Bodie2e Chapter12 (Lecture) PDF

Chapter 12:
Portfolio Opportunities
and Choice
Objective
To understand the theory of personal
portfolio selection in theory
and in practice
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall

Chapter 12 Contents
•  12.1 The process of personal portfolio

selection
•  12.2 The trade-off between expected
return and risk
•  12.3 Efficient diversification with many
risky assets
2
Objectives
•  To understand the process of personal

portfolio selection in theory and practice
3
Introduction
•  How should you invest your wealth

optimally?
–  Portfolio selection
•  Your wealth portfolio contains

–  Stock, bonds, shares of unincorporated
businesses, houses, pension benefits,
insurance policies, and all liabilities
4
12.2 Trade-Off between
Expected Return and Risk
•  Assume a world with a single risky asset

and a single riskless asset
•  The risky asset is, in the real world, a
portfolio of risky assets
•  The risk-free asset is a default-free bond
with the same maturity as the investor’s
decision (or possibly the trading) horizon
5
Trade-Off between Expected
Return and Risk
•  The assumption of a risky and riskless

security simplifies the analysis
6
Combining the Riskless Asset
and a Single Risky Asset
•  Assume that you invest W1 proportion of

your wealth in security 1 and proportion
W2 of your wealth in security 2
•  You must invest in either 1 or 2, so
W1+W2 = 1
•  Let 2 be the riskless asset, and 1 be the
risky asset (portfolio)
7
The Risk-Reward Trade-Off Line
8
•  At point F, the portfolio is 100% invested

in riskless securities offering a rate of
0.06 per year.
•  At point S, 100%-risky asset-
E(ROR)=0.14 per year and SD=0.20.
•  At point H, half-risky asset, half-riskless
asset.
9
•  To find the portfolio composition and SD for

any point lying on the trade-off line (not
only point F,G,H,J,S), we must derive the
formula for the trade-off line connecting all
of the points.
10
1.  Relate the portfolio’s expected return to the
proportion invested in the risky asset.
Composition?
-w=the proportion of the $100,000 investment to be
allocated to the risky asset.
-1-w=invested in the riskless asset.
-E(r) on any portfolio:
E(r) = wE(rs ) + (1− w)rf = rf + w[E(rs ) − rf ]
E(rs ) = 0.14, rf = 0.06
E(r) = 0.06 + w(0.14 − 0.06)
E(r) = 0.06 + 0.08w 11
•  If expected rate of return=0.09. the

portfolio composition,w?
E(r) = 0.06 + 0.08w
0.09 = 0.06 + 0.08w
w = 0.375
•  W=37.5%(risky asset), 1-0.375=62.5%
(riskless asset)
12
2. Relate the portfolio SD to the proportion
invested in the risky asset. SD?
σ = σ s w = 0.2w = 0.2 × 0.375 = 0.075
3. Relate the portfolio expected rate of
return to its standard deviation. Trade-off
function? E(r) = r + w[E(r ) − r ]
f s f
σ = σ sw
σ
w= ,
σs
σ " E(r ) − rf %
E(r) = rf + [E(rs ) − rf ] = rf +$ s 'σ
σs # σ s &
" 0.14 − 0.06 %
E(r) = 0.06 + $ '&σ = 0.06 + 0.40σ
# 0.2 13
Portfolio Efficiency
14
Portfolio Efficiency
•  An efficient portfolio is defined as the
portfolio that offers the investor the
highest possible expected rate of return
at a specific risk
•  We now investigate more than one risky
asset in a portfolio
•  In figure 12.2, at point R, the portfolio is
100% invested in Risky asset 2 offering
an expected ROR of 0.08 and a SD of
0.15 (inefficient) 15
12.3 Efficient Diversification
with Many Risky Assets
•  We have considered
–  Investments with a single risky, and a single
riskless, security
–  Investments where each security shares the
same underlying return statistics
•  We will now investigate investments with

more than one (heterogeneous) stock
16
Portfolio of Two Risky Assets
•  Recall from statistics, that two random

variables, such as two security returns,
may be combined to form a new random
variable
•  A reasonable assumption for returns on
different securities is the linear model:
rp = w1r1 + w2 r2 ; with w1 + w2 = 1
17
The Risk-Reward Trade-Off Curve:
Risky Assets Only
18
The Risk-Reward Trade-Off
Curve: Risky Assets Only
•  In figure 12.3, two-asset portfolios
constructed from risky assets given in
Table 12.3 with the correlations over the
range (+1,+0.5,-0.5,-1)
19
Equations for Two Shares
•  The sum of the weights w1 and w2 being

1 is not necessary for the validity of the
following equations, for portfolios it
happens to be true
•  The expected return on the portfolio is
the sum of its weighted expectations
µ p = w1 µ 1 + w 2 µ 2
20
Equations for Two Shares
•  Ideally, we would like to have a similar

result for risk
σ p = w1σ 1 + w 2σ 2 (wrong)
–  Later we discover a measure of risk with this
property, but for standard deviation:
2 2 2 2 2
σ = w σ + 2w w σ σ ρ + w σ
p 1 1 1 2 1 2 1, 2 2 2
21
Mnemonic
•  There is a mnemonic that will help you

remember the volatility equations for two
or more securities
•  To obtain the formula, move through
each cell in the table, multiplying it by
the row heading by the column heading,
and summing
22
Variance with 2 Securities
W1*Sig1 W2*Sig2
W1*Sig1 1 Rho(1,2)
W2*Sig2 Rho(2,1) 1
2 2 2 2 2
σ = w σ + w σ + 2w1w2σ1σ 2 ρ1,2
p 1 1 2 2
23
Variance with 3 Securities
W1*Sig1 W2*Sig2 W3*Sig3
W1*Sig1 1 Rho(1,2) Rho(1,3)
W2*Sig2 Rho(2,1) 1 Rho(2,3)
W3*Sig3 Rho(3,1) Rho(3,2) 1
2 2 2 2 2 2 2
σ = w σ + w σ + w σ + 2w1w2σ1σ 2 ρ1,2 +
p 1 1 2 2 3 3
2w1w3σ1σ 3 ρ1,3 + 2w2 w3σ 2σ 3 ρ2,3

24
Optimal Combination of Risky
Assets
•  The risk-reward combination we can

obtain by combining the riskless asset
with Risky Asset 1 and Risky Asset 2.
•  Point T is the optimal combination of
risky assets.
•  The formula for finding the portfolio
proportions at point T is
25
Formulae for Minimum
Variance Portfolio
2
* σ 2 − ρ1, 2σ 1σ 2
w1 = 2 2
σ 1 − 2 ρ1, 2σ 1σ 2 + σ 2
2
* σ − ρ1, 2σ 1σ 2 1
w = 2
2 2
σ 1 − 2 ρ1, 2σ 1σ 2 + σ 2
*
= 1− w 1
26
Optimal Combination of Risky
Assets
•  At point T, the optimal combination of

risky assets is composed of 69.23% Risky
Asset 1 and 30.77% Risky Asset 2.
•  E(rT)=0.122 SDT=0.146
•  New efficient trade-off line
E(r) = 0.06 + 0.42σ
27
Selection of the Preferred Portfolio
28
Selecting the Preferred
Portfolio
•  If investor choose to be at a point that is
halfway between point F and T. The
portfolio:50% invested in the tangency
portfolio and 50% invested in the riskless
asset.
E(r) = rf + w "# E(rT ) − rf $% = 0.06 + 0.5(0.122 − 0.06) = 0.091
σ = wσ T = 0.5 × 0.146 = 0.073
•  Weight in Risky Asset

1=0.5X0.692=34.6%, Risky Asset
2=0.5X0.38=15.4% 29
Summary
•  There is no single investment strategy

that is suitable for all investors; nor for a
single investor for his whole life
•  Time makes risky investments more
attractive than safer investments
•  In practice, diversification has somewhat
limited power to reduce risk
30

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Chapter 12:

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall

• 12.1 The process of personal portfolio

• To understand the process of personal

• How should you invest your wealth

• Your wealth portfolio contains

• Assume a world with a single risky asset

• The assumption of a risky and riskless

• Assume that you invest W1 proportion of

• At point F, the portfolio is 100% invested

• To find the portfolio composition and SD for

• If expected rate of return=0.09. the

• We will now investigate investments with

• Recall from statistics, that two random

• The sum of the weights w1 and w2 being

• Ideally, we would like to have a similar

• There is a mnemonic that will help you

W1*Sig1 1 Rho(1,2) Rho(1,3)

W2*Sig2 Rho(2,1) 1 Rho(2,3)

W3*Sig3 Rho(3,1) Rho(3,2) 1

2w1w3σ1σ 3 ρ1,3 + 2w2 w3σ 2σ 3 ρ2,3

• The risk-reward combination we can

• At point T, the optimal combination of

• Weight in Risky Asset

• There is no single investment strategy

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•  12.1 The process of personal portfolio

•  To understand the process of personal

•  How should you invest your wealth

•  Your wealth portfolio contains

•  Assume a world with a single risky asset

•  The assumption of a risky and riskless

•  Assume that you invest W1 proportion of

•  At point F, the portfolio is 100% invested

•  To find the portfolio composition and SD for

•  If expected rate of return=0.09. the

•  We will now investigate investments with

•  Recall from statistics, that two random

•  The sum of the weights w1 and w2 being

•  Ideally, we would like to have a similar

•  There is a mnemonic that will help you

•  The risk-reward combination we can

•  At point T, the optimal combination of

•  Weight in Risky Asset

•  There is no single investment strategy