Portfolio Management【Reading 63】Sample Investment, allocation, 2012, individual

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Gemini Investment Management Company (GIMC) assumes markets will remain at equilibrium indefinitely. GIMC defines security analysis as the examination of factors affecting the value of individual securities. GIMC defines asset allocation as the examination of factors affecting the optimal allocation of assets to the market portfolio and to the risk-free asset. Given GIMC’s assumption that markets are at equilibrium indefinitely, indicate whether GIMC should place significant or insignificant emphasis on security selection and asset allocation.

A) Insignificant emphasis on asset allocation only.

B) Insignificant emphasis on both.

C) Insignificant emphasis on security selection only.

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When markets are at equilibrium, all asset prices will equal their fair values. Assets are neither undervalued nor overvalued. Therefore, if GIMC believes markets will remain at equilibrium indefinitely, then they should place very little, if any, emphasis on security selection. In contrast, active portfolio management is needed to determine the appropriate allocation of the client’s investment between the market portfolio and the risk free asset. Active portfolio management is needed to forecast the expected returns and risk for the market portfolio and to forecast the return on the risk-free asset. GIMC should allocate large percentages to the market portfolio for highly risk tolerant clients and high percentages to the risk-free asset for highly risk averse clients. Significant effort must be expended to determine the appropriate mix of assets for the client