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# Efficient

Diversification

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SHOULD WE DIVERSIFY
Listen to Raymond Dalio, a billionaire investor,
hedge fund manager, and philanthropist, the
founder of investment firm Bridgewater Associates,
one of the world's largest hedge funds.

## “Diversification and sample size, knowing how to

engineer your bet is even more important than
knowing what the good bet is.”

https://www.investopedia.com/investing/importance-
diversification/

## 2 Of course other successful investor will say

differently
OUTCOMES
CHECK IF YOU CAN DO/UNDERSTAND THE FOLLOWING AFTER
CLASS

## • Understand systematic and nonsystematic risk

• Appreciate the benefit of diversification
• Allocate two risky assets
• Efficient diversification with many assets
• Index model

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6.1 DIVERSIFICATION AND PORTFOLIO
RISK
 Can you eliminate all risks through diversification?

##  Market/Systematic/Non diversifiable Risk

 Risk factors common to whole economy
 Example?

 Unique/Firm-Specific/Nonsystematic/ Diversifiable
Risk
 Risk that can be eliminated by diversification
 Example?

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FIGURE 6.1 RISK AS FUNCTION OF NUMBER
OF STOCKS IN PORTFOLIO

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FIGURE 6.2 RISK VERSUS
DIVERSIFICATION

## How many stocks should be included in a portfolio to eliminate

diversifiable risks?
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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Covariance and Correlation
 Portfolio risk depends on covariance between returns of
assets
 Expected return on two-security portfolio

E (rp )  W1r1  W2 r2

W1  Proportion of funds in security 1

W2  Proportion of funds in security 2
r1  Expected return on security 1
r 2  Expected return on security 2

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Can I change r to sigma to get the expected risk of the portfolio?
6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Covariance Calculations
S
Cov( rS , rB )   p(i )[ rS (i )  E (rS )][ rB (i )  E (rB )]
i 1

##  Excel example on the coming slides, spreadsheet 6.4

 Correlation Coefficient
Cov( rS , rB )
ρ SB 
σS  σB

Cov( rS , rB )  ρ SBσ S σ B
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EXPECTATIONS

## Spreadsheet exercises Not required in the tests,

but please try to repeat the exercise at home if you have spare
time.

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RETURNS

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PERFORMANCE

0.4x-37%+-0.6x-9 = -20.2%

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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Portfolio risk and return depend on the means and
variances of the component securities (the two risky
assets in this case)
 How can we get the means and variances?

##  Using Historical Data (a common approach)

 Variability/covariability change slowly over time, should be
more reliable when using realized returns to estimate
 However, using realized returns to estimate the averages of
past returns (the mean return) can be very noisy,
 Macroeconomic and security analysis are also used to
estimate the mean
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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Weighted average of returns on components, with
investment proportions as weights

##  Weighted average of expected returns on

components, with portfolio proportions as weights

 Variance:

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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Risk-Return Trade-Off (graph to be shown)
 Should we look for lower risk? But it usually comes with
lower return?
 We can look at the Investment opportunity set
 Available portfolio risk-return combinations
 and use the mean-Variance Criterion

 Mean-Variance Criterion
 If E(rA) ≥ E(rB) and σA ≤ σB
 Portfolio A dominates portfolio B

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OPPORTUNITY SET

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FIGURE 6.3 INVESTMENT
OPPORTUNITY SET

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FIGURE 6.4 OPPORTUNITY SETS: VARIOUS
CORRELATION COEFFICIENTS

## See port risk.xls as a

demonstration

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Near zero
CORRELATION COEFFICIENTS

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6.3 THE OPTIMAL RISKY PORTFOLIO WITH A
RISK-FREE ASSET
 How to find the optimal risky portfolio?
 i.e. for a given level of risk, you get the highest expected return.
 Refer to Figure 6.3 Investment Opportunity Set

##  Optimal Risky Portfolio

 Best combination of risky and safe assets to form
portfolio 20
6.3 THE OPTIMAL RISKY PORTFOLIO WITH A
RISK-FREE ASSET
 Calculating Optimal Risky Portfolio
 Two risky assets

[ E (rB )  rf ] S2  [ E (rs )  rf ] B S  BS
wB 
[ E (rB )  rf ] S2  [ E (rs )  rf ] B2  [ E (rB )  rf  E (rs )  rf ] B S  BS

wS  1  wB

## Note: Formula will be given if required

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FIGURE 6.5 TWO CAPITAL
ALLOCATION LINES

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FIGURE 6.6 BOND, STOCK AND T-BILL
OPTIMAL ALLOCATION

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FIGURE 6.7 THE COMPLETE PORTFOLIO
Once you have obtained the optimal risk
portfolio O, you may determine the complete
portfolio C based on your risk preference.

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FIGURE 6.8 PORTFOLIO COMPOSITION: ASSET
ALLOCATION SOLUTION
An example may look like
this.
You can refer to the
text for the calculations

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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Efficient Frontier of Risky Assets
 Graph representing set of portfolios that maximizes
expected return at each level of portfolio risk
 Maximize risk premium for any level standard deviation
 Minimize standard deviation for any level risk premium

##  Maximize Sharpe ratio for any standard deviation or risk

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FIGURE 6.9 PORTFOLIOS CONSTRUCTED
WITH THREE STOCKS (A, B AND C)

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E from AB and F from BC resulting curve EF, more northwest (i.e.
lower risk and higher return, a better feature)
FIGURE 6.10 EFFICIENT FRONTIER: RISKY
AND INDIVIDUAL ASSETS

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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Choosing Optimal Risky Portfolio
 Optimal portfolio CAL tangent to efficient frontier
 Similar to process of choosing an optimal risky portfolio of

## two risky assets

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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Optimal Risky Portfolio: An Illustration
 Efficiently diversified global portfolio using stock market
indices of six countries
 Standard deviation and correlation estimated from
historical data
 Risk premium forecast generated from fundamental
analysis (not for historical averages)

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FIGURE 6.11 EFFICIENT FRONTIERS/CAL: TABLE 6.1

0.09
Efficient Frontier
Capital Allocation Line
0.08 Eff Front - No Short
Min-Var with short sales
Min-Var no short sales
0.07 Optimum with short sales
Optimum no short sales
0.06 Individual countries

0.05
0.04
0.03
0.02
0.01
0.00
0.00 0.05 0.10 0.15 0.20 0.25 0.30 31
Standard Deviation

## Click the chart to access Excel data

6.5 A SINGLE-INDEX STOCK MARKET
 Index model
 Relates stock returns to returns on broad market index/firm-
specific factors
 Excess return
 Rate of return in excess of risk-free rate
 Beta
 Sensitivity of security’s returns to market factor
 Firm-specific or residual risk
 Component of return variance independent of market factor
 Alpha
 Stock’s expected return beyond that induced by market index
 Positive alpha means underpriced
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6.5 A SINGLE-INDEX STOCK MARKET
 Excess Return

Ri   i RM   i  ei
 RM : return from movements in overall market

 i : security's responsiveness to market
  i : expected return on stock beyond any return
induced by market index movements
ei : firm - specific risk

## William Sharpe (1963) introduced single-index model

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6.5 A SINGLE-INDEX STOCK MARKET
 Statistical and Graphical Representation of Single-
Index Model
 Security Characteristic Line (SCL), next slide
 Plot of security’s predicted excess return from

## excess return of market

 Algebraic representation of regression line

You can get Beta of the stock you want. How do we make
use of this in practice? 34
FIGURE 6.12 SCATTER DIAGRAM FOR
DELL

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6.5 A SINGLE-INDEX STOCK MARKET
 Statistical and Graphical Representation of Single-
Index Model
 Ratio of systematic variance to total variance, a measure on
the relative importance of systematic risk

## Total variance = Systematic variance + Residual variance

= β2Dσ2M + σ2(eD)
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Residual variance measures the dispersion of the scatter
of actual returns about the regression line
FIGURE 6.13 VARIOUS SCATTER
DIAGRAMS

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6.5 A SINGLE-INDEX STOCK MARKET
 What will be systematic and nonsystematic variances of a
portfolio if its securities’ returns follow single index model
 Diversification in Single-Index Security Market
 In portfolio of n securities with weights
 In securities with nonsystematic risk

## Note: Illustration only, proof

not required
 Portfolio nonsystematic variance

## when num. of securities increase, w2i will get smaller, so the 38

nonsystematic components become less important

6.5 A SINGLE-INDEX STOCK MARKET

## How about the systematic component?

Can it be diversify?

## Each security is driven by the market

factor RM, so no diversification?

## You may refer to the word file named “Portfolio risk_index

model” for details, proof will not be examined.

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EXERCISES

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