Portfolio Theory

Indifference Curve
Indifference Curve

Expected Return E(r)

Represents individuals
willingness to trade-off
return and risk

Assumptions:

1) 5 Axioms
2) Prefer more to less (Greedy)
3) Risk aversion
4) Assets jointly normally
distributed

Increasing Utility
Standard Deviation
(r)

Dominance
Expected Return
4
2

3
1
Standard Deviation

2 dominates 1; has a higher return

2 dominates 3; has a lower risk
4 dominates 3; has a higher return

Jointly normally distributed?

Individual stock return may not be normally distributed, but a portfolio

consists of more and more stocks would have its return increasingly close
to being normally distributed.

Jointly normally distributed?

1st moment: Mean = Expected return of portfolio
2nd moment: Variance = Variance of the return of portfolio (RISKNESS)
Mean and Var as sole choice variables => Distribution of return can be
adequately described by mean and variance only
That means, distribution has to be normally distributed.

2 reasons to support mean-variance criteria

1) As the table shows, a portfolio with large number of risky assets tend to
be close to normally distributed.
2) The fact that investors rebalance their own portfolios frequently will act
so as to make higher moments (3rd, 4th, etc) unimportant (Samuelson
1970)

Math Review I
Asset js return in State s:
rjs = (Ws W0) / W0
Expected return on asset j:
E(rj) = ssrjs
Asset js variance:
2j = ss[rjs- E(rj)]2
Asset js standard deviation:
j = 2j

Math Review I
Covariance of asset is return & js return:
Cov(ri, rj)= E[(ris- E(ri)) (rjs- E(rj))]
=ss[ris- E(ri)] [rjs- E(rj)]
Correlation of asset is return & js return:
ij = Cov(ri, rj) / (ij)
-1 ij 1
When ij = 1 => i and j are perfectly positively
correlated. They move together all the time.
When ij = -1 => i and j are perfectly negatively
correlated. They move opposite to each other all
the time.

A simple example: Asset j

60%

$150,000

Good State:

rgood = ($150,000 $100,000) / $100,000 = 50%

$10,000
40%

$80,000
Bad State:
$100,000 = -20%

rbad = ($80,000 $100,000) /

Expected Return:
E(rj) = ssrjs = 60%(50%) + 40%(-20%) = 22%

Variance:
2j = ss[rjs- E(rj)]2 = 60%(50%-22%)2 + 40%(-20%-22%)2 = 11.76%

Standard Deviation:
j = 2j = 11.76% = 34.293%

Math Review II
4 properties concerning Mean and Var
Let be random variable, a be a constant
1) E(+a) = a + E()
2) E(a) = aE()
3) Var(+a) = Var()
4) Var(a) = a2Var()

Portfolio Theory a bit of history

Modern portfolio theory (MPT)or portfolio theorywas introduced by

Harry Markowitz with his paper "Portfolio Selection," which appeared in the
1952 Journal of Finance. 38 years later, he shared a Nobel Prize with
Merton Miller and William Sharpe for what has become a broad theory for
portfolio selection.

Prior to Markowitz's work, investors focused on assessing the risks and

rewards of individual securities in constructing their portfolios. Standard
investment advice was to identify those securities that offered the best
opportunities for gain with the least risk and then construct a portfolio from
these. Following this advice, an investor might conclude that railroad
stocks all offered good risk-reward characteristics and compile a portfolio
entirely from these. Intuitively, this would be foolish. Markowitz formalized
this intuition. Detailing a mathematics of diversification, he proposed that
investors focus on selecting portfolios based on their overall risk-reward
characteristics instead of merely compiling portfolios from securities that
each individually have attractive risk-reward characteristics. In a nutshell,
inventors should select portfolios not individual securities. (Source:
riskglossary.com)

Link to his Nobel Prize lecture if you are interested:

http://nobelprize.org/economics/laureates/1990/markowitz-lecture.pdf

Illustration: 2 risky assets

Assume you have 2 risky assets (x & y) to
choose from, both are normally distributed.
rx ~ N(E(rx), 2x) & ry ~ N(E(ry), 2y)
You put a of your money in x, b in y.
a+b=1
Portfolio Expected Return:
E(rp) = E[arx + bry]=aE(rx)+ bE(ry)

Illustration: 2 risky assets

rx ~ N(E(rx), 2x) & ry ~ N(E(ry), 2y)
Portfolio Variance:
2p = E[rp - E(rp)]2
= E[(arx + bry)-E[arx + bry]]2
= E[(arx - aE[rx])+(bry - bE[bry])]2
= E[a2(rx - E[rx])2 + b2(ry - E[ry])2 + 2ab(rx
E[rx])(ry - E[ry])]
= a2 2x + b2 2y + 2abCov(rx, ry)
= a2 2x + b2 2y + 2abCov(rx, ry)
2p = a2 2x + b2 2y + 2abxyxy
p = (a2 2x + b2 2y + 2abxyxy)

Illustration: 2 risky assets

p = (a2 2x + b2 2y + 2abxyxy)
p increases as xy increase.
Implication: given a (and thus b), if xy is smaller,
variance of portfolio is smaller.
Diversification: you want to maintain the expected
return at a definite level but lower the risk you
expose. Ideally, you hedge by including another
asset of similar expected return but highly
negatively correlated with your original asset.

Diversification
Proposition: portfolio of less than perfectly
correlated assets always offer better riskreturn opportunities than the individual
component assets on their own.
Proof:
If xy = 1 (perfectly positively correlated)
then, p = a x + b y
If < 1 (less than perfectly correlated)
then, p < a x + b y

Varying the portion on X & Y

Suppose:

E(rp)

rx ~ N(13%, (20%)2) & ry ~ N(8%, (12%)2)

E(rp) = E[arx + bry]=aE(rx)+ bE(ry)

13%

%8
0%

100%

Varying the portion on X & Y

Suppose:
rx ~ N(13%, (20%)2) & ry ~ N(8%, (12%)2)

p = (a2 2x + b2 2y + 2abxyxy)
20%

xy=1
xy=-1
xy=0.3

12%

0%

100%

Min-Variance opportunity set with

the 2 risky assets
E(rp)
13%

= -1
= .3
= -1

=1
p

12%

20%

%8

Min-Variance opportunity set with

the Many risky assets
E(rp)

Efficient
frontier

Individual risky assets

Min-variance opp. set

Min-Variance opportunity set

E(rp)

Min-Variance Opportunity set the locus of risk & return

combinations offered by portfolios of risky assets that yields
the minimum variance for a given rate of return

Efficient set
E(rp)

Efficient set the set of mean-variance choices from the

investment opportunity set where for a given variance (or
standard deviation) no other investment opportunity offers a
higher mean return.

Individuals decision making with 2

risky assets, no risk-free asset
E(rp)

U U U

Efficient set
S
P
Q
More
risk-averse
investor

Less
risk-averse
investor

Introducing risk-free assets

Assume borrowing rate = lending rate
Then the investment opp. set will involve any
straight line from the point of risk-free assets to
any risky portfolio on the min-variance opp. set
However, only one line will be chosen because it
dominates all the other possible lines.
The dominating line = linear efficient set
Which is the line through risk-free asset point
tangent to the min-variance opp. set.
The tangency point = portfolio M (the market)

Capital market line = the linear

efficient set
E(rp)

E(Rm)

5%=Rf
m

Individuals decision making with 2

risky assets, with risk-free asset
CML

E(rp)
B
Q
M
A
rf

Implication
All an investor needs to know is the
combination of assets that makes up
portfolio M as well as risk-free asset. This
is true for any investor, regardless of his
degree of risk aversion.