Source: Modern Investment BMAN71171 Portfolio Investment

Management
by
Bob Litterman and QRG Goldman Sachs Lecture 2a: Intuition on Portfolio Selection
Chris Godfrey (christopher.godfrey@manchester.ac.uk)
Office Hours: Tuesdays – Email for an Appointment
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Suggested Reading:

Reading
Modern Investment Management, An Equilibrium Approach,
Bob Litterman and Quant Resources Group of Goldman Sachs, Wiley
2003
Available online, MBS username and password required
Chapter: 2

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Lecture Note Outline

• Intuition on Portfolio Selection

• Comparative statics
• Example

• Maximization of Expected Utility

• Analytics
• Numerical Example

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Risk and Return - 1
• Optimal Portfolio Selection trades-off risk vs. return

• Return is simple:
– Monetary returns of different investment at a point in time are
additive
$10 $20

$30 = 10 + 20

– Percentage returns compound over time

20% 20%

4
(1+0.2) x (1+0.2) = 1.44%, C = 44%
Risk and Return - 2
• Risk is not additive, generally
– Independence

– Dependence

why?
correlation: degree and sign of co-movement

– Portfolio: the expected return of each asset is judged on the

basis of its contribution to portfolio risk. Two channels:
• σ
• ρ 5
Comparative Statics - 1
• Consider a portfolio of two assets, then portfolio risk is

 p  w12 12  w22 22  2w1w2 12 1 2

• What is the change in portfolio risk for a unit change of

our investment in asset 1 or 2?

• First derivative of  p with respect to wi

– Marginal contribution of a unit change in wi to portfolio risk  p
– Recall: an increase in w1 results in an equal decrease in w2

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Comparative Statics - 2
 p
  2w  
1
1 2 2 
 w1  1  w22 22  2w1w2 12 1 2 2 2
 2w2 12 1 2
w1 2
1 1

w1 12  w2 12 1 2 w1 12  w2 12 1 2

 
w   p
1
2
1
2
1  w22 22  2w1w2 12 1 2 2

 p
  2w  
1
1 2 2 
 w1  1  w22 22  2w1w2 12 1 2 2 2
 2w1 12 1 2
w2 2
2 2

w2 22  w1 12 1 2 w2 22  w1 12 1 2

 
w   p
1
2
1
2
1  w22 22  2w1w2 12 1 2 2

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Example - 1
• Our two risky assets correspond to “domestic” and
“foreign” equity and have the following data:
Volatility Expected Excess Return Total Return
Domestic Equity 15% 5.5% 10.5%
International Equity 16% 5% 10%
Cash 0 0 5%
Correlation = 0.65
• Suppose foreign exposure w2  0 . Then marginal
contributions simplify to
 p w1 12
   1  0.15
w1
w  
1
2 2 2
1 1

 p w1 1  2 
   2   0.16  0.65  0.104
w2
w  
1
2 2 2
1 1 8
Example - 2
• Assume the invest aims at the maximization of expected
return for a total portfolio risk (SD) 10%
• Recall: domestic equity volatility is 15%
• So, a portfolio with
• 2/3 domestic equity
• 1/3 cash (zero volatility and correlation)
2
2 2
 p    0.152  0  0    0.15  0.10
3 3

• What will happen if the investor starts selling domestic

and buying foreign equity?

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Example - 3
• Suppose the investor sells 1 unit of domestic equity
– What will be the effect on portfolio risk?
 p w1 12
(1)    1  0.15
w1
w  
1
2 2 2
1 1

• Suppose the investor buys 1 unit of foreign equity

– What will be the effect on portfolio risk?
 p w1 1  2 
(1)    2   0.16  0.65  0.104
w2
w  
1
2 2 2
1 1

• What should be the required investment in foreign equity

to keep portfolio risk unchanged? 0.15  1.442
0.104

 p
• So, (1.442)  1.442  0.104  0.15 which offsets -0.15
w2 10
Example - 4
• Effects on portfolio returns

– Sale of 1 unit domestic equity: (-1) × 0.055 = -0.055

– Purchase of 1.442 foreign equity: 1.442 × 0.05 = 0.07215

– Net result: 0.07215 - 0.055 = 0.01715

• Recall: this strategy keeps portfolio risk constant and

increases portfolio return

• The investor can keep this strategy as long as risk

remains unchanged and return increases.
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Example – 5: the effect of diversification

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Expected Utility – Quadratic Example 1

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Expected Utility – Quadratic Example 2

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Expected Utility – Quadratic Example 3

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Expected Utility – Quadratic Example 4

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Expected Utility – Quadratic Example 5

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Expected Utility – Quadratic Example 6

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Expected Utility – Exponential Example 1

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Expected Utility – Exponential Example 2

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Expected Utility – Exponential Example 3

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 Take-Home Exercise
• Consider three assets with the following data and
find parameter “c”. Also, assume different values of
“c” and find the implied portfolio weights.
Assume an individual with negative exponential utility

 
~ ~
u W   exp  cW   c 0

two risky assets with

~ r    .12   .003 .001 

 ~A  ~ N   ,   
 rB    .18   .001 .005  

a risk-free asset with r f  0.06

 9 15 10 
Also, optimisation yields,  wA  14 , wB  14 , w f   14  22
 