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Lecture 4

Investment and Portfolio Analysis (Auckland University of Technology)

Studocu is not sponsored or endorsed by any college or university

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Lecture 4

Optimal Risky Portfolios

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The Investment Decision

• Top-down process with 3 steps:
1. Capital allocation between the risky
portfolio (asset) and risk-free asset
2. Asset allocation across broad asset
classes
3. Security selection of individual assets
within each asset class

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Diversification and Portfolio Risk

Why diversify by investing in many different
securities?
Answer: Reduce the risk of investment!

Two types of risks for investment in securities:

 Market risk

 Systematic or Non-diversifiable risk

 Attributable to market-wide risk sources

 Firm-specific risk

 Diversifiable or nonsystematic or unique risk

 Attributable to firm-specific influences

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Portfolio Risk and Number of Securities

(How many different securities should be invested?)

Equally weighted portfolios with randomly

Selected NYSE stocks

Most of the diversifiable risk

eliminated at 25 or so stocks

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Two-Asset Portfolio:
Return, Expected Return and Risk
Portfolio Return and Expected Return
rp  w1r1  w2 r2 ; E (rp )  w1 E (r1 )  w2 E (r2 )
where rp, r1, and r2 are returns on portfolio, asset 1 and asset 2
respectively, and w1 and w2 are the weights of the two assets in
the portfolio.
Portfolio Variance
 p2  w12 12  w22 22  2 w1w2 cov(r1 , r2 )
 w12 12  w22 22  2 w1w2 1  2 1,2
Portfolio Standard Deviation
 p   p2
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Covariance and Correlation

 Covariance and correlation are measure for

comovement between assets:

Cov(r1,r2) = 12
Range of values for  1,2
-1.0 < < 1.0

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Two-Asset Portfolio Example 1:

Bond and Stock
You invest $5,000 each in a bond and a
stock with the following information:

E(rB) = 6% E(rs) = 10%

B = 12% s = 25%
=0
Compute the expected return and risk of
your portfolio with the bond and stock!

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Two-Asset Portfolio Example 1:

Bond and Stock
wB = $5,000/($5,000+$5,000)=0.5
ws = 1- wB =0.5
Expected Portfolio Return = 8%
.5(6%) + .5 (10%)

Portfolio Standard Deviation = 13.87%

[(.5)2 (12%)2 + (.5)2 (25%)2
+ 2 (.5) (.5) (12%) (25%) (0)] ½
= 13.87%
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Two-Asset Portfolio Example 2:

Expected Return and Risk for Different Combinations

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Correlation Effects
 The amount of possible risk reduction
through diversification depends on the
correlation.
 The risk reduction potential increases
as the correlation approaches -1.
 If = +1.0, no risk reduction is possible.
 If = 0, σP may be less than the standard
deviation of either component asset.
 If = -1.0, a riskless hedge is possible.

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Two-Asset Portfolio: Return and Risk,

Correlation Effects

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The Minimum Variance Portfolio

 The minimum  When correlation is
variance portfolio less than +1, the
is the portfolio portfolio standard
composed of the deviation may be
smaller than that
risky assets that of either of the
has the smallest individual
standard component assets.
deviation, the
portfolio with  When correlation is
least risk. -1, the standard
deviation of the
minimum variance
portfolio is zero.

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Minimum Variance Combination of

Two Securities
For a two-asset portfolio, we can choose the portfolio
weights for assets 1 and 2, W1 and W2, using the
following formulas to obtain the minimum variance
combination with these two securities.

2
2 - Cov(r1,r2)
W1 =
21 +22 - 2Cov(r1,r2)
W2 = (1 - W1)
Cov(r1,r2) = 12
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Minimum Variance Combination:

Example

Stock 1: E(r1) 1 = .15 

= .10
12 = .2
Stock 2: E(r2) = .14 2 = .20

22 - Cov(r1r2) (.2)2 - (.2)(.15)(.2)

W1 = W1 =
12 + 22 - 2Cov(r1r2) (.15)2 + (.2)2 - 2(.2)(.15)(.2)
W2 = (1 - W1 ) W1 = .6733
Cov(r1,r2) = 12 W2 = (1 - .6733) = .3267

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Minimum Variance Combination:

Example
Stk 1 E(r1) = .10 1 = .15
12 = .2
Stk 2 E(r2) = .14  2 = .20
W1 = .6733
W2 = (1 - .6733) = .3267
E[rp] = .6733(.10) + .3267(.14) = .1131 or 11.31%

p2 = W1212 + W2222 + 2W1W2 1,212

1/2
σ p  (0.6733 2 ) (0.15 2 )  (0.3267 2 ) (0.2 2 )  2 (0.6733) (0.3267) (0.2) (0.15) (0.2)
 

 p  0.01711 / 2  13.08%

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Extending Concepts to Multi-Assets

Suppose there are N assets and the fraction of your
wealth you invest in asset i is wi. The return,
expected return and variance of the portfolio with
these assets are determined by:
N N
rp   wi ri ; E (rp )   wi E ( ri )
i 1 i 1
N N
 p2   wi w j cov(ri , rj )
i 1 j 1
N N N
  wi2 i2  2 wi w j i j i , j
i 1 i 1 j i
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Markowitz Portfolio Selection Model

 Security Selection
 The first step is to determine the
risk-return opportunities available.
 All portfolios that lie on the
efficient frontier from the global
minimum-variance portfolio and
upward provide the best risk-
return combinations

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The efficient frontier of risky assets

E(r)
Efficient Frontier is the set
of portfolios with the highest
Efficient expected return for given
frontier risk level

Global Individual
minimum assets
variance
portfolio

Largest expected return

for given risk

St. Dev.
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Extending to Include Riskless Asset

Investors form a total investment portfolio by combining a risky
portfolio (P) with the risk-free asset according to individual levels of
risk aversion. Note the correlation between P and the risk-free
asset is ZERO.

Investing w in Portfolio P and the rest in the risk-less asset gives:

If we plot this in (E(RTotal),Total) space for different values of w, we

obtain the Capital Allocation Line (CAL).

 Search for the CAL with the highest reward-to-variability ratio

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The Efficient Frontier of Risky Assets with the Optimal CAL

CAL (P)
CAL (A)
E(r)

Efficient Frontier
E(rP&F)

P
E(rP)
CAL (Global
minimum variance)

E(rA) A

F
Risk Free

A P P&F 
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The Optimal Risky Portfolio

o The optimal risky portfolio P is found by
the CAL that dominates other lines -- it
has the best tradeoff between risk and
return or the largest slope, i.e., the
highest reward-to-variability ratio
defined as
Sharpe Ratio = (E(Rp) - Rf) / p

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Markowitz Portfolio Optimization

Model
• Search for the CAL with the highest
reward-to-variability ratio
• Everyone invests in P, regardless of
their degree of risk aversion
• More risk averse investors put more in
the risk-free asset
• Less risk averse investors put more in P

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Capital Allocation and the Separation

Property

 The separation property tells us that

the portfolio choice problem may be
separated into two independent
tasks
 Determination of the optimal risky
portfolio is purely technical.
 Allocation of the complete portfolio
to T-bills versus the risky portfolio
depends on personal preference.

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The Optimal Risky Portfolio:

Two-security case
Consider a portfolio of two securities: bond
and stock with the following information:
E(r) σ(r)
Bond 6% 12%
Stock 10% 25%
1,2 = 0.2; rf=5%
Cov(r1,r2)
=0.2×12%×25%=0.006

O represents the optimal risky

portfolio.

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The Optimal Risky Portfolio: Example

The weight of risky asset 1 in the optimal
risky portfolio with two risky assets:

[ E (r1 )  rf ] 22  [ E (r2 )  rf ]Cov(r1 , r2 )

w1 
[ E (r1 )  rf ] 22  [ E (r2 )  rf ] 12  [ E (r1 )  rf  E (r2 )  rf ]Cov(r1 , r2 )
[6%  5%](25%)2  [10%  5%]  0.006

[6%  5%](25%)2  [10%  5%](12%)2  [6%  5%  10%  5%]  0.006
 0.3299
w2  1  w1  1  0.3299  0.6701

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The Optimal Risky Portfolio: Example

The expected return of the optimal risky
portfolio with two risky assets:
E (ro )  w1E (r1 )  w2 E (r2 )  0.3299  6%  0.670110%
 8.68%
The standard deviation of return for the
optimal risky portfolio with two risky assets:

 (ro )  w12 12  w22 22  2w1w 2 cov(r1 , r2 )

 (0.3299)2  (12%)2  (0.6701)2 (25%)2  2  0.3299  0.6701 0.006
 17.97%
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Practical Implications
 Financial advisors should identify what they
believe will be the best performing well
diversified portfolio, call it P.
 P may include funds, stocks, bonds, international
and other alternative investments.
 They should use this portfolio P as the starting
point to form investment portfolios for their
clients, and change the asset allocation
between the risky portfolio and “near cash”
investments according to risk tolerance of their
clients.
 The risky portfolio P may have to be adjusted
for individual clients for tax and liquidity
concerns if relevant and for the client’s
opinions.
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