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1、Chapter7:OptimalRiskyPortfoliosChapterOpenerPART IIp.196THEINVESTMENTDECISION canbeviewedasatop-downprocess:(i) Capitalallocationbetweentheriskyportfolioandrisk-freeassets,(ii) assetallocation acrossbroadassetclasses(e.g.,U.S.stocks,internationalstocks,andlong-termbonds),and(iii) securityselection
2、ofindividualassetswithineachassetclass. Capitalallocation,aswesawin Chapter6,determinestheinvestor'sexposuretorisk.Theoptimalcapitalallocationisdeterminedbyriskaversionaswellasexpectationsfortherisk–returntrade-offoftheoptimalriskyportfolio.Inprinciple,assetallocationandsecurityselectionaretechnic
3、allyidentical;bothaimatidentifyingthatoptimalriskyportfolio,namely,thecombinationofriskyassetsthatprovidesthebestrisk–returntrade-off.Inpractice,however,assetallocationandsecurityselectionaretypicallyseparatedintotwosteps,inwhichthebroadoutlinesoftheportfolioareestablishedfirst(assetallocation),whil
4、edetailsconcerningspecificsecuritiesarefilledinlater(securityselection).Afterweshowhowtheoptimalriskyportfoliomaybeconstructed,wewillconsiderthecostsandbenefitsofpursuingthistwo-stepapproach. Wefirstmotivatethediscussionbyillustratingthepotentialgainsfromsimplediversificationintomanyassets.Wethenp
5、roceedtoexaminetheprocessof efficient diversificationfromthegroundup,startingwithaninvestmentmenuofonlytworiskyassets,thenaddingtherisk-freeasset,andfinally,incorporatingtheentireuniverseofavailableriskysecurities.Welearnhowdiversificationcanreduceriskwithoutaffectingexpectedreturns.Thisaccomplished
6、,were-examinethehierarchyofcapitalallocation,assetallocation,andsecurityselection.Finally,weofferinsightintothepowerofdiversificationbydrawingananalogybetweenitandtheworkingsoftheinsuranceindustry. Theportfolioswediscussinthisandthefollowingchaptersareofashort-termhorizon—eveniftheoverallinvestmen
7、thorizonislong,portfoliocompositioncanberebalancedorupdatedalmostcontinuously.Fortheseshorthorizons,theskewnessthatcharacterizeslong-termcompoundedreturnsisabsent.Therefore,theassumptionofnormalityiss
