Professor Manolis Kavussanos 1

UTILITY FUNCTION
PORTFOLIO RISK AND RETURN
.
. INVESTMENT ANALYSIS
Thematic Area 3
Utility function. Portfolio risk
and return
Definitions of:
z Utility function, Diminishing marginal utility,
Diminishing marginal substitutability.
Expected utility model under uncertainty
z Risk aversion, risk seeking and risk neutrality,
Indifference curves, Quadratic utility function,
Absolute and relative risk aversion.
Mean-variance (Markowitz) approach for
evaluation of risky securities
z Calculation of expected return and standard
deviation of a portfolio, Covariance, Correlation
coefficient, Variance-Covariance matrix
Professor Manolis Kavussanos 2
Utility function
Utility is derived from consumption of goods and
services: level of satisfaction expressed in utils
z Under certainty: no risk and no disutility
Increase in wealth, derived from investing in
assets, is a source of utility
Risk averse investors face disutility from
uncertainty of outcomes measured through the
dispersion in expected returns
Common characteristics of utility functions
z 1. Nonsatiation - individuals prefer higher to lower
levels of wealth
Utility function, cont.
Common characteristics of utility functions,
z 2. diminishing marginal utility - as wealth increases,
utility increases but at a decreasing rate
U
Wealth
z Investors with diminishing marginal utility are risk averse
Professor Manolis Kavussanos 3
Expected utility function of the risk averse investor
E.g. U=X
0.5
U
U4
U3
U2
U1
100 105 110 Wealth(X)
The straight line is the expected utility line
Concave utility function of rational risk-averse investor
Initial investment of $100.
Investor is offered:
the choice of 105 for certain, giving
him utility U3,
a 50% chance for 110 and a 50%
chance of 100. Thus, expected value
is 105, with utility U2.
Reason for lower utility (U2<U3) is
risk averse preferences. A risk
premium is required for uncertainty
Expected utility function of the
risk seeking investor
Increasing marginal utility: U = X
2
U
22.5K
12.5K
10K
2.5K
50 100 111.30 150 Wealth (X)
Not a rational behaviour
Professor Manolis Kavussanos 4
Considers only the expected return, not the risk levels
U = X, expected utility line is the same as utility function
U
150
100
50
50 100 150 X
Not a rational behaviour
Expected utility function of the risk
neutral investor
Utility function from investment in risky
securities
U = [E(r), ]
Portfolios examined in terms of rewards and risks
Opportunity to choose the most desirable portfolio
Indifference curves - investors preferences related
to risk and return
Map or family of indifference curves
Selecting an optimal portfolio under
uncertainty
Professor Manolis Kavussanos 5
Utility from higher return, disutility from higher risk
Positive marginal rate of substitution for all levels of risk
I1 preferred to I2 preferred to I3
E(r)
I
1
I
2
I
3

Indifference curves of a risk

averse investor
All portfolios that are on one indifference curve
provide the investor with the same level of utility,
although they have different expected returns and
standard deviations
Indifference curves do not intersect, as portfolios
on the same indifference curve are equivalent
Portfolios that lie on the indifference curve
furthest northwest are the most desirable ones
There is an infinite number of indifference curves
for any investor
Indifference curves
Professor Manolis Kavussanos 6
Indifference curves of a risk
seeking investor
Investors that choose portfolios with higher standard
deviation
E(r)
I
1
I
2
I
3

The most desirable curve is the furthest northeast

Standard deviation is not important when evaluating
portfolios
Preferred portfolio is on the curve that is furthest north
E(r)
I
1
I
2
I
3

Indifference curves of a risk

neutral investor
Professor Manolis Kavussanos 7
It is assumed that all investors are risk averse
The steeper the indifference curves the higher is the degree
of risk aversion
E(r) E(r)

Risk aversion
When there is a normal distribution of asset returns
z normal distribution is bell shaped and symmetric around the
mean
z mean and standard deviation perfectly describe normal
distribution
z mathematical transformations may be used to convert skewed
and other non-normal distributions into a normal one
z for the right skewed distribution we add 1 to the return
and compute the natural logarithm of this value -
lognormal distribution
When investors have quadratic utility functions
U (X) = b X + c X
2
Where, U(X) is the utility from wealth, X is the wealth of the
investor and b and c are coefficients
When can we use the mean - variance
approach to evaluate risky alternatives?
Professor Manolis Kavussanos 8
The first derivative of quadratic utility function is
showing the marginal utility: b + 2 c X
z negative c: diminishing marginal utility
The second derivative is showing the changes in
marginal utility with respect to wealth: 2c
Quadratic utility function declines after a certain
level, but the declining part is not relevant -
insatiability assumption fails
Constraint: b + 2 c X > 0
Appropriate for investments with modest returns
Quadratic utility function
Measures how the investors preferences towards investing
in risky assets change when there is a change in wealth.
Assume that an investor has utility function U and wealth
X and a fair gamble Z whose expected value is: E(Z) = 0.
To be indifferent between the wealth and the risky gamble
on one side, and certain amount on the other side, the
investor must be paid the risk premium:
= (1/2)
z
2
[ - (U(X) / U(X))]
ARA = - (U(X) / U(X))
Decreasing ARA: more is invested in risky asset as wealth
increases and vice versa
Absolute risk aversion
Professor Manolis Kavussanos 9
Shows the percentage change of investment in the
risky asset as wealth increases
The proportion of the risk premium would be:
p = (1/2)
z
2
[ - x * (U(x) / U(x))]
RRA = x * ARA = - x * (U(x) / U(x))
As wealth (x) increases, the proportion of wealth
invested in the risky asset will decrease and vice
versa.
RRA can be constant
Relative risk aversion
Mean-variance
(Markowitz) approach to
portfolio formation
Professor Manolis Kavussanos 10
Modern portfolio theory
Markowitz, 1952
Single period approach
Selecting an optimal portfolio from a set
of portfolios - portfolio selection problem
Maximise expected returns and minimise
risk - diversification concept
Theory of choice under uncertainty
The existence of risk means that there are
more than one possible outcomes from
investment in a single asset.
A probability distribution describes such
variables. For a single share example:
State of nature Probability(P
i
) R
1
1 0.3 10
2 0.4 20
3 0.3 30
As more than one assets are usually held, it is
simpler to use summary statistics (mean and
variance), rather than distributions, for analysis.
Professor Manolis Kavussanos 11
Probability Distributions
Price changes vs. Normal distribution
Microsoft - Daily % change 1990-2001
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
-9 -8 -7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9
P
r
o
p
o
r
t
i
o
n

o
f

D
a
y
s
Daily % Change
Probability Distributions
Standard Deviation VS. Expected Return
Investment A
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y
% return
Professor Manolis Kavussanos 12
Probability Distributions
Standard Deviation VS. Expected Return
Investment B
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y
% return
Probability Distributions
Standard Deviation VS. Expected Return
Investment C
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y
% return
Professor Manolis Kavussanos 13
Probability Distributions
Standard Deviation VS. Expected Return
Investment D
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y
% return
Probability Distributions & Summary
Statistics. Example
Expected Value - Mean, E(R
i
)=:
E(R) = R
i
P(R
i
)
= 0.3 x 10 + 0.4 x 20 + 0.3 x 30 = 20%
Variance, V(R) =
2
:

2
= E{[R - E(R)]
2
} = E(R
2
) - [E(R)]
2
= [R
i
- E(R)]
2
P
i
= R
i
2
P
i
- [E(R)]
2
=(10-20)
2
x0.3 +(20-20)
2
x0.4 +(30-20)
2
x0.3=60
or
2
=(0.3 x 100 + 0.4 x 400 + 0.3 x 900) - 20
2
=60
Standard Deviation: = 7.75%
Professor Manolis Kavussanos 14
Portfolio consists of a set of securities:
P = w
1
R
1
+ w
2
R
2
+ ... + w
n
R
n
R
i
is the return on security i,
w
i
is % of portfolio value invested in the i-th security,
where w
i
= 1
Expected return of the portfolio, E(R
p
), is calculated as:
E(R
p
) = w
i
E(R
i
)
= w
1
E(R
1
) + w
2
E(R
2
) + ... + w
n
E(R
n
)
Where the following expectations property has been used:
E[w
1
R
1
+ ... + w
n
R
n
] = w
1
E(R
1
) + ... + w
n
E(R
n
)
The expected return of a
portfolio of assets
An investor has a total wealth of 10,000
and buys a portfolio with two securities.
He invests 7,000 in security A which
offers an expected return of 18%.
The remaining 3,000 are invested in
security B to produce a 12% return.
The expected return of this portfolio is:
E(R
p
) = 0.7 x 18% + 0.3 x 12% = 16.2%
Expected return of portfolio;
example
Professor Manolis Kavussanos 15
In the previous example, the two weights are
positive because the investor bought (is long on)
assets in the hope of selling them later at a
higher price - long position
Negative weights represent the opposite strategy
- short selling or short position
z The investor borrows shares from a broker, sells
them at the current market price and buys back the
shares later (hopefully) at the lower price
Short selling incurs unlimited losses
In reality, only large financial institutions invest
proceeds from sale.
The expected return of a
portfolio with short selling
Consider the sum of two variables: R
P
= R
1
+ R
2
The variance of R
p
is defined as:

p
2
= V(Rp) = E{[R-E(R)][R-E(R)]},
where R = (R
1
R
2
) is the vector of R
1
and R
2

p
2
= V(R
p
) = V(R
1
+R
2
) =
1
2
+
2
2
+ 2
12
,
=
1
2
+
2
2
+ 2
12

2
where
1
2
and
2
2
are the variances of R
1
and R
2
,
-<
12
<+ is the covariance between R
1
and R
2
, defined

12
=E{[R
1
-E(R
1
)][R
2
-E(R
2
)] = [R
1i
-E(R
1
)][R
2i
-E(R
2
)]P
i
-1
12
+1 is the correlation coefficient defined as

12
=
12
/
1

2
The Variance of the sum of two variables
Professor Manolis Kavussanos 16
The Variance-Covariance Matrix

p
2
= V(Rp) = E{[R- E(R)] [R- E(R)]}
(

=
(

=
(

|
|
.
|

\
|

=
2
2
12
21
2
1
2
2 2
2 2 1 1
1 1 2 2
2
1 1
2 2 1 1
2 2
1 1
} )] ( {[
)]} ( )][ ( {[
)]} ( )][ ( {[
} )] ( {[
)] ( ( )][ ( [
) (
) (

R E R E
R E R R E R E
R E R R E R E
R E R E
R E R R E R
R E R
R E R
E
Calculating the Covariance
State of Nature Probability(P
i
) R
1
R
2
1 0.3 10 -20
2 0.4 20 30
3 0.3 30 50
E(R
1
) = 20%, E(R
2
) = 21%,

1
2
= E{[R
1
-E(R
1
)]
2
} = [X
1i
-E(R
1
)]
2
P
i
= 60,
2
2
= 789
Hence,
1
= 7.75%,
2
= 28.09%
Covariance:

12
= E{[R
1
-E(R
1
)][R
2
-E(R
2
)]}=[R
1i
-E(R
1
)] [R
2i
-E(R
2
)] P
i
= (10-20)(-20-21)x0.3+(20-20)(30-21)x0.4+(30-20)(50-21)x0.3
= 123 + 0 + 87 = 210
Correlation Coefficient:

12
=
12
/
1

2
= 210 / (7.75 x 28.09) = 0.97
Professor Manolis Kavussanos 17
In matrix form
12
21
:
1 1 0.97
1 0.97 1
Correlation Matrix

( (
=
( (

2
12
1
2
2
21
var :
60 210
210 789
Variance Co iance Matrix

(
(
= =
(
(


1
2
Re :
( ) 20
( ) 21
Expected turns
E R
E R
( (
=
( (

When weights are attached to the shares of the
portfolio, that is for P = w
1
R
1
+ w
2
R
2

p
2
= w
1
2

1
2
+ w
2
2

2
2
+ 2 w
1
w
2

12
= w
1
2

1
2
+ w
2
2

2
2
+ 2w
1
w
2

12

2
This utilizes the following general properties:
V(w Rp) = w
2
V(Rp),
V(w
1
R
1
w
2
R
2
) = w
1
2

1
2
+ w
2
2

2
2
2 w
1
w
2

12
= w
1
2

1
2
+ w
2
2

2
2
2 w
1
w
2

12

1

2
The Variance of a weighted portfolio
Professor Manolis Kavussanos 18
Portfolio Risk
2
2
2
2
2 1 12 2 1
12 2 1
2 1 12 2 1
12 2 1 2
1
2
1
w
w w
w w
2 Stock
w w
w w
w 1 Stock
2 Stock 1 Stock
=
=
The variance of a two stock portfolio is the sum of
these four boxes:
Portfolio Risk - Example
In earlier example, for portfolio of two shares,
with 60% and 40% in shares 1 & 2:
Total return on portfolio is: R =0.6R
1
+ 0.4R
2
Expected return of the portfolio:
E(Rp)=E(0.6 R
1
+0.4 R
2
) =0.6 E(R
1
)+0.4 E(R
2
)
= 0.6 x 20 + 0.4 x 21 = 20.4%
Risk: V(Rp) = V(0.6 R
1
+ 0.4 R
2
)
=0.6
2

1
2
+ 0.4
2

2
2
+ 2 x 0.6 x 0.4 x
12
=0.36 x 60 + 0.16 x 789 + 0.48 x 210 = 443.04
p = 21.05%
Professor Manolis Kavussanos 19
Effect of Diversification - Example
Correlation Coefficient = 0.4
Stocks % of Portfolio Avg Return
ABC Corp 28% 60% 15%
Big Corp 42% 40% 21%
Standard Deviation = Portfolio = 28.1%
Return = weighted avg = Portfolio = 17.4%
Lets Add stock New Corp to the portfolio
Effect of Diversification - Example
Correlation Coefficient = 0.3
Stocks % of Portfolio Avg Return
Portfolio 28.1% 50% 17.4%
New Corp 30% 50% 19%
NEW Standard Deviation = Portfolio = 23.43%
NEW Return = weighted avg = Portfolio = 18.20%
NOTE: Higher return & Lower risk
How did we do that? DIVERSIFICATION
Adding more stocks reduces portfolio risk
Professor Manolis Kavussanos 20
E.g. - Portfolio Expected Return
Suppose 55% of portfolio is invested in Bristol-
Myers and 45% in McDonalds. Expected return in
first stock is 10%, while for the second it is 20%.
Expected return on BM is 0.55 x 10 =5.50%
and on McDonalds it is 0.45 x 20 = 9.0%
Expected return on portfolio is
E(R
p
) = 0.55 x 10 + 0.45 x 20 = 5.50 +9.0=14.50%
Further, assume
1
=17.1%,
2
=20.8%,
12
=1.
Example continued - Portfolio Risk
2 2 2
2
2
2
2 1 12 2 1
2 1 12 2 1 2 2 2
1
2
1
) 8 . 20 ( ) 45 (. w
8 . 20 1 . 17 1 45 . 55 .
w w
s McDonald'
8 . 20 1 . 17 1 45 . 55 .
w w
) 1 . 17 ( ) 55 (. w Myers - Bristol
s McDonald' Myers - Bristol
=
=
=
=
The variance covariance matrix of the portfolio is
% 18.7 352.1 Deviation Standard
352.10 20.8) x 17.1 x 1 x .45 x 2(.55
] (20.8) x [(.45) ] (17.1) x [(.55) Variance Portfolio
2 2 2 2
= =
= +
+ =
Professor Manolis Kavussanos 21
Calculation of Return and Risk for
Portfolio of 3 stocks
Portfolio of 3 Shares, Pisteos, Boutaris, Klaoudatos
Returns, 3 shares Variance-Covariance Matrix of 3 shares
Ri PIST MPOK KLAO
PIST 0.0259 PIST 0.0157 0.0067 0.0027
MPOK 0.0011 MPOK 0.0067 0.0399 0.0135
KLAO 0.0066 KLAO 0.0027 0.0135 0.0374
In Algebraic form
Rp = W1*R1 +W2*R2 +W3*R3
V(R) =w1^2*V1 +w2^2*V2 +w3^2*V3 +2*{w1*w2*C(1,2) +w1*w3*C(1,3)+w2*w3*C(2,3)}
Portfolio Weights
w1 w2 w3
0.30 0.40 0.30
Portfolio Return: Portfolio Variance: Portfolio SD:
0.0102 0.0165 0.1284
Return and Risk for Portfolio of 3 stocks
In Matrix form
Portfolio of 3 Shares, Pisteos, Boutaris, Klaoudatos
In Matrix form:
Returns, 3 shares Weights
Ri w'
0.0259 0.30 0.40 0.30
0.0011
0.0066
Variance-Covariance Matrix of 3 shares
VC w
PIST MPOK KLAO
PIST 0.0157 0.0067 0.0027 0.30
MPOK 0.0067 0.0399 0.0135 0.40
KLAO 0.0027 0.0135 0.0374 0.30
w' * VC
0 0 0
Portfolio Variance: Portfolio SD: Portfolio Return:
w' * VC * w =V(Rp)^0.5 w' * Ri
0.0165 0.1284 0.0102
Professor Manolis Kavussanos 22
Portfolio Risk N stocks
The shaded boxes contain variance terms; the remainder
contain covariance terms.
1
2
3
4
5
6
N
1 2 3 4 5 6 N
STOCK
STOCK
To calculate
portfolio
variance add
up the boxes
Portfolio Risk in Matrix form
V(w R) = E{[w R w E(R)] [w R w E(R)]}
= E{w [R - E(R)] w[R - E(R)]}
= w E{[R -E(R)] [R - E(R)]} w
= w V(R) w
=(w
1
2

1
2
+...+w
n
2

n
2
) + (w
1
w
2

12
+ w
1
w
3

13
+ ...
+ w
n-1
w
n

n-1,n
+ w
2
w
1

21
+ w
3
w
1

31
+ ... + w
n
w
n-1

n,n-1
)
1
2
1 12 1
1
2
1 2
...
.
( ... ) .
.
...
n
n
n n n
n
w
w w
w


| |
|
(
|
(
|
=
(
|
(
|
(

|
\ .

= = < =
= + =
n
i
n
j
n
i
n
j
n
i
p
w
1 1
j i j i j i j i
1
2 2 2
w w w w 2


Professor Manolis Kavussanos 23
There are n variances and n(n-1) covariances
which are added together to calculate the
portfolio variance.
Markowitz: as the number of securities in the
portfolio increases, the importance of
variances decreases and the importance of the
covariances increases.
The variance of the portfolio
Diversification and the number of
assets held in the portfolio
General formula for the variance of the portfolio of N assets:

p
2
= w
i
2

i
2
+ w
i
w
j

ij
If all assets in the portfolio are equally weighted, the weight of
each particular asset is 1/N
Variance equation can then be reformulated as:

p
2
= (1/N)
2

i
2
+ (1/N)
2

ij
There are N variance terms and N(N-1) covariance terms
Professor Manolis Kavussanos 24
Diversification and the number of
assets held in the portfolio
We can factor out 1/N from the variance term and (N-1)/N
from covariance term:

p
2
= (1/N)
i
2
/N+ [(N-1)/N]
ij
/ N(N-1)
The summation of the variance of asset i divided by the number
of assets is the average variance
The summation of the covariance term divided by N(N-1) is the
average covariance
Replacing the summations by averages gives:

p
2
= (1/N) Avg(
2
) + [(N-1)/N] Avg(
ij
)
Diversification and the number
of assets held in the portfolio
If all risk is company-specific, the covariance equals zero
As the number of assets in the portfolio increases the
portfolio variance approaches zero
In reality, assets are positively correlated and their total risk
has a market risk component as well
Therefore, the variance term will still approach zero, but the
covariance term will approach the average covariance as the
number of assets increases
Conclusion: company-specific risk can be driven to 0, while
the market risk cannot be diversified away as we increase
the number of assets in the portfolio
Professor Manolis Kavussanos 25
Diversification and the number of
assets held in the portfolio
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Fama (1976): The relationship between portfolio risk and
the number of securities in the portfolio
Diversification and the number of
assets held in the portfolio
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Market risk
Unique
risk
Professor Manolis Kavussanos 26
Portfolio variancecovariance matrices for 3
shares and 10 shares
(Population) Variance-Covariance Matrix
PIST MPOK KLAO
PIST 0.0157
MPOK 0.0067 0.0399
KLAO 0.0027 0.0135 0.0374
(Population) Variance-Covariance Matrix
PIST ELL MPOK EMP EEGA GTE KARE KLAO KLOK PAYL PETK TITK
PIST 0.0157
ELL 0.0121 0.0212
MPOK 0.0067 0.0070 0.0399
EMP 0.0165 0.0161 0.0093 0.0251
EEGA 0.0158 0.0157 0.0100 0.0212 0.0289
GTE 0.0114 0.0117 0.0099 0.0157 0.0146 0.0204
KARE 0.0078 0.0083 0.0113 0.0110 0.0110 0.0092 0.0147
KLAO 0.0027 0.0056 0.0135 0.0043 0.0077 0.0076 0.0075 0.0374
KLOK 0.0088 0.0137 0.0165 0.0104 0.0123 0.0099 0.0103 0.0121 0.0542
PAYL 0.0043 0.0025 0.0112 0.0049 0.0099 0.0061 0.0083 0.0123 0.0097 0.0402
PETK 0.0087 0.0123 0.0087 0.0118 0.0124 0.0115 0.0098 0.0124 0.0105 0.0081 0.0227
TITK 0.0123 0.0094 0.0061 0.0135 0.0152 0.0090 0.0077 0.0045 -0.0079 0.0041 0.0136 0.0335
Diversification - Concluding comments
Diversification is not minimising but averaging
market risk
Portfolio returns always depend on market
conditions
Unique or company specific risk can substantially
be reduced by diversification
20 or more randomly selected securities will form
a portfolio with small company specific risk
The lower the correlation between the assets in the
portfolio, the greater the possibility of risk
reduction
Professor Manolis Kavussanos 27
An example with real data from
ASE
Means, Variances, Standard
Deviations, Variance-
Covariance Matrix, Matrix of
Correlation Coefficients
Sample summary statistics
Average return
Variance - Average value of squared deviations from
mean. A measure of volatility.
Standard Deviation Square root of variance;
volatility in units of measurement of variable.
Covariance:
R
R
T
t
t
T
=

=1
1
) )( (

1
2 2 1 1
12

=

=
T
R R R R
T
t
t t

1
) (

1
2
2

=

=
T
R R
T
t
t

Professor Manolis Kavussanos 28

Mean return & Variance-covariance matrix of returns for
3 ASE stocks. Period: 1990:1- 2001:6
(Population) Variance-Covariance Matrix
PIST MPOK KLAO
PIST 0.0157
MPOK 0.0067 0.0399
KLAO 0.0027 0.0135 0.0374
Correlation Coefficient Matrix
PIST MPOK KLAO
PIST 1
MPOK 0.2660 1
KLAO 0.1127 0.3500 1
PIST MPOK KLAO
St.Deviation 0.1259 0.2004 0.1940
Mean 2.59% 0.11% 0.66%
Variance 0.0157 0.0399 0.0374
Alpha Bank(PIST), Boutaris(MPOK), Klaoudatos(KLAO)
Mean return & Risk for 3 ASE stocks and 3
portfolios. The benefits of portfolio formation
PIST MPOK KLAO PISTMPOK PISTKLAO MPOKKLAO
St.Deviation 0.1259 0.2004 0.1940 0.1318 0.1214 0.1620
Mean 2.59% 0.11% 0.66% 1.35% 1.62% 0.38%
Variance 0.0157 0.0399 0.0374 0.0174 0.0147 0.0263
Weights used: .5*PIST+.5*MPOK .5*PIST+.5*KLAO .5*MPOK+.5*KLAO
Risk-return profiles of 3 stocks and 3 portfolios
0.66%, KLAO
0.11%, MPOK
2.59%, PIST
1.35%,PISTMPOK
1.62%,PISTKLAO
0.38%,MPOKKLAO
0.00%
0.50%
1.00%
1.50%
2.00%
2.50%
3.00%
0.0000 0.0500 0.1000 0.1500 0.2000 0.2500
Standard Deviation
A
v
e
r
a
g
e

R
e
t
u
r
n
Alpha
Bank(PIST),
Boutaris
(MPOK),
Klaoudatos
(KLAO)
Professor Manolis Kavussanos 29
Earlier portfolios were set with arbitrary weights
(50% in each stock).
z The benefits of diversification are obvious, as we
move northwesterly in relation to holding single
shares.
When weights are determined which minimize
the variance s.t. sum of weights =1 then the
global minimum portfolio is determined.
When variance is minimized s.t. sum of
weights=1 over a range of required rates of
return on the portfolio, then the efficient frontier
is determined.
We consider the last two problems later on.