Portfolio Theory and Construction Flashcards

In the context of behavioral portfolio theory, investors often construct portfolios in mental account 'layers' primarily to:

Answer: Achieve specific goals (security, growth) for each layer separately

Behavioral portfolio theory (Shefrin & Statman) holds that investors segment portfolios into layers assigned to different financial goals, rather than optimizing holistically.

A portfolio has 30 securities with equal weights and equal pairwise correlations of 0.20. As the number of securities grows very large, portfolio variance approaches:

Answer: The average covariance (systematic risk)

As n→∞, individual asset variance terms wash out and portfolio variance converges to the average pairwise covariance, representing undiversifiable systematic risk.

Which of the following is most consistent with a long-only constraint in mean-variance optimization?

Answer: All asset weights must be non-negative, restricting the feasible set

A long-only constraint prohibits negative weights (short positions), shrinking the feasible set and typically reducing the achievable Sharpe ratio.

Dynamic asset allocation differs from strategic asset allocation primarily in that it:

Answer: Adjusts asset mix in response to changing capital market expectations or valuations

Dynamic (or tactical) allocation actively shifts weights based on evolving market conditions, valuations, or economic signals, unlike fixed strategic weights.

When constructing a portfolio using the Black-Litterman approach, a manager who expresses a relative view (e.g., 'Asset A will outperform Asset B by 2%') must specify:

Answer: The view vector, the pick matrix, and the confidence (omega) in that view

In Black-Litterman, each view requires: a view return (q), a pick matrix (P) identifying which assets are in the view, and an uncertainty matrix (Ω) reflecting confidence.

A portfolio with a Sortino ratio of 1.5 and a Sharpe ratio of 0.9 most likely indicates:

Answer: Upside volatility is relatively high compared to downside volatility

A Sortino ratio higher than the Sharpe ratio suggests that much of total volatility is upside (positive) volatility, which the Sortino ratio ignores but Sharpe penalizes.

Which statement about the efficient frontier is correct when short selling is allowed versus when it is prohibited?

Answer: Allowing short selling expands the efficient frontier, enabling higher return for the same risk

Permitting short selling relaxes constraints on portfolio construction, expanding the feasible set and pushing the efficient frontier upward and to the left.