Lecture 6 Diversification annotated Oct 22

What are the two possible returns for a risky asset X in the lecture's example?

20% and -10%.

How is the mean return calculated for a single risky asset?

It is the probability-weighted average of the two returns.

What is the variance formula for a single risky asset's returns?

Var(R) = (0.5 x (0.15)^2) + (0.5 x (-0.15)^2) = (0.15)^2.

What happens to the variance of returns when you have two independent risky assets?

The variance is halved compared to a single risky asset.

What is the relationship between an equal-weighted portfolio return and individual asset returns?

The portfolio return is an equal-weighted average of the two assets' returns.

How is the variance of a portfolio return defined?

Var(Rp) = (0.25 x (0.15)^2) + (0.5 x (0)^2) + (0.25 x (-0.15)^2).

What does correlation measure in terms of asset movements?

The tendency of two assets to move together due to common factors.

What is the significance of a correlation of 1?

It indicates that the assets move perfectly together, providing no diversification benefit.

What is a beta in finance?

A measure of how an individual asset's returns correlate with movements in the overall market.

What effect did the Fed’s policies in the late 20th Century have on bond and stock correlations?

The correlation was positive due to rising interest rates and recessions.

What is the main idea of passive investing?

Investing in a value-weighted index to earn the average return without actively managing the investment.

What does active investing entail compared to passive investing?

Selecting investments to outperform the average returns of a market index.

What is the iron law of active management?

Every dollar of active outperformance is matched by a dollar of active underperformance.

What does low-risk investing ideally achieve according to the lecture?

It allows investors to lower risk without sacrificing returns.

What are value stocks characterized by compared to growth stocks?

Value stocks have low market prices relative to their fundamental value, while growth stocks have high market prices.

What is ESG investing?

Investing with criteria related to environmental, social, and governance factors.

What is the expected impact of ESG investing on average return?

It is expected to lower the average return due to driving down prices of 'bad' companies.