Portfolio Management-Learning

Objective
Basic assumptions of Markowitz portfolio
theory?
What is meant by risk, and alternative
measures of risk?
Expected rate of return for an individual risky
asset and a portfolio of assets?
Standard deviation of return for an individual
risky asset and portfolio of assets?
Covariance and correlation between rates of
return.
1

Portfolio Management-Learning
Objective
Portfolio diversification.
What is the risk-return efficient frontier?
What determines which portfolio on the
efficient frontier is selected by an
individual investor?
Asset Allocation Models.

Markowitz Portfolio Theory

Quantifies risk
Derives the expected rate of return for a
portfolio of assets and an expected risk
measure
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
3

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.
2. Investors minimize one-period
expected utility, and their utility
curves demonstrate diminishing
marginal utility of wealth.
4

Assumptions of
Markowitz Portfolio Theory
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

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.

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.
7

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
8

Expected Rates of Return

For an individual asset - sum of the
potential returns multiplied with
the corresponding probability of
the returns
For a portfolio of assets - weighted
average of the expected rates of
return for the individual
investments in the portfolio
9

Computation of Expected
Return for an Individual Risky
Exhibit 7.1
Investment
Probability
0.25
0.25
0.25
0.25

Possible Rate of
Return (Percent)
0.08
0.10
0.12
0.14

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

10

Computation of the Expected

Return for a Portfolio of Risky
Weight (W )
Expected Security
Expected Portfolio
Assets(Percent of Portfolio) Return (R )
Return (W X R )
i

0.20
0.30
0.30
0.20

0.10
0.11
0.12
0.13

0.0200
0.0330
0.0360
0.0260
E(Rpor i) = 0.1150

E(R por i ) Wi R i

Exhibit 7.2

i 1

where :
Wi the percent of the portfolio in asset i
E(R i ) the expected rate of return for asset i
11

Variance (Standard Deviation)

of Returns for an Individual
Investment
n

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

i 1

Standard Deviation

( )

[R
i 1

- E(R i )] Pi
12

Variance (Standard Deviation)

of Returns for an Individual
Exhibit 7.3
Investment
Possible Rate
of Return (R i )

Expected
Return E(Ri )

Ri - E(R i )

[Ri - E(R i )]

0.08
0.10
0.12
0.14

0.11
0.11
0.11
0.11

0.03
0.01
0.01
0.03

0.0009
0.0001
0.0001
0.0009

Pi
0.25
0.25
0.25
0.25

[Ri - E(Ri )] Pi
0.000225
0.000025
0.000025
0.000225
0.000500

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

13

Variance (Standard Deviation)

Exhibit 7.4
of Returns for a Portfolio
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 (%)

60.938
58.000
-4.82%
53.030
-8.57%
45.160
0.18
-14.50%
46.190
2.28%
47.400
2.62%
45.000
0.18
-4.68%
44.600
-0.89%
48.670
9.13%
46.850
0.18
-3.37%
47.880
2.20%
46.960
0.18
-1.55%
47.150
0.40%
E(RCoca-Cola)= -1.81%

Closing
Price

Dividend Return (%)

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%

14

Covariance of Returns
A measure of the degree to which
two variables move together
relative to their individual mean
values over time
For two assets, i and j, the
covariance of rates of return is
defined as:
Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}
15

Covariance and
Correlation
The correlation coefficient is
obtained by standardizing
(dividing) the covariance by the
product of the individual standard
deviations

16

Covariance and
Correlation
Correlation coefficient varies from -1 to +1

rij

Cov ij

i j

where :
rij the correlation coefficient of returns

i the standard deviation of R it

j the standard deviation of R jt

17

Correlation Coefficient
It can vary only in the range +1 to -1. A
value of +1 would indicate perfect
positive correlation. This means that
returns for the two assets move together
in a completely linear manner. A value of
1 would indicate perfect correlation.
This means that the returns for two
assets have the same percentage
movement, but in opposite directions
18

Portfolio Standard
Deviation Formula
port

w
i 1

2
i

2
i

w i w j Cov ij
i 1 i 1

where :

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

Cov ij the covariance between the rates of return for assets i and j,
where Cov ij rij i j

19

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
20

Combining Stocks with

Different Returns and Risk
Asset
1
2

Case
a
b
c
d
e

E(R i )

Wi

.20

.50

.10

.50

Correlation Coefficient
+1.00
+0.50
0.00
-0.50
-1.00

.0049

.07

.0100

.10

Covariance
.0070
.0035
.0000
-.0035
-.0070
21

Combining Stocks with

Different Returns and Risk
Assets may differ in expected rates of
return and individual standard
deviations
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
22

Constant Correlation
with Changing Weights
Asset
1
Case 2
f
g
h
i
j
k
l

E(R i )
.10

r ij = 0.00
2

W1 .20

0.00
0.20
0.40
0.50
0.60
0.80
1.00

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
23

Constant Correlation
with Changing Weights
Case

W1

W2

E(Ri )

E( port)

f
g
h
i
j
k
l

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

0.20
0.18
0.16
0.15
0.14
0.12
0.10

0.1000
0.0812
0.0662
0.0610
0.0580
0.0595
0.0700

24

Constant Correlation
with Changing Weights
Asset
1

E(R i )
.10

r ij = 0.00

Constant correlation with changing weig

2

.20
2

Case

W1

f
g
h
i
j
k

0.00
0.20
0.40
0.50
0.60
0.80

1.00
0.80
0.60
0.50
0.40
0.20

E(R i )
0.20
0.18
0.16
0.15
0.14
0.12

25

Constant Correlation
with Changing Weights
Case

W1

W2

E(Ri )

f
g
h
i
j
k
l

0.00
0.20
0.40
0.50
0.60
0.80
1.00

1.00
0.80
0.60
0.50
0.40
0.20
0.00

0.20
0.18
0.16
0.15
0.14
0.12
0.10

E(

port )

0.1000
0.0812
0.0662
0.0610
0.0580
0.0595
0.0700

26

Portfolio Risk-Return Plots

for Different Weights
E(R)

0.20
0.15
0.10
0.05

With two perfectly

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

2
Rij = +1.00
1

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

27

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

j
k

Rij = +1.00
Rij = +0.50

1
Rij = 0.00

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

28

Portfolio Risk-Return Plots

Exhibit 7.13
for Different Weights
E(R)

0.20

Rij = -1.00

Rij = -0.50

0.15

0.10

0.05
-

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

29

Estimation Issues
Results of portfolio allocation depend on
accurate statistical inputs
Estimates of

Expected returns
Standard deviation
Correlation coefficient
Among entire set of assets
With 100 assets, 4,950 correlation estimates

Estimation risk refers to potential errors

30

Estimation Issues
With assumption that stock returns
can be described by a single
market model, the number of
correlations required reduces to
the number of assets
Single
market
R i aindex
i bi R
m i model:
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

31

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

32

Efficient Frontier
for Alternative Portfolios
E(R)

Efficient
Frontier

Exhibit 7.15

Standard Deviation of Return

33

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
34

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

35

Selecting an Optimal Risky

Portfolio
Exhibit 7.16
E(R port )

U3
U2

U1

Y
U3
U2

X
U1

E( port )

36