Chapter 6 An Introduction to Portfolio Management

Background Assumptions
As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets and liabilities

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The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.

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Risk Aversion
Given a choice between two assets with equal rates of return, most investors will select the asset with the lower level of risk.

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Evidence That Investors are Risk Averse

Many investors purchase insurance for: life, automobile, health, and disability income. The purchaser trades known costs for unknown risk of loss. Yield on bonds increases with risk classifications from AAA to AA to A .
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Definition of Risk
1. Uncertainty of future outcomes or 2. Probability of an adverse outcome

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Markowitz Portfolio Theory

Quantifies risk Derives the expected rate of return and expected risk for a portfolio of assets.

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Shows that the variance of the rate of return is a meaningful measure of portfolio risk Derives the formula for computing the variance of a portfolio, showing how to effectively diversify a portfolio

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Assumptions of Markowitz Portfolio Theory

1. Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.

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Assumptions of Markowitz Portfolio Theory

2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.

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Assumptions of Markowitz Portfolio Theory

3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.

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Assumptions of Markowitz Portfolio Theory

4. Investors base decisions solely on expected return and risk, so their utility curves are a function of expected return and the expected variance (or standard deviation) of returns only.

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Assumptions of Markowitz Portfolio Theory

5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.

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Markowitz Portfolio Theory

Using these five assumptions, a single asset or portfolio of assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return with the same (or lower) risk, or lower risk with the same (or higher) expected return.

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Alternative Measures of Risk

Variance or standard deviation of expected return Range of returns Returns below expectations Semivariance a measure that only considers deviations below the mean These measures of risk implicitly assume that investors want to minimize the damage from returns less than some target rate

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Expected Return for an Individual Risky Investment

Probability 0.25 0.25 0.25 0.25 Possible Rate of Return (Percent) 0.08 0.10 0.12 0.14

Exhibit 6.1

Expected Return (Percent) 0.0200 0.0250 0.0300 0.0350 E(R) = 0.1100

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Expected Return for a Portfolio of Risky Assets

Exhibit 6.2
Weight (Wi) (Percent of Portfolio) 0.20 0.30 0.30 0.20 Expected Security Return (Ri) 0.10 0.11 0.12 0.13 Expected Portfolio Return (Wi X Ri) 0.0200 0.0330 0.0360 0.0260 E(Rpor i) = 0.1150

E(R por i ) Wi R i where : Wi the percent of the portfolio in asset i E(R i ) the expected rate of return for asset i
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i 1

Variance (Standard Deviation) of Returns for an Individual Investment

Variance ( ) [R i - E(R i )] Pi
2 2 i 1

where Pi is the probability of the possible rate of return, Ri

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Variance (Standard Deviation) of Returns for an Individual Investment

Possible Rate of Return (R i ) 0.08 0.10 0.12 0.14 Expected Return E(R i ) 0.11 0.11 0.11 0.11 Ri - E(Ri ) 0.03 0.01 0.01 0.03 [Ri - E(Ri )]2 0.0009 0.0001 0.0001 0.0009 Pi 0.25 0.25 0.25 0.25

Exhibit 6.3
[Ri - E(Ri )]2 Pi 0.000225 0.000025 0.000025 0.000225 0.000500

Variance ( 2) = .0050 Standard Deviation ( ) = .02236

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Variance (Standard Deviation) of Returns for a Portfolio Exhibit 6.4

Computation of Monthly Rates of Return
Date Dec.00 Jan.01 Feb.01 Mar.01 Apr.01 May.01 Jun.01 Jul.01 Aug.01 Sep.01 Oct.01 Nov.01 Dec.01 Closing Price Dividend Return (%) -4.82% -8.57% -14.50% 2.28% 2.62% -4.68% -0.89% 9.13% -3.37% 2.20% -1.55% 0.40% -1.81% Closing Price Dividend Return (%) 60.938 58.000 53.030 45.160 0.18 46.190 47.400 45.000 0.18 44.600 48.670 46.850 0.18 47.880 46.960 0.18 47.150 E(RCoca-Cola)= 45.688 48.200 5.50% 42.500 -11.83% 43.100 0.04 1.51% 47.100 9.28% 49.290 4.65% 47.240 0.04 -4.08% 50.370 6.63% 45.950 0.04 -8.70% 38.370 -16.50% 38.230 -0.36% 46.650 0.05 22.16% 51.010 9.35% E(Rhome E(RExxon)= Depot)= 1.47%

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Covariance of Returns
A measure of the degree to which two variables move together relative to their individual mean values over time

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Covariance of Returns
For two assets, i and j, the covariance of rates of return is defined as: Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}

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Computation of Covariance of Returns for Coca cola and Home Depot: 2001
Exhibit 6.7

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Covariance and Correlation

Correlation coefficient varies from -1 to +1

rij

Cov ij

i j

where : rij the correlatio n coefficien t of returns

i the standard deviation of R it j the standard deviation of R jt

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Portfolio Standard Deviation Formula

port
where :

w w w Cov
i 1 2 i 2 i i 1 i 1 i j

ij

port the standard deviation of the portfolio

Wi the weights of the individual assets in the portfolio, where weights are determined by the proportion of value in the portfolio

i2 the variance of rates of return for asset i

Covij the covariance between th e rates of return for assets i and j, where Covij rij i j
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Portfolio Standard Deviation Calculation

Any asset of a portfolio may be described by two characteristics: The expected rate of return The expected standard deviations of returns The correlation, measured by covariance, affects the portfolio standard deviation Low correlation reduces portfolio risk while not affecting the expected return
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Time Patterns of Returns for Two Assets with Perfect Negative Correlation Exhibit 6.10

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Risk-Return Plot for Portfolios with Equal Returns and Standard Deviations but Different Correlations (page 182-183)

Correlation affects portfolio risk

Exhibit 6.11

A: correlation=1 B: correlation=0.5 C: correlation=0 D: correlation=-0.5 E: correlation=-1

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Combining Stocks with Different Returns and Risk

Asset
1 2
Case a b c d e

E(R i )
.10 .20

.50 .50

Wi

.0049 .0100
Covariance .0070 .0035 .0000 -.0035 -.0070

.07 .10

Correlation Coefficient +1.00 +0.50 0.00 -0.50 -1.00

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Combining Stocks with Different Returns and Risk

Negative correlation reduces portfolio risk Combining two assets with -1.0 correlation reduces the portfolio standard deviation to zero only when individual standard deviations are equal.

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Risk-Return Plot for Portfolios with Different Returns, Standard Deviations, and Correlations
Exhibit 6.12

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Constant Correlation with Changing Weights

Asset
1
2

E(R i )
.10

rij = 0.00
W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00 E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10
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Case f g h i j k l

W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00

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Constant Correlation with Changing Weights

Case f g h i j k l W1 0.00 0.20 0.40 0.50 0.60 0.80 1.00 W2 1.00 0.80 0.60 0.50 0.40 0.20 0.00 E(Ri ) 0.20 0.18 0.16 0.15 0.14 0.12 0.10 E(F port ) 0.1000 0.0812 0.0662 0.0610 0.0580 0.0595 0.0700

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Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

With two perfectly correlated assets, it is only possible to create a two asset portfolio with riskreturn along a line between either single asset

Rij = +1.00 1

Standard Deviation of Return

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Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

f With uncorrelated h assets it is possible i j to create a two Rij = +1.00 asset portfolio with k lower risk than 1 either single asset Rij = 0.00 g

Standard Deviation of Return

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Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

f With correlated h assets it is possible i j to create a two Rij = +1.00 asset portfolio k Rij = +0.50 between the first 1 two curves Rij = 0.00 g

Standard Deviation of Return

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Portfolio Risk-Return Plots for Different Weights

E(R) With 0.20 negatively correlated assets it is 0.15 possible to create a two 0.10 asset portfolio with much 0.05 lower risk than either single asset
-

Rij = -0.50 g h j k i

Rij = +1.00 1 Rij = 0.00 Rij = +0.50

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

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Portfolio Risk-Return Plots for Different Weights

E(R)
0.20 0.15 0.10 0.05 -

Exhibit 6.13

Rij = -0.50

f g

Rij = -1.00
h j k i

Rij = +1.00 Rij = +0.50

1 Rij = 0.00 With perfectly negatively correlated assets it is possible to create a two asset portfolio with almost no risk

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

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Estimation Issues
Results of portfolio allocation depend on accurate statistical inputs Estimates of Expected returns Standard deviation Correlation coefficient
n(n-1)/2 correlation estimates: with 100 assets, 4,950 correlation estimates

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Estimation Issues
Single index market model:

R i a i bi R m i
bi = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market

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Estimation Issues
The correlation coefficient between two securities i and j is given as:
2 m rij b i b j i j 2 where m the variance of returns for the

aggregate stock market

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The Efficient Frontier

The efficient frontier represents that set of portfolios with the maximum rate of return for every given level of risk, or the minimum risk for every level of return Frontier will be portfolios of investments rather than individual securities Exceptions being the asset with the highest return and the asset with the lowest risk
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Efficient Frontier for Alternative Portfolios

Exhibit 6.15

E(R)

Efficient Frontier

Standard Deviation of Return

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The Efficient Frontier and Investor Utility

An individual investors utility curve specifies the trade-offs he is willing to make between expected return and risk The slope of the efficient frontier curve decreases steadily as you move upward These two interactions will determine the particular portfolio selected by an individual investor

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The Efficient Frontier and Investor Utility

The optimal portfolio has the highest utility for a given investor It lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility

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Selecting an Optimal Risky Portfolio

E(R port )
Exhibit 6.16

U3 U2

U1

Y U3 X U1

U2

E( port )
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