Portfolio Selection - A

8/5/2019 Portfolio Selection | A Matter of Course
A Matter of Course
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Archive for the ‘Portfolio Selection’ Category
[FM] Diversifiable vs. Non-diversifiable Risk: The

Math (Wonkish)
with 2 comments
The result that variance of the market portfolio is a weighted average of covariance of the underlying
stocks with the market is a general result. This post fills in the mathematical blanks.
Diversifiable vs. Non-diversifiable Risk: The Math
Consider the variance of a Markowi portfolio containing assets:
Now if we let the weight of each asset in the portfolio to be the same, i.e. , and
consider the “average variance” as:
and “average covariance” as:
then the above portfolio variance simplifies to:
https://pgpfm.wordpress.com/category/portfolio-selection/ 1/19
Then as , the portfolio variance converges to:
That is, as the number of assets in the portfolio go up, the variance of individual assets become
unimportant, and its the covariance terms that dominate. This is just our diversification. Graphically this
can be represented as:
Diversification (Click on the figure to zoom; Source: Brealey-Myers, 9th Ed.)
Unique Risk (or alternatively, Diversifable Risk, or Unsystematic Risk, or Idiosyncratic Risk) is the “average
variance” of the individual assets.
As number of assets in the portfolio increase, this “average variance” tends to zero. The only risk, then,
that ma ers is the one that remains after diversification has done its work. And this is just the average
covariance between all assets in the portfolio. This is called Market Risk (or alternatively, Systematic
Risk, or Undiversifiable Risk). And accordingly, the covariance of an asset with the market portfolio is
called its market risk.
The fact that portfolio variance after diversification is just the weighted average of covariance between
assets can be seen by first noting that:
Since the expectations add up, we can take out the summation sign outside the expectation, and it
follows that:
That is the covariance of any asset with the market portfolio is nothing but the weighted average of its
covariance with all other assets in the portfolio.
Next, note that we can write:
(If you are looking for the variance terms, note the change in the limits in the summation operator, and
recall that )
Then if we substitute our result that , we see that:
That is the variance of the market portfolio is just the weighted average of the covariance of all assets in
the portfolio with itself. Again, this result is important enough to warrant a separate ‘box’:
If you notice, what we have done is essentially given a proof that covariances add up.
To see this, recall from your basic probability theory that for any three random variables, and :
If we let , and use the fact that , it immediately follows that
Our proof above is just a generalization of this result. Combine this with our observation that in the limit
individual variances (unique risks) disappear and we have our economic result that:
Moral of the Story 4: The risk of an individual asset is determined not by its individual variance, but
by its covariance with the market portfolio, because the diversifiable/unique/idiosyncratic risk can be
diversified away.
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Wri en by Vineet
September 3, 2015 at 9:19 am
Posted in Diversification, FM, Portfolio Selection
Tagged with Diversification, FM-2, Portfolio Theory, Session 9
[FM] Markowitz on Markowitz
leave a comment »
Enjoy!
IFA.tv - An Hour with Harry Markowitz, Father of Modern Portfolio Theory
Wri en by Vineet
August 29, 2015 at 6:09 am
Posted in FM, Portfolio Selection, Stories
Tagged with FM-2015-16, History, Interview, Markowi , Stories
[FM] Capital Market Line
with 3 comments
At this stage, having introduced the new straight line efficient set, we are all but there to our final
destination. So, let’s step back a bit and try and understand the larger picture.
In the beginning was the efficient frontier. Markowi gave us that. Efficient frontier describes
the maximum possible expected return for any given amount of risk from the portfolio of available assets. Or
alternatively, the minimum amount of risk that one must live with for any given amount of expected return.
As a first step, we moved from individual assets to portfolios that lay on the efficient frontier. When we
did that implicitly the x-axis (labeled as risk/standard deviation) then became the risk of the portfolio
(and not the risk of the individual assets). There should be no cause for this confusion, but no harm
emphasizing it nonetheless – the right risk to consider is the risk of the portfolio and not the individual
asset.
Moral of the Story 1: When we consider the efficient frontier the relevant quantities to consider
are portfolio risk and portfolio expected return.
Then, of course, Tobin came along and introduced a risk free asset in the Markowi world, and he said
we could ignore all other points on the frontier except the tangency one – because everybody would
hold some proportion of only the tangency portfolio (as all other points even on the envelope are
now inferior), and the line connecting the return from the risk free asset and the tangency portfolio
offers the best possible combinations of portfolio risk and expected return. Remember, the operative
word here is portfolio.
This gave us our revised efficient set as:
(Click on the figure to zoom.)
The equation of the new efficient set immediately follows (it’s a linear line with intercept at and
slope ) as:
What is the tangency portfolio ?
Having said that all investors should hold the tangency portfolio , the next thing to understand is the
meaning of this tangency portfolio. By saying that all investors should hold , what we are essentially
saying is that investors would demand only combinations of portfolio and the risk-free asset.
(Holding any other risky portfolio other than is inefficient.) This is the demand side of the problem.
What is the supply side? The supply side is just all the assets that exist in the market.
And by now you would know enough of microeconomics to understand that equilibrium requires that
demand be same as supply. That is, assets demanded in the portfolio must exactly equal the supply
of each asset in the market. And the supply of each asset in the market is given by its market
capitalization. So, in equilibrium all assets must be held in in exactly the same proportion as their
market capitalization. That is, in percentage terms weight of assets in the total market capitalization and
in the portfolio must be the same.
Consider the case where you run your Markowi optimizer and find that that weight of a particular
asset, say is . Is that possible? Mathematically, of course, yes. But what about economically? Let’s
try and understand this.
Saying that the weight of an asset in the Markowi portfolio is is saying that no investor
wants to hold the asset. If no investor wants to hold that asset, but the asset exists in the market then
we have a state of disequilibrium. And what happens in a state of disequilibrium? Prices adjust. So, if no
wants to hold an asset, its price will drop. Once the price starts to drop its expected return:
will rise. As the price starts to fall, and expected return starts to rise, investors would start to find this
asset more a ractive. As its expected return rises even more, then when you re-run your
Markowi optimizer again, you’ll find that this asset has a non-zero weight in the tangency portfolio
. That is, all assets that exist in the market must be held. This brings us to another important lesson:
Moral of the Story 2: The tangency portfolio is nothing but the market itself!
As another example consider a situation where the Markowi optimizer prescribes a weight of
for an asset whose market capitalization is . What happens in that case? Well, now you know how to
think about such disequilibrium situations. This is the case where the asset has more demand than
supply. When demand is more than supply, prices rise. As price rises, the expected return will fall. As
expected return falls, the Markowi optimizer will prescribe a lower weight to this asset and in
equilibrium the price and the market capitalization of the asset would adjust to make the demand
exactly equal supply. That is:
When one imposes equilibrium, the line passing through the tangency portfolio has a specific name and
it is called the Capital Market Line.
Note that at this stage, when we impose economic equilibrium, we have to necessarily assume that
everybody has the same information – things don’t quite work the same way otherwise. And this brings
us to the last moral of the story for today:
Moral of the Story 3: All efficient portfolios lie on the Capital Market Line.
Again, as in the case of the efficient frontier, the relevant quantities in the Capital Market Line are
the expected return and risk of efficient portfolios. All individual stocks and other inefficient portfolios,
however, would be anywhere below the efficient frontier, as say in the shaded portion of the graph
below (from your book; think of in the plot below as the equilibrium market portfolio):
CML with the Efficient Frontier (Click to zoom; Source: Brealey-Myers, 9th Ed.)
Wri en by Vineet
August 28, 2015 at 3:54 pm
Posted in Capital Market Line, FM, Portfolio Selection
Tagged with Bank, Capital Market Line, Equilibrium, FM-2015-16, Markowi , Session 8, Tangency
Portfolio, Tobin
[FM] Portfolio Selection with a Risk-free Asset
with one comment
For all his insights on the portfolio choice problem, somehow Markowi didn’t explicitly consider a
bank in the system. In principle, of course, one could have solve the problem by just adding one more
security in his set up. However, it turns out that having a bank in the system is not just a ma er of
adding one more security to the world – there is a bit more to it.
Let’s first consider how a Markowi -ian would handle this problem. A fan of Markowi would just
rerun the following optimization problem, but instead would consider assets instead of , i.e.
nothing much really changes:
So, we would need to rerun our optimization software and this will give us a new allocation of weights
to all the securities. Today, of course, the problem is hardly difficult (you can even do it in Excel). But is
it the best way to introduce a risk-free asset in the Markowi world?
James Tobin, a colleague of Markowi ’s at the Cowles Foundation in the ’50s (and another Nobel
Laureate) argued that it’s not. And brilliant as his device was, we can easily see its impact in a two stock
world.
In our familiar two stock world, let one of the assets be risk-free, such that it’s rate of return is known
‘today’ as with variance, of course, zero. Then, since of the assets is no more a random variable,
even the correlation between the two would also be 0. So, if in our set of equations:
we let we are left with:
That is, our Efficient Frontier in this case is simply a straight line connecting the rate of return from the
risk-free asset and the expected return from the asset , with slope If one could assume
that people could both borrow and lend at the same risk-free rate, , then we could even consider
negative weights on the risk-free asset, and extend the Efficient Frontier to the right (the “blue dots” in
the graph below). So, if an investor would extremely risk-loving he/she could borrow money from the
bank and invest it in the second risky asset.
(Click on the graph to zoom.)
With this insight Tobin said that with the risk-free asset in the world in the asset Markowtiz-ian
world, we can just consider such straight lines emanating from the intercept on the ordinate (return from
the risk-free asset ) and connecting with all the points on Efficient Frontier. That is, he said, rather
than re-running the Markowi optimizer, let’s only consider following straight lines connecting the
Efficient Frontier:
(Click on the graph to zoom.)
That is, instead of considering just single assets, Tobin argued we could consider connecting straight
lines to efficient portfolios. And lines of the kind , and all such possibilities.
By now it should be clear that we have a new Efficient Frontier which is the line . So while
points lying to the left of the “blue dots” mean that some of the wealth is invested in the risk-free asset
and some in the portfolio (called the tangency portfolio), and points lying on the “blue dots”
represent the points where an investor has put all of one’s wealth in the tangency portfolio and then
some.
That is, as we see having a risk-free asset in the Markowi world changes everything. Instead of a
concave envelope superior to all other individual assets and inefficient portfolios, having a bank in the
world means that all investors should park all their weight only in combination of the risk-free asset and
the tangency portfolio.
Another way of stating the same thing is to say that the line from to is the steepest, or
alternatively offers the maximum reward per unit of risk compared to any other point on the frontier.
That is, the slope of the line is more than slope of both lines and .
Financial market professionals have kinda made this idea their own and turned it into a measure of
performance to gauge the excess return per unit of risk from investment choices made by fund
managers. They call the slope of the lines emanating from and joining points on the efficient
frontier, like , and , as the Sharpe ratio.
Since the slope of the line is the highest, so is the Sharpe ratio of investment in the market
portfolio. Note that since Sharpe ratio is defined in terms of expected returns, ex-ante (or before-the-fact)
Sharpe ratio of investment in the market portfolio is the highest. So, for a given point, say, , on the
efficient frontier the Sharpe ratio is given as:
This brings us to the second separation theorem in finance, and it goes by multiple names of Tobin/Two-
fund/Mutual-fund Separation Theorem. It’s important enough to warrant a formal statement:
Mutual Fund Separation Theorem: Each investor will have a utility maximising portfolio that is a combination
of the risk-free asset and a tangency portfolio . All risky portfolios other than the portfolio are
inefficient.
Note that all points to the ‘top’ of are una ainable. Our original Efficient
Frontier presented all possibilities giving maximum return for any given level of risk. Having a risk-free
asset implies that the line connecting the return from the risk-free asset and the tangency portfolio
dominates all other possibilities. This is the new efficient frontier.
And now we can get rid of the original concave envelope, and we are left with just the
line. And a quick Google Image search gives us this nice li le picture presenting different possibilities
combining the risk-free asset and the tangency portfolio:
[Click on the figure to zoom; Source: Wikipedia]
Post-script
Needless to say, by definition, Sharpe ratio coincides with the slope of the line when the
investment manager chooses as the point on the frontier, i.e.:
Here is Nobel Laureate William Sharpe on the ratio that bears his name.
Wri en by Vineet
August 28, 2015 at 3:45 pm
Posted in Capital Market Line, FM, Portfolio Selection
Tagged with Bank, Capital Market Line, FM-2015-16, Markowi , Session 8, Tangency Portfolio, Tobin
[FM] Markowitz’s Portfolio Theory: II
with 2 comments
With Markowi having shown us that only expected return and variance of the gambles ma er, we
need not restrict ourselves to considering 120-80 kind of gambles with only two possible states of the
world. The only thing we need is estimates of expected return and variance of the gambles – and we can
study their combinations more generally. Let’s do that now.
Consider two stocks and with expected returns , variances and

correlation between them. If we consider an investor with unit wealth, with amount invested
in stock , and invested in stock then the portfolio expected return
and portfolio variance are easily obtained using some basic results from probability theory as:
That is, as long as , portfolio risk (standard deviation) is always less than the risk (standard
deviation) of the linear combination of assets in the portfolio. This is called diversification.
It should be clear that the relationship between the portfolio weight in any asset and portfolio expected
return is linear, and that between portfolio weight and variance is quadratic. Our purpose, however, is to
look at the trade-off between expected return and variance of the portfolio.
We are lucky that the relationship between expected return and weight in any asset is linear so we can
eliminate the weights and express expected return as a quadratic function of variance. The algebraic
expression is messy and lacks intuition, but for any given level of , it can shown (and as we did in the
class using Excel) that shape of the trade-off is something like this:
Efficient Frontier: Two Assets
That is, the opportunities available to an investor is a concave envelope. And this envelope captures the
trade-off between expected return and risk available from the portfolio (geometrically speaking, it is a
conic section – you can do the math and check which one!).
It should be clear that to a rational investor all the points below the minimum variance point should be
inferior – as all those points represent a lower expected return for any given level of risk. That is, no
rational investor would prefer to choose a portfolio that lie below the minimum variance point.
The envelope traced by the upper arm of the curve above the minimum variance point is called
the Opportunity Set (or Efficient Set or Efficient Frontier). This is the set of opportunities available to a
rational investor given the securities available in the market.
So, according to Markowi all investors should choose one of the portfolios lying on the Efficient
Frontier depending on their degree of risk aversion. So, if an investor is risk loving he/she should choose
one of the points on the top right end (high risk, high expected return), or if he/she is risk-averse choose
one of the points on the bo om left part of the frontier, but never below the Frontier.
In a two-asset world it was easy to visually identify the Efficient Frontier – but for an asset world,
the Markowi portfolio selection boils to solving the following Quadratic Programming problem:
or alternatively,
And how does the Efficient Frontier looks like for the case of assets? As expected, all the set of
opportunities available increase. But, importantly, luckily for us, Robert Merton showed that
the Efficient Frontier retains the same concave shape whatever be the number of securities in the
market. In general, the shape looks something like the following (from your book):
Efficient Frontier: Multiple Assets (Click on the graph to zoom; Source: Brealey-Myers, 9th Ed.)
Again, according to Markowi , no investor should be on any point below the “pink line” (Efficient
Frontier, traced by ABCD), i.e. in the shaded region, as all points on the curve ABCD offer a higher
expected return for any given level of risk / variance.
Given that expected utility is also a function of expected return and variance, by clubbing the two
together Markowi had solved the Portfolio Selection problem for a rational investor. So, if an investor
were risk-averse he/she would choose a portfolio like C or D, and if one were risk-loving then he/she
would choose a portfolio like B or A, but never anything below the curve ABCD.
Special Cases
In the two-stock world two special cases are interesting.
Consider two stocks and with expected returns , variances and

correlation between them. We had the following relationships for the portfolio variance from the
two stocks:
1. Perfect positive correlation:
Se ing doesn’t change the expected return , but simplifies the portfolio variance to:
i.e. the portfolio standard deviation is just a weighted average of the standard deviation of the two
assets. This is the case of zero diversification. Think of it this way. If the two stocks are perfectly
positively correlated, that is they move in lock-step in the same direction all the time, it’s as if they are
the two same stocks
2. Perfect negative correlation:
Again, se ing doesn’t change the expected return , but simplifies the portfolio variance
to:
While even in this case the portfolio standard deviation is just a weighted average of the standard
deviation of the two assets, there are two possibilities (two roots) given the magnitude of .
While mathematically there are two possibilities, as the graph below shows us, economically there is
only one possibility.
What’s more interesting, however, is that when , we can reduce the portfolio variance to zero.
How is that? We have:
And se ing,
That is, when there is perfect negative correlation (recall our earlier 120-80 example), by appropriately
allocating our wealth in the two stocks we can reduce our portfolio variance to 0, i.e. remove all risk.
This is the case of perfect diversification.
In general, depending on whether the value of the correlation is such that or , or ,

the efficient frontier changes as below:
Efficient Frontier: Two Assets (Special Cases)
Wri en by Vineet
August 27, 2015 at 11:06 am
Posted in FM, Portfolio Selection
Tagged with FM-2015-16, Markowi , Portfolio Theory, Session 7
[FM] Markowitz’s Portfolio Theory: I
with one comment
In our journey so far – from giving a justification for NPV for valuing investments to valuation of
common stocks – we have been talking about risk all along, but we haven’t really done full justice to it.
Fair enough, it’s been at the back of our mind in all our discussions all along, but we still don’t quite
have a way to measure it.
Like for most fundamental ideas in finance, the first systematic treatment of risk can also be traced back
to early/mid-twentieth century, and this brings us to the third protagonist in our story.
In the early ’50s, a precocious graduate student at the University of Chicago named Harry
Markowi was looking for a suitable topic for his dissertation. An encounter with a trader sparked
his interest in financial markets, and his would-be adviser suggested he read John Burr Williams’ Theory
of Investment Value, whose Dividend Discount Model we learnt while talking about common stock
valuation.
What struck Markowi was that if John Burr Williams’ theory is correct, then people should buy just
one stock – the one that offered the maximum possible expected return and nothing else. But, he noticed,
obviously it’s not what people did (or do). To quote Peter Bernstein in his rather entertaining biography
of finance, Markowtiz
…was stuck with the notion that people should be interested in risk as well as return.
This, of course, is nothing new to us now. We learnt that while talking about the St. Petersburg Paradox:
that while valuing risky gambles we should not be looking at expected return from the gamble, but
expected utility of returns from the gamble.
We’ve already talked at length about the implications of concavity of utility curves. One of the
consequences of that was for any risky gamble , expected utility is always less than the
utility of the payoff (mathematically also known as the Jensen’s inequality for concave
functions), i.e.:
Markowi figured this out too, and he exploited this idea to come up with a way to quantify the trade-
off between risk and return.
Given a certain starting wealth , Markowi studied the change in expected utility to marginal
investments in risky gambles.
That is, he considered the quantity for any small risky gamble relative to the
starting wealth .
As you may have done in your statistics courses, a useful way to think about a risky gamble is as a
random variable (something that takes a different value depending on the ‘state of the world’). Since we
can talk about as a random variable, we can talk about its expected value, say , and variance, say
.
With small we can evaluate as a Taylor series, and then the expected utility from
wealth including the gamble can be wri en as:
With small we can ignore the the exponents of greater than , and this gives us:
Given a certain (sure) starting , we can write the above as:
that is, the change in expected utility:
Given that is small, its expected value , being an average, would be smaller still and we can ignore
the higher powers of to give:
Since is known, so are , and we have:
where because concavity of implies and . The

coefficient defines a measure of relative risk aversion. That is, higher the value of , more risk-
averse the person, and lower its value more risk-loving the person. (What would be the value of for a
risk-neutral person? What about for a risk-loving person?)
That is, the change in expected utility from a marginal gamble depends only on the expected return and
variance of the gamble. And expected utility goes up as the expected return from the gamble increases
and goes down as variance increases.
For small gambles, then according to Markowi people should only consider a single number to talk
about risk, i.e. its variance , irrespective of the number of states of the world. This turned out to be a
revolutionary idea in the history of finance, and is a cornerstone in the theory of portfolio choice and
asset pricing. For his efforts Markowi was awarded the Nobel Prize in Economics in 1990.
This result, that however complex the world maybe, for small gambles people need only consider the
expected return and variance of the gamble will form the basis for our further discussions.
Not only did Markowi notice that people care both about risk and return, he also observed that people
held not one but a portfolio of stocks. Just on its own, the fact that people should care about expected
return and variance of gambles doesn’t necessarily imply that people would hold multiple stocks. If they
knew their degree of risk-aversion, they would just want to pick one that offered the ‘right’ trade-off for
them.
The fact that people could and did hold a portfolio of stocks made ample economic sense. Consider the
following two risky gambles:
It should be clear that by holding half of each and , an investor could make his end-of-period
payoff the same (= 100), irrespective of the end-of-period state of the world, i.e. the portfolio of and
with equal percentage invested in each is completely risk-less.
This, of course, is an extreme example and in general such gambles would be rare that offered perfectly
negatively correlated payoffs. However, Markowi ’s point had been made. As long as end-of-period
payoffs are not perfectly positively correlated investors could reduce the variance or risk associated with
the end-of-period payoffs by holding multiple stocks. We’ll generalize this idea next.
Wri en by Vineet
August 27, 2015 at 11:02 am
Posted in FM, Portfolio Selection
Tagged with FM-2015-16, Markowi , Portfolio Theory, Session 7
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8/5/2019 Portfolio Selection | A Matter of Course

Companion webage-cum-blog for PGP-1 Financial Markets class

Archive for the ‘Portfolio Selection’ Category

[FM] Diversifiable vs. Non-diversifiable Risk: The

Diversiﬁable vs. Non-diversiﬁable Risk: The Math

Consider the variance of a Markowi portfolio containing assets:

and “average covariance” as:

then the above portfolio variance simpliﬁes to:

Then as , the portfolio variance converges to:

Diversiﬁcation (Click on the ﬁgure to zoom; Source: Brealey-Myers, 9th Ed.)

Next, note that we can write:

Then if we substitute our result that , we see that:

If we let , and use the fact that , it immediately follows that

September 3, 2015 at 9:19 am

Posted in Diversiﬁcation, FM, Portfolio Selection

Tagged with Diversiﬁcation, FM-2, Portfolio Theory, Session 9

[FM] Markowitz on Markowitz

IFA.tv - An Hour with Harry Markowitz, Father of Modern Portfolio Theory

August 29, 2015 at 6:09 am

Posted in FM, Portfolio Selection, Stories

Tagged with FM-2015-16, History, Interview, Markowi , Stories

[FM] Capital Market Line

This gave us our revised eﬃcient set as:

(Click on the ﬁgure to zoom.)

What is the tangency portfolio ?

August 28, 2015 at 3:54 pm

Posted in Capital Market Line, FM, Portfolio Selection

[FM] Portfolio Selection with a Risk-free Asset

with one comment

we let we are left with:

(Click on the graph to zoom.)

(Click on the graph to zoom.)

[Click on the ﬁgure to zoom; Source: Wikipedia]

August 28, 2015 at 3:45 pm

Posted in Capital Market Line, FM, Portfolio Selection

[FM] Markowitz’s Portfolio Theory: II

Consider two stocks and with expected returns , variances and

Eﬃcient Frontier: Two Assets

In the two-stock world two special cases are interesting.

Consider two stocks and with expected returns , variances and

1. Perfect positive correlation:

2. Perfect negative correlation:

In general, depending on whether the value of the correlation is such that or , or ,

Eﬃcient Frontier: Two Assets (Special Cases)

August 27, 2015 at 11:06 am

Posted in FM, Portfolio Selection

Tagged with FM-2015-16, Markowi , Portfolio Theory, Session 7

[FM] Markowitz’s Portfolio Theory: I

with one comment

Given a certain (sure) starting , we can write the above as:

that is, the change in expected utility:

Since is known, so are , and we have:

where because concavity of implies and . The

August 27, 2015 at 11:02 am

Posted in FM, Portfolio Selection

Tagged with FM-2015-16, Markowi , Portfolio Theory, Session 7

Create a free website or blog at WordPress.com.

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