Chapter 7: An Introduction to Portfolio Management

Narrative Report

One of the Major Advances in the field of investment in the past few decades is the recognition
that in creating an optimum investment portfolio, it’s not all about combining unique individual
securities which have great returns. It has been shown that you should actually consider the relationship
among your investments. This recognition has been demonstrated in deriving the portfolio theory. This
chapter explains the portfolio theory, which will introduce the basic portfolio risk formula when
combining different assets. This will increase your understanding on why and how should you diversify.

Before tackling the portfolio theory, clarifications should first be made on the general
assumptions of the said theory. One basic assumption is that as an investor, you want to maximize the
returns from your investment for a given level of risk. To deal with this assumption, you should first
include all your assets and liabilities. And by all, it means everything, from your stocks to coins and
stamps. This is because all of the assets interact, so all must be factored, considering the relationships
between the returns of your investments are important. Another assumption is that investors are
basically risk averse, which means that given two choices of investments with the same return, one
would choose the choice with the lower risk. Evidence is shown from the buying of all kinds of
insurances by the investors. But this does not imply that everybody is risk averse or that investors are
completely risk averse regarding financial commitments. Some investors buy insurances while gambling,
where expected returns are negative. The combination of risk preference and risk aversion can be
explained by an attitude towards risk that depends on the money involved. We should recognize that
there’s a diversity of attitudes, but the general idea is that most are risk averse. This means that we
expect a positive relationship between expected returns and expected risks.

Now that the general assumptions are clarified, let us start on the portfolio theory.
The basic portfolio model was developed by Harry Markowitz who derived the expected rate of return
for a portfolio of assets and an expected risk measure. He also derived the formula for computing the
variance of a portfolio. This portolio variance formula indicated the importance of diversifying your
investments to reduce the total risk of a portfolio but also showed how to effectively diversify. The
Marrkowitz model is based on several assumptions reagarding investor behavior : 1.Investors consider
each investment alternative as being represented by a probability distribution of expected returns over
some holding period 2.Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth.3. Investors estimate the risk of the portfolio on the
basis of the variability of expected returns.4. Investors base decisions solely on expected return and risk,
so their utility curves are a function of expected return and the expected variance of returns only.5. For
a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected
return, investors prefer less risk to more risk. Under these assumptions, a single asset or portfolio of
assets is considered to be efficient if no other asset or portfolio of assets offers higher expected return
with same (or lower) risk, or lower risk with the same (or higher) expected return.
One of the best-known measures of risk is the variance, or otherwise known as standard
deviation. It is a measure of the dispersion of returns around the expected value whereby a larger
dispersion means greater uncertainty. Another measure is range of returns. It is assumed that a larger
range of returns, which is the difference between the highest and lowest return, means greater
uncertainty on the expected returns. Although there are numerous measures of risk, the variance
method will be used because it is a correct and widely recognized risk measure and it has been used in
most of the theoretical asset pricing models.
To get the variance, we should first get the expected return. The expected rate of return for a portfolio
of investments is the weighted average of the expected rates of return for the individual investments in
the portfolio. This means that the rates of return of the individual investments should be computed first.
The formula for the individual expected rate of return

W= the percent of the portfolio in asset i

E(Ri) =the expected rate of return for asset i
After getting the expected return, we can now compute for the variance or the standard deviation of
returns as the measure of risk. We first compute with individual assets, which were already discussed in
the previous chapters.

The standard deviation is the square of the variance

Two concepts must first be understood before discussing the variance of the rate of return of a
portfolio. These are the Covariance of Returns and the Correlation. Covariance is a measure of the
degree to which two variables move together relative to their individual means over time. A positive
covariance means that the rates of return for two investments tend to move in the same direction, and
a negative covariance is the opposite. The magnitude of the covariance depends on the variances of the
individual return series, as well as on the relationship between the series. The covariance statistics
provide an absolute measure of how they moved together over time.
The formula for covariance is

Covariance is affected by the variability of the two individual return series. To standardize covariance
measures, correlation coefficient is used.

These coeffcicients vary only in the range -1 to +1. A +1 would indicate a perfect positive linear
relationship between the two investments, meaning the two stocks move together in a completely
linear manner. A -1 would indicate a perfect negative relationship between the two return series. A
value of 0 would mean that the returns had no linear relationship, meaning , they were uncorrelated
statistically.
Now that we have discussed the two concepts, we can now compute for the standard deviation of a
portfolio of assets. Markowitz derived the general formula as follows

The standard deviation for a portfolio of assets encompasses not only the variances of the
individual assets, but also the covariances between pairs of individual assets in the portfolio. The relative
weight of these numerous covariances is substantially greater than the asset’s unique variance. This
means that the important factor to consider when adding an investment to a portfolio that contains a
number of other investments is not the investment’s own variance but its average covariance with all
the other investments in the portfolio.
If we graphed different combinations of two-asset combinations, and derived the curves
assuming all the possible weights, we could get the efficient frontier. It is the envelope curve that
contains the best of al these possible combinations. It represents that set of portfolios that has the
maximum rate of return for every given level of risk, or the minimum risk for every level of return.
The optimal portfolio is the portfolio on the efficient frontier that has the highest utility for a given
investor.