TERMS YOU NEED TO KNOW
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When a portfolio
can meet its expected returns with the smallest possible risk, it is called an
optimal portfolio.
By adjusting the allocation of investments in a portfolio, you
can create a number of different optimal portfolios with varying returns. All of
these portfolios provide the lowest level of risk possible for each level of
return. They also provide the highest returns for each risk level.
This entire group of possible optimal portfolios is known as the
efficient frontier.
For each risk level, the efficient frontier locates the portfolio
with the highest returns. It also reveals the portfolio with the smallest amount
of risk for each level of return. An efficient frontier is charted as a curve
like this:
The investor then uses the efficient frontier to choose a
portfolio that matches his or her risk tolerance.
Systematic
risk is the risk that assets in your portfolio will be affected by changes
in their markets.
Systematic risk is the risk of holding your portfolio.
Investments in your portfolio are grouped into asset
classes.
Asset
classes are another way of saying "investment type," such as cash
equivalents, stocks, bonds, real estate, etc.
Asset classes behave differently from one another. When one asset
class moves up in value, another may lose value or not change at all. The degree
to which the movement of one asset class relates to the movement in another is
known as asset correlation. For example, if each time asset "A"
gained or lost 10 percent, asset "B" also gained or lost 10 percent
respectively, we would say that "A" and "B" were perfectly correlated. Their
correlation would be +1. On the other hand, if every time "A" gained 10 percent,
"B" lost 10 percent, we would say they are perfectly negatively correlated.
Their correlation would be -1. Asset classes can be correlated to each other
between -1 and +1 with 0 representing "uncorrelated."
Now let's look at the characteristics of an efficient
portfolio.
