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

2. Investors minimize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. 3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns. 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. 5. For a given risk level, investors prefer higher returns

RELATIONSHIP BETWEEN DIVERSIFICATION AND RISK

Standard Deviation of Return Unsystematic (diversifiable) Risk Total Risk Standard Deviation of the Market Portfolio (systematic risk)

Systematic Risk

Number of Stocks in the Portfolio

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

Efficient Frontier
Expected Return

Googl 100% investment in security e No points plot above with highest E(R) the line Points below the efficient frontier are dominated

All portfolios on the line are efficient

Coca cola

100% investment in minimum variance portfolio

Standard Deviation

Figure shows the efficient frontier for just two stocks - a high risk/high return technology stock (Google) and a low risk/low return consumer products stock (Coca Cola).

Formulas
Portfolio Return

Where, E(Rp)=expected return on portfolio xi=weight of securities i in the portfolio E(Ri)=Expected return on securities i n= No. of securities in the portfolio

Portfolio Risk 2 2 2

xA A

x
2 B

2 B

2xA xB AB A B
Interactive Risk

Total Risk Risk from A Risk from B

Example
Assume the following statistics for Stocks A, B, and C Stock A Stock B Stock C Expected return Standard deviation .20 .232 .14 .136 .10 .195

The correlation coefficients between the three stocks are: Stock A Stock B Stock C Stock A Stock B Stock C 1.000 0.286 0.132 1.000 -0.605 1.000

An investor seeks a portfolio return of 12%. Which combinations of the three stocks accomplish this objective? Which of those combinations achieves the least

Solution: Two combinations achieve a 12% return: 1) 50% in B, 50% in C: (.5)(14%) + (.5)(10%) = 12% 2) 20% in A, 80% in C: (.2)(20%) + (.8)(10%) = 12%

Solution (contd): Calculate the variance of the B/C combination:

x x 2 x A xB AB A B
2 p 2 A 2 A 2 B 2 B

(.50) (.0185) (.50) (.0380) 2(.50)(.50)( .605)(.136)(.195)

2 2

.0046 .0095 .0080 .0061

 Solution (contd): Calculate the variance of

the A/C combination:

x x 2 x A xB AB A B
2 p 2 A 2 A 2 B 2 B

(.20) (.0538) (.80) (.0380) 2(.20)(.80)(.132)(.232)(.195)

2 2

.0022 .0243 .0019 .0284

Solution (contd): Investing 50% in Stock B and 50% in Stock C achieves an expected return of 12% with the lower portfolio variance. Thus, the investor will likely prefer this combination to the alternative of investing 20% in Stock A and 80% in Stock C.

CONCLUSION
Various portfolio combinations

may result in a given return

The investor wants to choose

the portfolio combination that provides the least amount of variance