Patrick Landry

CPA #2

1. Modern Portfolio Theory is a way of diversifying and allocating assets in a

modern financial portfolio to maximize the return in investment given the
investors risk tolerance. Modern Portfolio uses precise financial mathematics
to construct a balanced portfolio.
2. Portfolio Rebalancing is the process of straightening up the weighting of a
portfolios assets. Rebalancing involves Periodically buying or selling assets in
a portfolio to maintain the original desired level of allocation. Example: Say
an investor had 70% stocks and 30% bonds. At the end of the period the
investor looked at the stocks and they did well, the stocks increased the
weighting to 85%. With the stocks having a new weight the investor may
decide to sell some stocks and buy bonds to get the portfolio back to the
original target allocation of 70/30.-(this could be an example of why asset
allocation and portfolio rebalancing may cause the investor to buy low, sell
high). Reversion to the mean is a theory that states that prices and returns
will eventually move back toward the mean or the average. This theory states
that if the thought of any prices strays far from the long-term norm will again
return.
3. Correlation is measured in two securities moving in relationship to one other
by negative one, zero, and positive one. Negative correlation shows that the
two assets are moving in opposite directions of one other. Zero correlation as
stated, the two securities have no relationship of one other. Positive
correlation the two securities moves in lockstep or in the same direction of
one other. The numbers could be shown exactly as negative one, zero, or
positive one but does not have to be exactly negative one, for example two
securities could have a +.98 correlation.
4. In order to have an efficient portfolio or optimal portfolio an investor must
relate to efficient frontier. An assumption to investing is that having a higher
degree of risk means a higher potential to return or vice versa lower risk,
lower potential return. With this being said does not simply state that having
an optimal portfolios including securities with the highest potential returns or
low-risk securities. An optimal portfolio will aim to have a balance of
securities with the greatest potential returns with an acceptable degree of
risk. Also to be noted the efficient frontier is curved, rather than linear, a key
concept was the benefit of diversification. It is stated to have a higher degree
of diversification to hit the target of having an efficient portfolio on the
efficient frontier graph.