Portfolio Management
What you must know
Portfolio risk and return: expected return as a weighted average, portfolio variance including covariance, the efficient frontier, the capital market line, the capital asset pricing model and the security market line. Understand systematic versus unsystematic risk, diversification, investor types and the investment policy statement (return objective plus liquidity, time horizon, tax, legal and unique constraints), behavioural biases, risk management (VaR, stress testing) and performance measurement (Sharpe, Treynor, Jensen's alpha, M-squared).
Traps
(1) Portfolio expected return and beta are weighted averages of the components, but portfolio standard deviation is not - it depends on covariance. (2) Sharpe ratio uses total risk; Treynor and Jensen's alpha use beta. (3) The CML prices efficient portfolios using total risk; the SML prices any asset using beta. (4) Adding a low-correlation asset can reduce portfolio risk even if the asset has lower expected return. (5) VaR says nothing about the size of losses beyond the threshold.
Worked example
A portfolio holds 60% in asset A (standard deviation 20%) and 40% in asset B (standard deviation 10%), with correlation 0.2. Variance = (0.6)^2(20)^2 + (0.4)^2(10)^2 + 2(0.6)(0.4)(0.2)(20)(10) = 144 + 16 + 19.2 = 179.2, so standard deviation = 13.4% - well below the weighted average of 16%.