an investor respond to a fair gamble?

1. If she does not invest, then she is risk averse, Mathematically, this is the equivalent of the second order derivative [U"(W)] being less than 0.

2. If she invests, then she demonstrates a risk preference. This is the equivalent of the second order derivative [U"(W)] being greater than 0.

3. A risk neutral investor would be indifferent between investing and not investing i.e. U"(W) would equal zero.

» CAGR, simple return and annualized return are examples of absolute returns.

» Relative returns entail comparison with a benchmark.

» In risk adjusted returns, a composite view is taken of risk and returns.

» Portfolio return is the weighted average of the returns on the securities comprising the portfolio.

» Portfolio risk would be the weighted average of the risk of the securities comprising the portfolio, only if the securities have perfect positive correlation.

» With negative correlation, the portfolio risk would be lower than the summation of the risk of the securities in the portfolio.

» The portfolio return can be given by the formula:

» If the portfolio had only two securities, then the proportion in the portfolio that is not represented by one security, would be represented by the other i.e. XB = 1 - XA and XA = 1 - XB. The portfolio return can be given by the formula:

» The formula for perfectly positive correlation is:

» The formula for perfectly negative correlation is:

» Counter party risk, credit risk, inflation risk, re-investment risk, liquidity risk and operations/system risk are other risks associated with investments.

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