File: ch08, Chapter 8: PORTFOLIO SELECTION

Type: Multiple Choice

1. Which of the following is the single most important concept in portfolio management?

a. Expected return
b. Risk as measured by standard deviation
c. Risk as measured by variance
d. Risk reduction through diversification

Ans: d
Difficulty: Easy
Response: Diversification is key to optimal risk management.
Ref: Portfolio Selection and Asset Allocation

2. Using the Markowitz model, which of the following inputs is not necessary in choosing
the most efficient portfolio(s)?

a. The expected return of each asset

b. The standard deviation of each asset
c. The correlation between each pair of assets
d. The risk preference of the investor

Ans: d
Difficulty: Easy
Response: The expected returns, standard deviations and correlations are necessary to find the
efficient frontier. The investor then chooses from those portfolios on the efficient frontier.
Ref: Building a Portfolio Using Markowitz Principles

3. Which of the following is not an assumption underlying Markowitz’s portfolio theory?

a. All returns are measured in dollars

b. The investor is risk averse
c. The investor may buy or sell with no transaction costs
d. Investor preference is based only on expected return and standard deviation of returns

Ans: a
Difficulty: Easy
Response: The theory works just as well in any currency.
Ref: Building a Portfolio Using Markowitz Principles

4. What is meant by an “efficient” portfolio?

a. The portfolio consists of the fewest possible securities

b. The portfolio has the highest return for a given level of risk
c. The portfolio has the highest return premium
d. The portfolio includes all appropriate securities

Ans: b
Difficulty: Easy
Response: An efficient portfolio is also defined as the one with the smallest risk for a given level
of return.
Ref: Building a Portfolio Using Markowitz Principles

5. What is the difference between an “efficient” portfolio and an “obtainable” portfolio?

a. Obtainable portfolios are any that an ordinary investor can purchase; efficient are those
that the investor can purchase with reasonable commissions.
b. Efficient portfolio refers to all possible combination of the underlying securities;
obtainable portfolio refers to those that can actually be found in existing mutual funds.
c. Obtainable portfolios are all possible combinations of the underlying assets; the efficient
portfolios are a subset with minimum risk for a given level of return.
d. Obtainable and efficient mean the same thing in this context.

Ans: c
Difficulty: Medium
Response: Not all obtainable portfolios are considered efficient.
Ref: Building a Portfolio Using Markowitz Principles

6. With a risk-free asset, why is the CML considered the efficient set?

a. Any point on the CML has a higher return, but the same risk, as any point directly below.
b. The portfolios on the CML are designed to include the fewest possible securities.
c. Any point on the CML has less return, but the same risk as portfolios directly above.
d. Any point on the CML has the same return, but less risk as portfolios directly below.

Ans: a
Difficulty: Medium
Ref: Building a Portfolio Using Markowitz Principles

7. How does an investor choose from among the portfolios on the CML?

a. The investor picks the portfolio with the lowest risk.

b. The investor picks the portfolio with the highest return.
c. The investor picks the portfolio tangent to the investor’s indifference curve.
d. The investor picks a portfolio on the investor’s highest indifference curve.

Ans: c
Difficulty: Medium
Ref: Building a Portfolio Using Markowitz Principles
8. Which of the following is a good argument for international investing?

a. The corporate profits in some foreign countries are increasing faster than in the U.S.
b. Some European countries have better investor protection laws than the U.S.
c. Correlations between U.S. and international securities have been decreasing.
d. Correlations between U.S. and international securities have remained constant over time.

Ans: a
Difficulty: Easy
Response: Emerging markets, for example, are thought to have growth prospects well in excess
of those of the U.S. market.
Ref: The Global Perspective – International Diversification

9. Which of the following is not a feature of the Markowitz portfolio selection model?

a. The Markowitz model assumes that investors make decisions based on their preferences
of risk and return but no other parameters.
b. The Markowitz model generates a set of many efficient portfolios.
c. The Markowitz model allows investors to borrow or lend the risk-free asset.
d. The Markowitz model is cumbersome to work with because of the large variance-
covariance matrix.

Ans: c
Difficulty: Easy
Response: The Markowitz model does not allow borrowing or lending.
Ref: Some Important Conclusions about the Markowitz Mode

10. Which of the following is probably a market-related event affecting all stocks?

a. The discovery of new oil reserves in a field owed by BP

b. The indictment of a corporate officer for fraud and insider trading
c. The increase in interest rates announced by the Federal Reserve Chairman
d. The FDA approval of a new treatment for cancer

Ans: c
Difficulty: Easy
Response: Interest rate moves will tend to affect entire markets, and often will impact stock
markets in other countries also.
Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision

11. Which of the following asset classes has shown the highest historical price volatility?

a. Treasury bonds
b. Money market instruments
c. High yield corporate bonds
d. Common stocks
Ans: d
Difficulty: Easy
Response: While most asset classes experience some degree of price volatility, common stocks
have been far more volatile throughout history, particularly in the last 10 years.
Ref: Asset Allocation and the Individual Investor

12. Which of the following asset classes is most highly correlated with the S&P 500?

a. Large-cap European stocks

b. U.S. Real Estate Investment Trusts
c. TIPS
d. Investment-grade corporate bonds in the U.S.

Ans: a
Difficulty: Easy
Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision

13. Which of the following is often considered an “alternative” asset?

a. Blue chip stocks

b. Small cap stocks
c. International equities
d. Real estate funds such as REITS

Ans: d
Difficulty: Easy
Response: The non-traditional (alternative) asset classes are simply more newly developed
investment vehicles.
Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision

14. Which of the following is a risk that cannot be eliminated?

a. Nonsystematic risk
b. Market risk
c. Unique risk
d. Business risk

Ans: b
Difficulty: Easy
Response: Market risk is also known as systematic risk, which cannot be eliminated.
Ref: The Impact of Diversification on Risk

15. Asset allocation accounts for approximately what percent of the variance in the quarterly
returns of pension funds?

a. 50%
b. 65%
c. 75%
d. 90%

Ans: d
Difficulty: Medium
Response: Many knowledgeable market observers agree that the asset allocation decision is the
most important decision made by an investor.
Ref: Asset Allocation and the Individual Investor

16. Why do portfolios now require more securities to become well diversified as compared to
25 years ago?

a. Government regulations have changed

b. The volatility of individual stocks has increased
c. The volatility of the overall stock market has increased
d. Investors are more risk averse

Ans: b
Difficulty: Easy
Response: Increased individual stock volatility requires greater effort to achieve the benefits of
portfolio diversification.
Ref: The Impact of Diversification on Risk

17. An international index commonly used as a proxy for international equities of developed
countries is the:

a. MSCI EAFE Index.

b. MSCI Emerging Markets Index.
c. Russell 1000 Index.
d. FTSE NAREIT Index.

Ans: a
Difficulty: Medium
Ref: The Global Perspective - International Diversification

18. The S&P 500 is correlated at what percent with the MSCI Emerging Market Index?

a. approximately 25%
b. approximately 40%
c. approximately 65%
d. approximately 95%

Ans: c
Difficulty: Medium
Ref: The Global Persepective – International Diversification
Type: True False

1. All investors are risk averse, that is, investors prefer less risk for a given level of expected
return.

Ans: False
Response: Most investors are risk averse, but some are risk neutral or risk seeking.
Ref: Building a Portfolio Using Markowitz Principles

2. If two investors have different risk preferences, their utility functions will have different
slopes, and they will find different points of tangency on the efficient frontier. In other
words, the investors will choose different efficient portfolios.

Ans: True
Ref: Building a Portfolio Using Markowitz Principles

3. By adding securities issued in other countries, or adding securities of companies doing

significant business in other countries, the shape and location of the efficient frontier
changes.

Ans: True
Ref: The Global Perspective – International Diversification

4. Recent research suggests that investing in stocks has become safer and more predictable
in recent years.

Ans: False
Response: Chapter 8 discusses two articles documenting that the volatility of individual stocks is
increasing.
Ref: The Impact of Diversification on Risk

5. Simon is considering buying a stock with considerable idiosyncratic risk. Simon

should expect to be compensated for this risk by receiving a higher return.

Ans: False
Response: Idiosyncratic risk can be reduced by holding this stock in a well-diversified portfolio.
Informed investors will therefore diversify, so Simon cannot expect to be compensated for a risk
he can easily avoid.
Ref: The Impact of Diversification on Risk

6. Asset allocation explains about 90% of the variation in returns of a portfolio.

Macroeconomic factors explain the remainder.

Ans: False
Ref: Selecting Optimal Asset Classes – The Asset Allocation Decision