Portfolio Theory - Many Risky Assets

The purpose of this note is to show you how to calculate the optimal investment portfolio
and the ecient frontier in the case of many risky assets and one risk free asset. The examples
in this note are demonstrated in the Excel le portfolio theory.xls posted on Blackboard.
I. Basic Denitions
We would like to build an optimal portfolio out of many risky assets (possibly stocks). Suppose
we have n risky assets (n2). Using historical data we can calculate the expected returns and
the variance-covariance matrix of these n assets. The expected returns are given by a column
vector of dimension n 1:
R =

2
.
.

.
The variance-covariance matrix is given by an nn matrix:
V =

11

12
...
1n

21

22
...
2n
. .
. .

n1

n2
...
nn

.
A portfolio is just an array of proportions - the percentage of capital we allocate to each
asset. Thus, a portfolio is a vector:
x =

x
1
x
2
.
.
x
n

,
such that
n

i=1
x
i
= 1. (*)
1
Typically we use a column vector for a portfolio, but we can also sometimes use a row
vector. This does not matter. Notice that x
i
can be negative. Why?
II. Expectation, Variance and Covariance of Portfolio Returns
A. Expected Return of a Portfolio
The expected return of a portfolio x is

x
= x
1

1
+ x
2

2
+ ... + x
n

n
.
Using matrix notation we have

x
= x
T
R.
Example: Suppose that the vector of expected returns is
R =

0.1
0.12
0.08

.
Consider the portfolio:
x =

0.2
0.5
0.3

.
The expected return of the portfolio is

x
= (0.2 0.5 0.3)

0.1
0.12
0.08

= 0.104 = 10.4%.
Consider the portfolio
y =

0.2
0.3
1.1

.
The expected return on this portfolio is

y
= (0.2 0.3 1.1)

0.1
0.12
0.08

= 0.072 = 7.2%.
In Excel: use TRANSPOSE( ) and MMULT( ).
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B. Variance of a Portfolio
The variance of portfolio x is given by

2
x
= x
T
V x. (**)
Example: Consider the case of just 2 risky assets (n =2). Then

2
x
= (x
1
x
2
)

11

11

21

22

x
1
x
2

= x
2
1

2
1
+ x
2
2

2
2
+ 2x
1
x
2

12
= x
2
1

2
1
+ x
2
2

2
2
+ 2x
1
x
2

12
.
Thus, in the case of just two assets we can use the simple formula that you have learned before.
In general, when n is larger than 2 it is convenient to use (**). In Excel: Use TRANSPOSE
and MMULT.
Example: Assume that
V =

0.0025 0.001 0.0012

0.001 0.003 0.0018
0.0012 0.0018 0.002

.
Calculate the variance of the portfolio:
x =

0.2
0.5
0.3

.
We can do it easily using Excel. The variance of the portfolio is

2
x
= x
T
V x = (0.2 0.5 0.3)

0.0025 0.001 0.0012

0.001 0.003 0.0018
0.0012 0.0018 0.002

0.2
0.5
0.3

= 0.001914.
Now, calculate the variance of the portfolio
y =

0.2
0.3
1.1

.
The result is
(0.2 0.3 1.1)

0.0025 0.001 0.0012

0.001 0.003 0.0018
0.0012 0.0018 0.002

0.2
0.3
1.1

= 0.00201.
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C. Covariance of the Returns of Two Portfolios
The covariance of the returns of two portfolios x and y is given by:
Cov(x, y) = x
T
V y.
Example: Calculate the covariance of the portfolios x and y given above. The result is
(0.2 0.5 0.3)

0.0025 0.001 0.0012

0.001 0.003 0.0018
0.0012 0.0018 0.002

0.2
0.3
1.1

= 0.001514.
In Excel: use Transpose() and MMULT().
III. The Case of Just Two Risky Assets
The case n =2 is the simplest case, but it is also very important. It will turn out later that
the general case of many risky assets can be boiled down to the case of just two assets. For
this reason, it is important to study this case carefully.
As we saw above, in the case of n =2 we can write:

x
= x
1

1
+ x
2

2
(***)

2
x
= x
2
1

2
1
+ x
2
2

2
2
+ 2x
1
x
2

12
,
where x
1
+ x
2
= 1.
If we plot the combinations of means and variances, we obtain Figure 1. Figure 1 shows the
opportunity set given two portfolios. The opportunity set becomes better as the correlation
becomes lower. The opportunity set reects the benet of diversication.
The global minimum variance portfolio is given by:
x
G
1
=

2
2

12

2
1
+
2
2
2
12
=

2
2

12

2
1
+
2
2
2
1

12
x
G
2
= 1 x
G
1
.
4
Figure 1: : The opportunity set with dierent levels of correlation.
Example:
1
= 12%,
2
= 8%,
1
= 8%,
2
= 7%,
12
= 0.3. Find a portfolio with an
expected return of 9%. We solve:
12x + 8 (1 x) = 9
x = 0.25.
The variance of this portfolio is:

2
x
= 0.25
2
0.08
2
+ 0.75
2
0.07
2
+ 2 0.25 0.75 0.08 0.07 0.3
= 0.0037863.
The standard deviation is:

x
=

0.0037863 = 0.0615.
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Figure 2: : The minimum variance frontier with many risky assets
The global minimum variance portfolio is:
x
G
1
=
0.07
2
0.08 0.07 0.3
0.08
2
+ 0.07
2
2 0.08 0.07 0.3
= 0.40554.
x
G
2
= 1 0.40554 = 0.59446.
IV. The General Case - Many Risky Assets and a Riskfree
Asset
A. Calculating the Optimal Investment Portfolio
Figure 2 presents the minimum variance frontier with many risky assets. Each point on this
curve has the minimum variance for a given expected return. The ecient frontier is the
portion of this curve which lies above the global minimum variance. If we add a risk free asset
with return r
f
, then we obtain alternative Capital Allocation Lines (CALs) as in Figure 3.
The best CAL is the one that passes through the point P on the ecient frontier. This CAL
is tangent to ecient frontier and has the highest reward to volatility ratio.
The reward to volatility ratio (Sharpe ratio) of portfolio x is given by

x
r
f
x
=
x
T
Rr
f

x
T
V x
.
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Figure 3: : Alternative capital allocation lines
Therefore, the optimal portfolio P is given by the following optimization problem:
max
x
x
T
R r
f

x
T
V x
s.t.
n

i=1
x
i
= 1.
That is, we have to nd the portfolio that maximizes the reward to volatility ratio. De-
riving the solution to this optimization problem requires some calculus. We will not show the
derivation. We can easily nd the answer using solver in excel.
Example: Consider a case with 3 risky assets. The vector of expected returns and variance-
covariance matrix are:
R =

0.10
0.12
0.08

V =

0.045 0.010 0.012

0.010 0.055 0.018
0.012 0.018 0.020

.
The risk free rate is r
f
= 6%. Using solver, the weights for the optimal portfolio (lets call
the portfolio x
p
) are

0.53976
0.77587
0.31563

.
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The expected return of the optimal portfolio is

p
= (0.53976 0.77587 0.31563)

0.10
0.12
0.08

= 0.12183 = 12.183%.
The variance of the optimal portfolio is

2
p
= (0.53976 0.77587 0.31563)

0.045 0.010 0.012

0.010 0.055 0.018
0.012 0.018 0.020

0.53976
0.77587
0.31563

= 0.043682.
The standard deviation of the optimal portfolio is

p
=

0.043682 = 20.9%.
The Capital Allocation Line is:

C
= r
f
+

C

p
r
f

= 6% + 0.29
C
.
Consider an investor with a risk aversion coecient of A =3. The proportion that the investor
will allocate to the risky portfolio P is:
w

=
1
0.01A

p
r
f

2
p
=
1
0.01 3

12.18 6
20.9
2
= 0.47 = 47%.
The investor should allocate 53% of his funds to the risk free investment.
Assume that the investor has $100,000. How much should he allocate to each asset?
Risk Free Asset 53 ,000
Risky Asset 1 0 .53976 47 ,000 = 25 ,369
Risky Asset 2 0 .77587 47 ,000 = 36 ,466
Risky Asset 3 -0 .31563 47 ,000 = -14 ,835
Total 100 ,000
B. Calculating the Entire Ecient Frontier
To calculate dierent points on the ecient frontier, we need another point on the frontier.
Imagine that the riskfree rate suddenly goes down to 2%. The ecient frontier should stay
the same since it is a combination of stocks. So what we can do is to use the same matrix of
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R and V but use a lower riskfree rate at 2%. Using the solver we nd that the new portfolios
weights are

0.3307
0.3364
0.3328

.
The Two Fund Separation Theorem tells us that it is enough to calculate just two portfolios
on the ecient frontier. Any other portfolio is just a combination of these two. Lets call this
portfolio with lower riskfree rate y
p
. The expected return of y
p
is
(0.3307 0.3364 0.3328)

0.10
0.12
0.08

= 10%.
The variance of y
p
is
(0.3307 0.3364 0.3328)

0.045 0.010 0.012

0.010 0.055 0.018
0.012 0.018 0.020

0.3307
0.3364
0.3328

= 0.02226.
The standard deviation of y
p
is

0.02226 = 14.92%.
All the rest of the portfolios on the ecient frontier are just combinations of x
p
and y
p
.
Example: Find a portfolio on the ecient frontier with an expected return of 11%. We
solve
11 = 12.183 x + 10 (1 x)
x = 45.8%.
Example: Find the global minimum variance portfolio.
We rst have to calculate the covariance between x
p
and y
p
. Using the formula in Section
2.3 we have:
cov (x
p
, y
p
) = (0.53976 0.77587 0.31563)

0.045 0.010 0.012

0.010 0.055 0.018
0.012 0.018 0.020

0.3307
0.3364
0.3328

= 0.028311.
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Now, the weight of x
p
in the global minimum variance portfolio is (using the formula in
Section 3)
0.02226 0.028311
0.043682 + 0.02226 2 0.028311
= 0.64925.
The mean of the global minimum portfolio is

G
= 0.64925 0.12183 + (1 (0.64925)) 0.1 = 8.5827%.
The variance of the global minimum variance portfolio is

2
G
= (0.64925)
2
0.043682 + (1 (0.64925))
2
0.02226 + 2 (0.64925) (1 (0.64925)) 0.028311
= 0.018331
The standard deviation of the global minimum variance portfolio is

G
=

0.018331 = 13.5%.
V. Short Sales Restrictions
The above methodology tends to yield portfolios with negative components - short sales. In
many real life situations there are restrictions to short sale usage. Thus, in order to nd the
optimal investment portfolio in this case we have to nd the tangency portfolio numerically.
Recall that the tangency portfolio is the portfolio x that maximizes the reward to volatility
ratio:

x
r
f
x
and is given by the following optimization problem.
max
x
x
T
R r
f

x
T
V x
s.t.
n

i=1
x
i
= 1.
Now in solver we can introduce additional constraints such that x
i
0 for all i. This kind
of constraints will eliminate short sales. Solver will give the optimal portfolio with short sales
restrictions.
10
To construct the ecient frontier with short sale restrictions we cannot use the two funds
theorem in this case, because it is not valid. Instead, we have to nd the optimal portfolio for
many values of the risk free rate using Solver, and draw the curve that connects them.
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