1.

The expected return of a portfolio is calculated as the weighted average of the expected
returns of its constituent securities, with each security's expected return weighted by its
proportion in the portfolio. This calculation provides insight into the anticipated
performance of the portfolio based on the performance of its individual components.
2. Portfolio variance measures the dispersion of returns around the expected return of the
portfolio. It is computed as the weighted sum of the covariances between pairs of
assets, with the products of the investment proportions serving as weights. This
methodology accounts for both the individual volatilities of assets and their correlations
with one another.
3. Even in cases where the covariances between assets are positive, the portfolio's
standard deviation is typically lower than the weighted average of the standard
deviations of the individual assets, provided that the assets are not perfectly positively
correlated. Portfolio diversification benefits arise from holding assets with less than
perfect correlation, as it helps to mitigate overall portfolio risk.
4. Assets with greater covariance with other assets in the portfolio contribute more
significantly to portfolio variance. Conversely, an asset that is perfectly negatively
correlated with the portfolio can serve as a perfect hedge, effectively reducing portfolio
variance to zero.
5. The efficient frontier represents the set of portfolios that offer the maximum expected
return for each level of portfolio risk. Rational investors aim to construct portfolios lying
on the efficient frontier, as these portfolios offer the optimal trade-off between risk and
return.
6. Portfolio managers identify the efficient frontier by initially estimating expected returns
and the covariance matrix of assets. These estimates are then utilized in an optimization
process, such as mean-variance optimization, to determine the optimal allocation of
assets that maximize expected return for a given level of risk.
7. Due to differences in methods and the quality of security analysis, portfolio managers
may arrive at different efficient portfolios. Competition among managers often centers
on the quality of their security analysis relative to the management fees charged.
8. In the presence of a risk-free asset and identical input lists, all investors will select the
same portfolio on the efficient frontier: the portfolio tangent to the Capital Allocation
Line (CAL). Investors differ only in their allocation between this optimal portfolio and the
risk-free asset. This principle, known as the separation principle of portfolio
construction, underscores the universality of optimal portfolio selection.
9. Diversification involves spreading a portfolio across multiple assets to limit exposure to
any single source of risk. Increasing the number of assets in a portfolio does not reduce
dollar risk, but it can enhance predictability by diversifying across different sources of
uncertainty. Similarly, extending the investment horizon does not reduce risk but allows
for a more extended period of risk exposure. The insurance industry's risk-sharing
principle aligns with portfolio diversification, as it involves spreading risks across multiple
policyholders to mitigate individual risk exposures.