Introduction

Risk can be defined in many ways, and for each person this defintion of risk can be different.
However, most people have one thing in common: they are all risk averse (Ebgels, 2004).
A rational and risk averse investor will only invest in efficient portfolios. Efficient portfolios have
the highets expected return for a given standard deviation (Diether,...). every investorss goal is to
determine an optimal asset portfolio. The investir will earn the highest possible expected return
given the level of volatility the investor is willing to accept or, equivalently; the investors portfolio
will have the lowest level of volatility given the expected return the investor requires.
Nowadays, variance is the most popular risk measure, which has been employed widely in may real
estate and finance studies; and it is also the most popular risk measure for investors (Evans, 2004)

Portfolio variance is a measurement of how the aggregate actual returns of a set of securities
making up a portfolio fluctuate over time. This portfolio variance statistic is calculated using the
standard deviations of each security in the portfolio as well as the correlations of each security pair
in the portfolio.

Portfolio variance looks at the covariance or correlation coefficient for the securities in the
portfolio. Generally, a lower correlation between securities in a portfolio results in a lower portfolio
variance. Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding twice the weighted average weight multiplied by the covariance
of all individual security pairs.

LITERATURE REVIEW
Theoretical review
MODERN PORTFOLIO THEORY
This theory was pioneered by Harry Markowitz in his paper entittled Portfolio Selection in 1952.
Modern Portfolio Theory (MPT) is a theory on how risk-averse investors can construct portfolios to
optimize or maximize expected return based on a given level of market risk, emphasizing that rsk is
an inherent part of higher reward. Modern Portfolio Theory is an investment theory whose purpose
is to maximise a portfolios expected return by altering and selecting the proportions of the various
assets in the portfolio. According to this theory, it is possible to construct an efficient frontier of
optimal portfolios offering the maximum possible expected return for a given level of risk. The
theory explains how to find the besst possible divesification. If investors are presented with two
portfolios of equal value that offer the same expected return, MPT explains how the investor will
prefer and should select the less risky one.nvestors assume additional risk only when faced with the
prospect of additional return. In brief, MPT explains how investors can reduce overall risk by
holding a diversified portfolio of assets.

Modern Portfolio theory says that the portfolio variance can be reduced by choosing asset classes
with a low or negative correlation such as stocks and bonds. An assumption in Markowitz Portfolio
Theory that all investors will have the same expectations and make the same choices given a
particular set of circumstances. The assumption of homogeneous expectations states that all
investors will have the same expectations regarding inputs used to develop efficient portfolios,
including asset returns, variances and covariances. However, modern Portfolio Theory takes in to
account many assumptions which are not always correct in the real world. As an example, the
theory assumes that asset returns are normally distributed random variables. A real life examination
indicates this is often far from true. Another major flaw in the theory relates to the assumption that
all investors have access to the same information.

Covariance is used in the portfolio theory to determine what assets to include in the portfolio.
Covariance is a statistical measure of the directional relationship between two asset prices. Porfolio
theory uses this statistical measurement to reduce the overall risk of a portfolio. A positive
covariance means that assets generally move in the same direction. Negative covariance means
assets generally move in opposite directions. Covariance can be used to maximize diversification in
a portfolio of assets. By adding assets with a negative covariance to a portfolio, the overall risk is
quickly reduced. Covariance provides a statistical measurement of the risk for a mix of assets. In the
construction of a portfolio, it is important to attempt to reduce overall risk by including assets that
have a negative covariance with each other. Analysts use historical price data to determine the
measure of covariance between different stocks. This assumes that the same statistical relationship
between the asset prices will continue into the future, which is not always the case. By including
assets that show a negative covariance, the risk of a portfolio is minimized.

MEAN-VARIANCE OPTIMIZATION
mean variance analysis is component of the modern portfolio theory, which assumes investors make
rational decisions and expect a higher return for increased risk. The process of wighing risk
(variance) against expected return. To make more efficient investment choices- seeking the lowest
variance for a given expected return, or seeking the highest expected return for a given variance
level. Markowitz model, also known as Mean-Variance Model is based on the expected returns
(mean) and the standard deviation (variance) of different portfolios. It helps to make the most
efficient selection by analysing various portfolios of the given assets. It shows the investor how to
reduce their risk in case they have chosen assets not moving together.
the fundamental goal of portfolio theory is to optimally allocate your investments between different
assets. Mean variance optimization is a quantitative tool that will allow you to make this allocation
by considering the trade-off between risk and return. In conventional single period MVO, you will
make your portfolio allocation for a single upcoming period, and the goal will be to maximise your
expected return subect to a selected level of risk. Single period MVO was developed in the
pioneering work of Markowitz. Single period portfolio optimization using the mean and variance
was first formulated by Markowitz. There are many criticisms which were put forward on this
model of mean-variance analyisis. Investors care about more than ust mean variance; they are not a
complete description of market returns; returns are not linear functions of the investment weights;
and investment strategies are not simple; and the mean and variance are hard to estimate (Fall,
2009)

Portfolio variance is a measurement of how the aggregate actual returns of a set of securities
making up a portfolio fluctuate over time. This portfolio variance statistic is calculated using the
standard deviations of each security in the portfolio as well as the correlations of each security pair
in the portfolio.
Portfolio variance looks at the covariance or correlation coefficients for the securities in the
portfolio. Generally, a lower correlation between securities in a portfolio results in a lower portfolio
variance.
Portfolio variance is calculated by multiplying the squared weight of each security by its
corresponding variance and adding twice the weighted average weight multiplied by the covariance
of all individual security pairs.

The Mutual Fund Theorem and Covariance Pricing Theorems

Overview
This lecture continues the analysis of the Capital Asset Pricing Model, building up to two key
results. One, the Mutual Fund Theorem proved by Tobin, describes the optimal portfolios for agents
in the economy. It turns out that every investor should try to maximize the Sharpe ratio of his
portfolio, and this is achieved by a combination of money in the bank and money invested in the
"market" basket of all existing assets. The market basket can be thought of as one giant index fund
or mutual fund. This theorem precisely defines optimal diversification. It led to the extraordinary
growth of mutual funds like Vanguard. The second key result of CAPM is called the covariance
pricing theorem because it shows that the price of an asset should be its discounted expected payoff
less a multiple of its covariance with the market. The riskiness of an asset is therefore measured by
its covariance with the market, rather than by its variance. We conclude with the shocking answer to
a puzzle posed during the first class, about the relative valuations of a large industrial firm and a
risky pharmaceutical start-up.

Empirical
the buy side of the financial services industry is about deciding how to invest resources. An investor
is a person who has (or an institution that has) an endowment to invest for the purpose of increasing
the endowment to invest for the purpose of increasing the endowment (Fall, 2009). the investor or
the buy side proffessional acting on the investors behalf, has a trade off between expected return
and risk. He or she makes investment decisions without knowing which ones will yield the greatest
return. An investor may hesitate to invest in a scheme that is likely to make him or her wealthy but
has some chance of bankrupting him or her instead.

When considering two or more random variables, their mutual dependence can be summarised by
their covariance (.MATH362 ). having 2 investments X and Y, the cavariance of these variables is
defined to be the expectation of their product of deviations from the respective mean of X and Y. If
two random variables Xand Y have a covariance of zero (Qxy=0), then they are said to be
uncorrelated. This is the situation (roughly) where knowledge of the value of one variable gives no
information about the other. If two random variables are independent, then they are uncorrelated. If
the covariance of X and Y is greater than zero, the two variables are said to be positively correlated.
In this case, if one variable is above its mean, the other is likely to be above its mean as well. On the
other hand, if Qxy is less than zero, the two variables are said to be negatively correlated
(MATH362).

According to Engels (2004)

Finding the optimal portfolio that is the portfolio with the highest utility of an investor, means
finding the best combination of the risk free asset and the market portfolio. The basic thought with
mean variance analysis is that an investor wants to minimize his variance given some return. If he
can choose between portfolios with the same expected return, he will take the portfolio with
minimum variance. Variance is a measure of dispersion.

The basic thought is to reduce the sensitivity of the optimal portfolios to input uncertainity. In other
words, if the input parameters mean and varaince change a small amount, the optimal portfolio
should not change much (Engels(2004). Frost and Savarino propose to constrain the portfolio
weights, so one asset doesnt become too important for the portfolio. Chopra et al proposes to use a
ames-Stein Estimator for means, while Black and Litterman suggest Bayesian estimation of means
and covariances. Jorion reasearches the Bayes-Stein Estimators. There are also sample based and
scenario based approaches as described in papers of Mich and Ziemba et al. All thes methods
reduce the sensitivity of the portfolio allocation to the input parameters , but do not provide any
hard guarantees on the portfolio perfomance.

IMPOTANCE OF VARIANCE AND OR COVARIANCE IN PORTFOLIO CONSTRUCTION

Allowas identification of portfolios with the best risk return profiles
variances and standard deviations are statistical measures used for measuring risk in investments.
These measures shows the extend to which the returns are expected to vary around average over
time. This means that an investor will have a clear picture on the size of risk hi or she is going to
take on the investment. Usually high risky investments have a high return hence risk loving
investors will go for those investments. On the other hand, risk averse investors can opt to leave
investments with high risks. Variance analysis will give them a picture of how much risk they are
going to take and this can allow them to look for other investments with best risk return profiles.

it is inexpensive because we have fancy computers and whatnot

programs that do it are cheap and readily available. In the modern world it is now easy for some
computations to be done with less difficulties. Historical data is fed into computers and other recent
technological tool which can calculate the variances and covariances.

easily and well understood

variance is the most popular risk measure and it emerges as a risk measure that is more suitable for
individual investors who normally have some basic background on risk management and
computation of variance is not as complex as other risk measures. While, variance is the only risk
measure requires assumption on the asset return distributions.
LIMITATIONS
its a static approach
which means that ist inly useful for one period

highly sensitive to return estimates

which make it subect to significant estimation error and input bias. MV optimisation is very
sensitive to errors in the estimates of the inputs. Chopra (1993) shows that small changes in the
input parameters can result in large changes in the input parameters can result in large changes in
composition of the optimal portfolio.Errors in varainces are about twice as important as errors in
covariances. The relative impact of errors in means, variances and covariances also depends on the
investors risk tolerance (Chopra and Ziemba). A higher risk tolerances, errors in means are even
more important relative to errors in variance and covariances. At lower risk tolerances, the relative
impact of errors in means, variances and covariances is closer. Even though errors in means are
more important than those in variances and covariances, the difference in important diminishes with
a decline in risk tolerance. These results have an implication for allocation of resources according
to the MV framework. The primary emphasis should be on obtaning superior estimates of means,
followed by good estimates of variances. Estimates of covariances are the least important in terms
of their influence on the optimal portfolio (Chopra and Ziemba).

it can yield asset alloxcations that are highly concentrated in ust one asset class
which means they are not diversified

portfolios produced using the MVO method often require frequent rebalancing

Covariance are more influential than with a 2-asset portfolio. as we add more assets, covariances
become a more important determinate of the portfolios variance (Diether,...)
if the number of securities is large (and the weights are small), covariance become the most
important derteminant of a portfolios variance. For a n asset portfolio there are n(n-1)/2 covariance
terms, and n variance terms. For example a portfolio of a 100 stocks has 1000 variance terms and
499950 unique covariance terms. Compare that to a portfolio of two assets which has 2 variance
terms and 1 covariance term.

An assets influence on a portfolios variance primarily depends on how it covaries with the other
assets in the portfolio. Thus, what matters is how an asset covaries with the portfolio.

The use of covariance does have drawbacks. Covariance can only measure the directional
relationship between two assets. It cannot show the strength of the relationship between assets. The
correlation coefficient is a better measure of that strength. An additional drawback to the use of
covariance is that the calculation is sensitive to higher volatility returns. More volatile assets
include returns that are farther from the mean. These outlying returns can have an undue influence
on the resulting covariance calculation. Large single-day price moves can impact the covariance,
which leads to an inaccurate estimate of the measurement.

Valatitity if a large potfolio: the benefits of diversification

the measure of risk by variance would place equal weight on the upside deviations and downside
deviations.

References
Diether, K.B, Mean Variance Analysis, Fisher College of Business
Risk and Portfolio Management with Econometrics, Courant Institute, Fall 2009
http://www.math.nyu.edu/faculty/goodman/teaching/RPME09/index.html
Jonathan Goodman
1
, goodman@cims.nyu.edu

http://oyc.yale.edu/economics/econ-251/lecture-23

Michaud (1998), Efficient Asset Management: a practical guide to Stock Portfolio Management and
asset allocation

Ziemba, Mulvey (1998), Worldwide Asset and liability Modelling

Chopra (1993), improving optimization

Black, Litterman (1990), Asset allocation: combining investor views with market equilibrium:
techinical report, fixed income research

Evans, J.L. (2004) Wealthy Investor Attitudes,

Expectations, and Behaviors toward Risk and Return,
The Journal of Wealth Management
, 7(1): 12-18.