Capital Markets I – ECN226

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Lecture 5:
Optimal Risky Portfolios and the Mean Variance Analysis
Lecture 5 Overview

1. Optimal Asset Allocation

1. A portfolio of two risky assets
2. A portfolio of two risky assets and a free-risk asset
3. A portfolio with many assets - The Markowitz Portfolio Selection Model

2. Portfolio Diversification

3. Conclusions

Bodie, Kane and Marcus

Chapter 7: ‘’ Optimal Risky Portfolio” 2
OPTIMAL ASSET ALLOCATION

3
Investment decision

• Two steps:
– Step 1 Compose a portfolio of risky assets.
– Step 2 Decide how much to invest in the risky portfolio vs.
a risk free asset.

• Last week we assumed that the optimal risky portfolio

has been created and we focus on Step 2.
Sources of risk

1. General economic conditions: business cycles, interest

rates and exchange rates. All firms are affected.

2. Firm specific factors: R&D success or not, change in firm

governance and so on. Only a specific firm is affected.

• Adding a security to your portfolio may reduce the risk, since

the firm-specific influences are different.

• However even with a large number of stocks we cannot avoid

the macroeconomic factors of risk that affect all the firms.

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Diversification

• The types of risk:

– market, systematic or non-diversifiable risk: remains
after diversification.

– unique, firm-specific, non-systematic, diversifiable: can

be eliminated by diversification.

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A PORTFOLIO OF TWO RISKY ASSETS

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Asset Allocation (Asset class or different assets within a class)

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A portfolio of two risky assets

THE MAIN IDEA: AN EXAMPLE

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DIVERSIFICATION QUIZ

• Example: Two stocks A and B have the same individual risk of

24% return std. deviation; but, the expected return of stock A
is 14% and that of stock B only 6%.

• Question: Would anyone ever hold stock B?

• Answer:

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 Portfolio Diversification Miracle

Stock A Stock B Expected Return Std. Dev. of Std. Dev. of

E(RA) = 14% E(RB) = 6% of Portfolio, E(Rp) Portfolio Portfolio
σA = 24% σB = 24% (if correlation (if correlation
Portfolio Weight: xA Portfolio Weight: xB ρAB= 0), σp ρAB= 1), σp

1.00 0.00 14% 24% 24%

0.75 0.25 12% 19% 24%
0.50 0.50 10% 17% 24%
0.25 0.75 8% 19% 24%
0.00 1.00 6% 24% 24%

E ( R p )  x A E ( RA )  xB E ( RB ) p  x A 2 A2  xB 2 B 2  2 x A xB A  B  AB

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Two Risky Assets (same Std Dev.) – Nobel Prize # 1

• Given two assets, we can plot the expected returns and standard
deviation of all possible portfolio combinations.
• The risk return trade-off depends on the correlation of the two assets
• Negative return correlation between assets increases the
diversification benefit
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Two Risky Assets (different Std. Dev.)

• In case of perfect negative correlation we can obtain a riskless portfolio

• In case of perfect positive correlation portfolio risk is the same as average
risk: NO risk reduction from diversification , only risk averaging

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Asset Allocation Example: Why Buy Gold?

Asset Return Variability

Gold 8.8% 20.8

S&P 500 12.8% 18.3

• Gold has a lower return and a higher variability than the S&P 500.

• Is Gold a bad investment?

• Coefficient of correlation between S&P 500 and Gold = -0.4

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 Create a Portfolio with Gold

• Alternative strategy: hold a portfolio of gold and stocks: a fraction of

x% in gold and (100 - x)% in the S&P 500:
Weight x% Return Variability
100% 8.8% 20.8 Hold only Gold
80% 9.6% 15.5
60% 10.4% 11.7
45.4 10.6% 10.7 Minimum Var Portfolio
40% 11.2% 10.8
20% 12.0% 13.5
0% 12.8% 18.3 Hold only S&P 500

• Conclusion: “Similar to a car insurance, even if gold is very risky when you hold it as part of a portfolio, it
reduces significantly the total portfolio risk since it works as an insurance against some forms of risk (inflation,
exchange rate risk … etc.).
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A portfolio of two risky assets

THE THEORY

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Portfolios of two risky assets – the aim

Let us consider a portfolio of two assets:

• a bond with return 𝒓𝑩
• a stock with return 𝒓𝑺 .
A portfolio is a combination of those two assets.

A fraction 𝒘𝑩 is invested in bonds and a fraction 𝒘𝑺 = 𝟏 − 𝒘𝑩 is invested in

stocks.

The rate of return on the portfolio is:

𝒓𝒑 = 𝒘𝑩 𝒓𝑩 + (𝟏 − 𝒘𝑩 )𝒓𝑺

The aim: find the allocations that provide the lowest possible risk for
any level of expected return.

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Portfolios of two risky assets – Return and Risk

• The expected return of the portfolio is:

𝑬 𝒓𝒑 = 𝒘𝒃 𝑬 𝒓𝑩 + 𝟏 − 𝒘𝑩 𝑬 𝒓𝑺

• The variance of the portfolio is:

𝝈𝟐𝒑 = 𝒘𝟐𝑩 𝝈𝟐𝑩 + (𝟏 − 𝒘𝑩 )𝟐 𝝈𝟐𝑺 + 𝟐𝒘𝑩 𝟏 − 𝒘𝑩 𝑪𝒐𝒗(𝒓𝑩 , 𝒓𝑺 )

Where 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺 = 𝐄 𝒓𝑩 − 𝑬 𝒓𝑩 𝒓𝑺 − 𝑬 𝒓𝑺 = 𝑬 𝒓𝑩 𝒓𝑺 − 𝑬 𝒓𝑩 𝑬 𝒓𝑺

Notice that: 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺 = 𝑪𝒐𝒗 𝒓𝑺 , 𝒓𝑩

𝟐 𝟐
And 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑩 = 𝐄 𝒓𝑩 − 𝑬 𝒓𝑩 𝒓𝑩 − 𝑬 𝒓𝑩 = 𝐄 𝒓𝑩 − 𝑬 𝒓𝑩 = 𝝈18
𝑩
Portfolios of two risky assets – the covariance matrix

The covariance matrix:

𝒘𝑩 𝒘𝑺

𝒘𝑩 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑩 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺

𝒘𝑺 𝑪𝒐𝒗 𝒓𝑺 , 𝒓𝑩 𝑪𝒐𝒗 𝒓𝑺 , 𝒓𝑺

So the variance of the portfolio can also be represented as:

𝝈𝟐𝒑
= 𝒘𝑩 𝒘𝑩 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑩 + 𝒘𝑺 𝒘𝑩 𝑪𝒐𝒗 𝒓𝑺 , 𝒓𝑩 + 𝒘𝑩 𝒘𝑺 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺 + 𝒘𝑺 𝒘𝑺 𝑪𝒐𝒗 𝒓𝑺 , 𝒓𝑺

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Portfolios of two risky assets – correlation coefficient

𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺 = 𝝆𝑩𝑺 𝝈𝑩 𝝈𝑺

𝝆𝑩𝑺 is the correlation coefficient between the returns of the two assets, 𝝆𝑩𝑺 ∈
−𝟏, 𝟏 .

Thus, The variance of the portfolio becomes:

𝝈𝟐𝒑 = 𝒘𝟐𝑩 𝝈𝟐𝑩 + (𝟏 − 𝒘𝑩 )𝟐 𝝈𝟐𝑺 + 𝟐𝒘𝑩 𝟏 − 𝒘𝑩 𝝆𝑩𝑺 𝝈𝑩 𝝈𝑺

For any 𝝆𝑩𝑺 < 𝟏 the standard deviation of the portfolio is lower than the
weighted average of the component standard deviations.

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Portfolios of two risky assets (two extreme cases)

The case of perfect positive correlation 𝝆𝑩𝑺 = 𝟏:

𝝈𝒑 = 𝒘𝑩 𝝈𝑩 + 𝟏 − 𝒘𝑩 𝝈𝑺

→ The standard deviation of the portfolio is the weighted average of the

component standard deviations. So, you minimise risk by simply investing
your whole wealth in safer asset.

The case of perfect negative correlation 𝝆𝑩𝑺 = −𝟏:

𝝈𝟐𝒑 = (𝒘𝑩 𝝈𝑩 − 𝟏 − 𝒘𝑩 𝝈𝑺 )𝟐

→ The weights can be chosen in a way so that the variance of the portfolio is
𝝈𝑺
equal to zero: 𝒘𝑩 𝝈𝑩 − 𝟏 − 𝒘𝑩 𝝈𝑺 = 𝟎 ⇒ 𝒘𝑩 =
𝝈𝑩 +𝝈𝑺
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Portfolios of two risky assets

For the weights of the minimum variance portfolio in the general case:
min 𝝈𝟐𝒑 = 𝒘𝟐𝑩 𝝈𝟐𝑩 + (𝟏 − 𝒘𝑩 )𝟐 𝝈𝟐𝑺 + 𝟐𝒘𝑩 𝟏 − 𝒘𝑩 𝑪𝒐𝒗(𝒓𝑩 , 𝒓𝑺 )
𝑤𝐵

The first order condition is:

𝟐𝒘𝑩 𝝈𝟐𝑩 − 𝟐 𝟏 − 𝒘𝑩 𝝈𝟐𝑺 + 𝟐 𝟏 − 𝟐𝒘𝑩 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺 = 𝟎

hence the weights that minimise the variance of the portfolio are:
𝝈𝟐𝑺 − 𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺
𝒘𝑩,𝒎𝒊𝒏 = 𝟐
𝝈𝑺 + 𝝈𝟐𝑩 − 𝟐𝑪𝒐𝒗 𝒓𝑩 , 𝒓𝑺
𝒘𝑺,𝒎𝒊𝒏 = 𝟏 − 𝒘𝑩,𝒎𝒊𝒏
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Example

Example: Suppose we have the following information.

Bond Stock
𝐸(𝑟) 8% 13%
𝜎 12% 20%
𝐶𝑜𝑣 72
𝜌 0.3

1. Express the expected return and the variance of the portfolio as a

function of the weights: 𝒘𝑩 and 𝒘𝑺 .

2. Find the weights of the minimum variance portfolio.

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Example: Portfolios of two risky assets

• In this case the expected return is:

𝑬 𝒓𝒑 = 𝒘𝑩 × 𝟖% + 𝒘𝑺 × 𝟏𝟑%

• And the standard deviation:

𝝈𝒑 = 𝒘𝟐𝑩 × 𝟎. 𝟎𝟏𝟒𝟒 + 𝒘𝟐𝑺 × 𝟎. 𝟎𝟒 + 𝟐𝒘𝑩 𝒘𝑺 × 𝟎. 𝟑 × 𝟎. 𝟏𝟐 × 𝟎. 𝟐

In Matrix form:
𝒘𝑩 𝒘𝑺
𝒘𝑩 144 72
𝒘𝑺 72 400
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Example: Portfolios of two risky assets

Expected return as a function of portfolio allocation

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Example: Portfolios of two risky assets

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Example: Portfolios of two risky assets

Standard deviation as a function of portfolio allocation

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Example: Portfolios of two risky assets

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Example: Portfolios of two risky assets

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Example: Portfolios of two risky assets

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Example: Portfolios of two risky assets

We can draw the portfolio opportunity set: all the

combinations of portfolio expected return and standard
deviation that can be constructed from the two
available assets.

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Example: Portfolios of two risky assets

Expected return and standard deviation as a function of portfolio allocation

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Example: Portfolios of two risky assets

Expected return and standard deviation as a function of portfolio allocation

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Example: Portfolios of two risky assets

From the formula of minimum variance we the portfolio with: WB=0.82 , WS=0.18
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You cannot find any combination to its left!
Example: Portfolios of two risky assets

• The expected return of the minimum variance portfolio is:

E(rP) = 0.82 x 8 + 0.18 x 13 = 8.9%

• Its standard deviation is:

• Notice that any portfolio below the minimum variance portfolio is inefficient
since other portfolios of the same assets pay a higher expected return for the
same risk!
• We call efficient frontier the part of the opportunity set above the minimum
variance portfolio 35
OPTIMAL PORTFOLIO OF TWO RISKY ASSETS AND A RISK-FREE ASSET

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Optimal portfolio with two risky assets and a risk free asset

• What happens if we add to our portfolio a risk-free

asset?....we are able to derive a CAL!

• Assume that the return on the risk-free asset is 5%. We

consider two portfolios 𝑨 and 𝑩, wherethat 𝑨 is the
minimum variance portfolio.

– We can derive the CAL for the two portfolios

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Optimal portfolio with two risky assets and a risk free asset

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Optimal portfolio with two risky assets and a risk free asset

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Optimal portfolio with two risky assets and a risk free asset

The portfolio 𝑨 is with the following characteristics:

𝑬 𝒓𝒑 = 𝟖. 𝟗% and 𝝈𝒑 = 𝟏𝟏. 𝟒𝟓%
The slope of this CAL will be:
𝑬 𝒓𝑨 − 𝒓𝒇 𝟎. 𝟎𝟖𝟗 − 𝟎. 𝟎𝟓
𝑺𝑨 = = = 𝟎. 𝟑𝟒
𝝈𝑨 𝟎. 𝟏𝟏𝟒𝟓

The portfolio 𝑩 is with the following characteristics: 𝑬 𝒓𝒑 = 𝟗. 𝟓% and 𝝈𝒑 =

𝟏𝟏. 𝟕𝟎%.
The slope of this CAL will be:
𝟎. 𝟎𝟗𝟓 − 𝟎. 𝟎𝟓
𝑺𝑩 = = 𝟎. 𝟑𝟖
𝟎. 𝟏𝟏𝟕𝟎
→ Portfolio 𝑩 dominates portfolio 𝑨. Better Sharpe Ratio!
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Optimal portfolio with two risky assets and a risk free asset

• A combination of portfolio B with the risk-free

asset offers a higher expected return for any level
of risk than a combination of the risk free asset
with portfolio A.

• Shall we stop at portfolio B?

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Optimal portfolio with two risky assets and a risk free asset

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Optimal portfolio with two risky assets and a risk free asset

The objective: Find the weights of the risky portfolio that maximizes
the Sharpe ratio.
𝑬 𝒓𝒑 − 𝒓𝒇
max 𝑺𝒑 =
𝑤𝑖 𝝈𝒑

Subject to:
𝒘𝑩 + 𝒘𝑺 = 𝟏
𝑬 𝒓𝒑 = 𝒘𝑩 𝑬 𝒓𝑩 + 𝒘𝑺 𝑬 𝒓𝑺

𝝈𝒑 = 𝒘𝟐𝑩 𝝈𝟐𝑩 + 𝒘𝟐𝑺 𝝈𝟐𝑺 + 𝟐𝒘𝑩 𝒘𝑺 𝑪𝒐𝒗(𝒓𝑩 , 𝒓𝑺 )

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Optimal portfolio with two risky assets and a risk free asset

The weights of the optimal risky portfolio:

𝑬 𝒓𝑩 − 𝒓𝒇 𝝈𝟐𝑺 − 𝑬 𝒓𝑺 − 𝒓𝒇 𝑪𝒐𝒗(𝒓𝑩 , 𝒓𝑺 )
𝒘∗𝑩 =
𝑬 𝒓𝑩 − 𝒓𝒇 𝝈𝟐𝑺 + 𝑬 𝒓𝑺 − 𝒓𝒇 𝝈𝟐𝑩 − 𝑬 𝒓𝑩 − 𝒓𝒇 + 𝑬 𝒓𝑺 − 𝒓𝒇 𝑪𝒐𝒗(𝒓𝑩 , 𝒓𝑺 )

𝒘∗𝑺 = 𝟏 − 𝒘∗𝑩

Notice that the optimal risky portfolio does not depend on risk preferences!

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Optimal portfolio with two risky assets and a risk free asset

We can
• Find the weights of the optimal risky portfolio in the
case of our example.
• Find the expected return and the standard deviation
• Find the Sharpe ratio of the optimal portfolio.

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Optimal portfolio with two risky assets and a risk free asset

• Let's find the optimal risky portfolio in the case of our example:

𝟖 − 𝟓 𝟒𝟎𝟎 − 𝟏𝟑 − 𝟓 𝟕𝟐
𝒘∗𝑩 = = 𝟎. 𝟒
𝟖 − 𝟓 𝟒𝟎𝟎 + 𝟏𝟑 − 𝟓 𝟏𝟒𝟒 − 𝟖 − 𝟓 + 𝟏𝟑 − 𝟓 𝟕𝟐
𝒘∗𝑺 = 𝟎. 𝟔

• The expected return and standard deviation of this portfolio are:

• 𝑬 𝒓𝒑 = 𝟏𝟏% 𝝈𝒑 = 𝟏𝟒. 𝟐%

• And the Sharpe ratio: 𝑺𝒑 = 𝟎. 𝟒𝟐

Now that we know the optimal risky portfolio (step 1) we can go back to
what we saw last week (step 2) and account for risk preferences.

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Optimal portfolio with two risky assets and a risk free asset

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Optimal portfolio with two risky assets and a risk free asset

The steps to follow to derive the complete portfolio:

• Step 1: Specify the return characteristics of all assets .
• Step 2: Establish the optimal risky portfolio 𝑷.
– Find the weights.
– Find the characteristics: expected return and standard deviation.
• Step 3: Allocate funds between the portfolio 𝑷 and the risk-free
asset.
– Find the fraction allocated to portfolio 𝑷.
– Calculate the shares allocated to each risky asset and to the
risk-free asset.

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PORTFOLIO ALLOCATION WITH MANY SECURITIES

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Portfolio allocation with many securities

• A general problem: many risky securities.

• The minimum variance frontier: the lowest variance for

a given portfolio expected return.

• The efficient frontier of risky assets: the part of the

frontier lying above the minimum variance portfolio
(Markowitz, 1952).

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Portfolio allocation with many securities

• The expected return of a portfolio with 𝒏 securities and

weights 𝒘𝒊 in each security writes:
𝒏

𝑬 𝒓𝒑 = 𝒘𝒊 × 𝑬 𝒓𝒊
𝒊=𝟏

• The variance of a portfolio with 𝒏 securities and weights

𝒘𝒊 in each security writes:
𝒏 𝒏

𝝈𝟐𝒑 = 𝒘𝒊 × 𝒘𝒋 𝑪𝒐𝒗(𝒓𝒊 , 𝒓𝒋 )
𝒊=𝟏 𝒋=𝟏

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Portfolio allocation with many securities

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Portfolio allocation with many securities

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Portfolio allocation with many securities

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The Markowitz Portfolio Selection Model

• See Excel
“Markowitz Optimiser”

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Putting all together:
determination of the Optimal Complete Portfolio

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Capital Allocation and the Separation Property

• A portfolio manager will offer the same risky portfolio

(𝑷) to all clients regardless of their degree of risk
aversion.

• The portfolio choice can be separated into two

independent tasks (Tobin, 1958):
– the determination of the optimal risky portfolio – technical;
– the allocation to T-bills vs. the risky portfolio – depends on
personal preferences.

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DIVERSIFICATION

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Strategic Asset Allocation: Practical Example (1)

• Strategic Asset Allocation is about using correlation structure to our advantage

• Consider investing in the DJIA stocks:

– 3M (MMM), Procter & Gamble (PG), IBM (IBM), United Technologies (UTX), Merck
(MRK), Alcoa, Amex, ATT, Boeing, Caterpillar, Citigroup (C), Coca Cola (KO),
Dupont (D), Eastman Kodak, Exxon-Mobil (XOM) GE, GM, HD, Honeywell, HP, Intl,
International Paper (IP) Johnson and Johnson (JNJ), MacDonalds, Microsoft, Phillip
Morris SBC, Walmart (WMT), Walt Disney

• What does minimum variance frontier look like?

• When do we achieve diversification?

– Do we have to buy all 30 stocks to achieve full diversification?
– Do we have to buy more than these 30 stocks to achieve diversification?

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Diversification with Two Stocks

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Diversification with Three Stocks

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Diversification with Four Stocks

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Diversification with Five Stocks

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Dow Jones Industrial Average

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S&P 500

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How standard deviation of a portfolio of average NYSE stocks
changes as we change the number of assets in the portfolio

Average (annual) return

standard deviation is 49%.

Average (annual)
covariance between stocks
is 0.037, and the average
correlation is about 39%.

Since average covariance

positive, even very large
portfolio of stocks will be
risky.

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Impact of Diversification on Portfolio Risk in Different
Countries

Market Standard Deviation (%)

Index
US (S&P 500) 13.4

UK 14.5

Japan 18.2

France 21.5

Germany 24.1

Finland 43.2

• Average standard deviation falls as number of stocks increases

• For “well-diversified” portfolio:

– Variance of each asset contributes little to portfolio risk.
– Covariances among assets determine portfolio risk.

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Diversification Benefit: Intuition

Var (rP )  Var ( X i ri )

i

  X i X jCov  ri , rj 
i j

  X i 2Var (ri )   X j X i cov(ri , rj )

i i j i

The Variance-Covariance Matrix

As number of assets This term remains

VAR COV COV COV
rises this term go to even with large
zero number of assets so
COV VAR COV …
(in an equal- long as average
weighted portfolio, covariance is COV COV … COV

Xi=1/n) positive
COV .. COV VAR

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ANNEX: Understanding Diversification: Mathematical Details

A. Start with our equation for variance:

N N N
   w     w i w j covr˜i , r˜j 
2
p
2
i
2
i
i1 i1 j1
i j
1
B. Then make the simplifying assumption that wi  for all
N
assets:
N N N
 1 1 1
 2p    i2    2 covr˜i , r˜j 
N i1 N j1 i1 N
j i

C. Next note that:

1. The average variance and covariance of the securities are:

1 N 2 1 N N
    i ;   covr˜i , r˜j 
2
p cov =
N i1 NN -1 j1 i1
j i 69
ANNEX :Understanding Diversification: Details
Understanding Diversification: Details

2. Plugging these into our equation gives:

1  N  1
 2p    2   cov
N   N 
3. What happens as N becomes large?
 1  N 1
  0 and   1
N   N 
4. Only the average covariance matters for large portfolios.

If the average covariance is zero, then the portfolio variance is
close to zero for large portfolios
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Diversification example

• See Excel Spreadsheet on QMPLUS:

“Application Optimal Portfolio”

See what the solver does!

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CONCLUSIONS

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The essence of the Mean Variance Analysis

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Lecture Take-aways

• Need for an overall investment scheme that maintains diversification across asset
classes

– Don’t put all eggs into one basket (identification of the efficient frontier of risky
assets)

Modern Portfolio Theory (Nobel Prize #1)

Only undiversifiable risk matters

Next Lecture : The CAPM (Nobel Prize #2)

High contribution to undiversifiable risk, high expected return.

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