PORTFOLIO THEORY

Let us begin our discussion on Portfolio Theory with an example of two investments
(assets or securities) – Ace and Bravo. Their return expectations are given in the table
below. You will notice that both Ace and Bravo are risky investments because they do
not offer a certain return. You can begin by comparing the expected return and risk of
Ace and Bravo:

State of Probability Return

Economy of occurrence Ace Bravo

Boom 0.2 +20 -15

Growth 0.6 +5 +5
Recession 0.2 -10 +25

1. What kind of a correlation do you observe between the two securities?

2. Calculate the expected return and standard deviation of both Ace and Bravo.
Interpret the results.

Expected Return = E(R) = ∑ ri.pi for each state of the economy

Standard Deviation = σ = √ [∑ (ri – E(R))2 .pi] for each state of the economy

Thus calculated, we have the following results:

Security Expected Return Expected Risk

(measured by σ)
Ace 5% ±9.49%
Bravo 5% ±12.65%

Ace is better than Bravo when viewed in the risk-return framework, because it offers the
same level of return as Bravo, while exposing its investor to a lower level of risk.
However, is it possible to combine Ace and Bravo into a portfolio to achieve a
combination that is better than its constituent securities?

Let us now understand how these two assets can be combined into a portfolio such that
the expected return from the portfolio is higher than that of its component assets and its
risk is lower. Assuming we had Rs.1000 to invest, and we put Rs.571 into Ace and
Rs.429 into Bravo, we would achieve a portfolio that gives an assured return of 5% under
all economic conditions. This is shown below:

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Returns over 1 year from placing Rs.571 in Ace and Rs.429 in Bravo:
State of Returns Ace Returns Bravo Total Percentage
Economy Returns on Returns
Rs.1000
Boom 571(1.2) = 685 429(0.85) = 365 1,050 5%
Growth 571(1.05) = 600 429(1.05) = 450 1,050 5%
Recession 571(0.9) = 514 429(1.25) = 536 1,050 5%

However, the following points must be noted when choosing assets to build a portfolio:
1. With perfect negative correlation, the risk on a portfolio can fall to zero if an
appropriate allocation of funds is made. In this context, we discussed the case of
Ace and Bravo, two assets with their individual risk-return profiles, but with
perfect negative correlation. This explains why we got an assured return of 5%
and risk was 0, when we put 571 into Ace and 429 into Bravo.
2. With perfect positive correlations between the returns of two assets, both the
expected returns and the standard deviations of the portfolios made by combining
these two are weighted averages of the expected returns and standard deviations,
respectively, of the constituent assets.
3. In cases of zero correlations between the assets, or independent assets, risk can be
reduced through diversification, but will not be eliminated or brought to 0.

The correlation coefficient ranges from -1 to +1, with perfect –ve correlation being given
a coefficient of -1 and perfect +ve being +1. Independent assets have a correlation
coefficient of 0.

The degree of risk reduction for a portfolio depends on:

 The extent of statistical interdependence between the returns on different
investments; and
 The number of securities in the portfolio.

Portfolio expected returns are a weighted average of the expected returns of the
constituent investments. If the two investments are A and B, with a being invested in A
and (1-a) in B, then

R p  a R A  (1  a) RB

Portfolio standard deviation is less than the weighted average of the standard deviation of
the constituent investments (expect for perfectly +vely correlated investments where it is
the weighted average). The risk of a portfolio is measured by its standard deviation and
calculated as:

 P  a 2 2 A  (1  a) 2  2 B  2a(1  a) cov(RA , RB )

Covariance means the extent to which the returns on two investments move together. It is
related to correlation coefficient, but can take on any –ve or +ve value.

Let us learn the above concepts with the help of a solved example:

Let there be two shares A and B, with the following returns for alternative economic
states:

State of Economy Probability Returns on A Returns on B

Boom 0.3 20% 3%
Growth 0.4 10% 35%
Recessions 0.3 0% -5%

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You will be able to calculate the expected return and standard deviation for A and B
which is summarized below:

Expected Return Standard Deviation

A 10% 7.75%
B 13.4% 17.91%

PORTFOLIO EXPECTED RETURNS AND STANDARD DEVIATION

The rules stated above will now be illustrated by calculating the expected return and
standard deviation when 90 per cent of the portfolio funds are placed in A and 10 per cent
are placed in B.

Expected returns, two-aspect portfolio

The expected returns from a two-asset portfolio are as follows.
Proportion of funds in A = a = 0.90
Proportion of funds in B = 1- a = 0.10

The expected return of a portfolio Rp is solely related to the proportion of wealth invested
in each constituent. Thus we simply multiply the expected return of each individual
investment by their weights in the portfolio, 90 per cent for A and 10 per cent for B.

R p  a R A  (1  a) RB
R p  0.90 x10  0.10 x13.4  10.34%

Calculating standard deviation for a two-asset portfolio:

Now comes the formula for the standard deviation of a two-asset portfolio. This is:

 P  a 2 2 A  (1  a) 2  2 B  2a(1  a) cov(RA , RB )

where σP = portfolio standard deviation

σ2A = variance of investment A
σ2B = variance of investment B
cov (RA, RB) = covariance of A and B

The formula for the standard deviation of a two-asset portfolio may seem daunting at
first. However, the component parts are fairly straightforward. To make the formula
easier to understand it is useful to break it down to three terms:

1. The first term, a 2 2 A is the variance for A multiplied by the square of its weight –
in the example a2 = 0.902.
2. The second term (1-a)2σ2B, is the variance for the second investment B multiplied
by the square of its weight in the portfolio, 0.102.
3. The third term, 2a (1-a) cov (RA, RB), focuses on the covariance of the returns of
A and B, which is examined below.

When the results of all three calculations are added together the square root is taken to
give the standard deviation of the portfolio. The only piece of information not yet
available is the covariance. What is this and how is it measured?

COVARIANCE

The covariance measures the extent to which the returns on two investments ‘co-vary’ or
‘co-move’. If the returns tend to go up together and go down together then the
covariance will be a positive number. If, however, the returns on one investment move in
the opposite direction to the returns on another when a particular event occurs than these
securities will exhibit negative covariance. If there is no co-movement at all, that is, the
returns are independent of each other, the covariance will be zero. This positive-zero-
negative scale should sound familiar, as covariance and the correlation coefficient are

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closely related. However the correlation coefficient scale has a strictly limited range
from -1 to +1 whereas the covariance can be any positive or negative value. The
covariance formula is:

   
n
covR A , RB    R A  R A RB  RB pi
i 1

To calculate covariance take each of the possible events that could occur in turn and
calculate the extent to which the returns on investment A differ from expected returns
 
RA  RA - and note whether this is a positive or negative deviation. Follow this with a
similar deviation calculation for an investment in B if those particular circumstances (that
 
is, boom, recession, etc.) prevail RB  RB . Then multiply the deviation of A by the
deviation of B and the probability of that event occurring, pi . (Note that if the deviations
are both in a positive direction away from the mean, that is, a higher return than average,
or both negative, then the overall calculation will be positive. If one of the deviations is
negative whilst the other is positive the overall result is negative.) Finally the results
from all the potential events are added together to give the covariance.

Applying the formula to A and B will help to clarify matters

Event and Returns Expected Deviations Deviations of A x Deviation
probability of RA RB returns R A  R A RB  RB of B x probability
event pi R A RB R A  
 RA RB  RB pi
Boom 0.3 20 3 10 13.4 10 -10.4 10 x -10.4 x 0.3 = -31.2
Growth 0.4 10 35 10 13.4 0 21.6 0 x 21.6 x 0.4 = 0
Recession 0.3 0 -5 10 13.4 -10 -18.4 -10 x -18.4 x 0.3 = 55.2

Covariance of A and B, cov ( R A , RB ) = +24

It is worth spending a little time dwelling on the covariance and seeing how a positive or
negative covariance comes about. In the calculation for A and B the ‘Boom’ eventuality
contributed a negative 31.2 to the overall covariance. This is because A does particularly
well in boom conditions and the returns are well above expected returns, but B does
badly compared with its expected return of 13.4 and therefore the co-movement of
returns is a negative one. In is a recession both firms experience poor returns compared
with their expected values, thus the contribution to the overall covariance is positive
because they move together. This second element of co-movement outweighs that of the
boom possibility and so the total covariance is positive 24.

Now that we have the final piece of information to plug into the standard deviation
formula we can work out the risk resulting from splitting the fund, with 90 per cent
invested in A and 10 per cent in B.

 p  a 2 2 A  1  a 2  2 B  2a1  a  covR A , RB 

 p  0.90 2 x60  0.10 2 x320.64  2 x0.90 x0.10 x24

 p  48.6  3.206  4.32

 p  7.49%
Summary table: expected return and standard deviation
Expected return (%) Standard deviation (%)
All invested in Company A 10 7.75
All invested in Company B 13.4 17.91
Invested in a portfolio 10.34 7.49
(90% in A, 10% in B)

A 90:10 portfolio gives both a higher return and a lower standard deviation than a simple
investment in A alone.

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In the example shown, the degree of risk reduction is so slight because the returns on A
and B are positively correlated. Later we will consider the example of Augustus and
Brown, two shares which exhibit negative correlation. Before that, it will be useful to
examine the relationship between covariance and the correlation coefficient.

Expected returns and standard deviation for A and B and a 90:10 portfolio of A and
B

Expected 20 Portfolio (A=90%, B=10%)

Return
R% 15 B

10
A
5

5 10 15 20
Standard Deviation %

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CORRELATION COEFFICIENT

Both the covariance and the correlation coefficient measure the degree to which returns
move together. The covariance can take on any value and so it is difficult to use the
covariance to compare relationships between pairs of investments. A ‘standardized
covariance’ with a scale of interrelatedness is often more useful. This is what the
correlation coefficient gives us. To calculate the correlation coefficient, RAB, divide the
covariance by the product of the individual investment standard deviations.

cov(R A R B )
R AB 
 A B

24
R AB   0.1729
7.75 x17.91

The correlation coefficient has the same properties as the covariance but it measures co-
movement on a scale of -1 to +1 which makes comparisons easier. It also can be used as
an alternative method of calculating portfolio standard deviations:

cov(R A R B )
If R AB  then covR A RB   R AB A B
 A B

This can then be used in the portfolio standard deviation formula:

 p  a 2 2 A  1  a 2  2 B  2a1  a R AB  A B

Exhibit given below illustrates the case of perfect positively correlated returns (R FG = +1)
for the shares F and G. All the plot points lie on a straight upward sloping line.
Perfect positive correlation

Returns on G

Returns on F

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If the returns on G vary in an exactly opposite way to the returns on F, we have perfect
negative correlation, RFG = -1

Perfect negative correlation

Returns on G

Returns on F

If the securities have a zero correlation coefficient (R=0) we are unable to show a line
representing the degree of co-movement.

Zero correlation coefficient

Returns on G

X X
X X X X X
X X X X X
Returns on F
X X X X
X X X X X
X X

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DOMINANCE AND THE EFFICIENT FRONTIER

Suppose an individual is able to invest in shares of Augustus, in shares of Brown or in a

portfolio made up from Augustus and Brown shares. Augustus is an ice-cream
manufacturer and so does well if the weather is warm. Brown is an umbrella
manufacturer and so does well if it rains. Because the weather is so changeable from
year to year an investment in one of these firms alone is likely to be volatile, whereas a
portfolio will probably reduce the variability of returns

Standard deviation for Augustus and Brown

Event (Weather for Probability Returns on Returns

season) of event Augustus on Brown
Pi RA RB
Warm 0.2 20% -10%
Average 0.6 15% 22%
Wet 0.2 10% 44%
Expected Return 15% 20%

Standard Deviation for Augustus and Brown

Probability Returns
pi
on
Augustus RA
R A  RA 2
pi Returns on Brown R B  RB 
2
pi
0.2 20 5 -10 180.0
0.6 15 0 22 2.4
0.2 10 5 44 115.2
Variance, σ2A 10 Variance, σ2B 297.6
Standard Deviation, σA 3.162 Standard Deviation, σB 17.25

Covariance

Probability Returns Expected returns Deviations Deviations of A x Deviation

RA RB R A  R A RB  RB of B x probability
R  
pi RA RB
 RA RB  RB pi
A
0.2 20 -10 15 20 5 -30 5 x -30 x 0.2 = -30
0.6 15 22 15 20 0 2 0 x 2 x 0.6 = 0
0.2 10 44 15 20 -5 24 -5 x 24 x 0.2 = -24
Covariance ( R A , RB ) -54

The correlation coefficient is:

cov(R A R B )
R AB 
 A B
 54
R AB   0.99
3.162 x17.25
There are an infinite number of different potential combinations of Augustus and Brown
shares giving different levels of risk and return. To make the analysis easier we will
examine only five portfolios. These are shown in the following table:

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Risk-return correlations: two-asset portfolios for Augustus and Brown

Portfolio Augustus Brown Expected Standard Deviation

weighing weighing return
(%) (%) (%)
A 100 0 15 =3.16
J 90 10 15.5 0.9 2 x10  0.12 x297.6  2x0.9x0.1x  54  1.16
K 85 15 15.75 0.852 x10  0.15 2 x297.6  2x0.85x0.15x  54  0.39
L 80 20 16.0 0.82 x10  0.2 2 x297.6  2x0.8x0.2x  54  1.01
M 50 50 17.5 0.52 x10  0.52 x297.6  2x0.5x0.5x  54  7.06
N 25 75 18.75 0.25 2 x10  0.75 2 x297.6  2x0.25x0.75x  54  12.2
B 0 100 20 =17.25

This table lists the risk-return profile for alternative portfolios. Portfolio K is very close
to the minimum risk combination which actually occurs at a portfolio consisting of 84.6
per cent in Augustus and 15.4 per cent in Brown. The formula for calculating this
minimum standard deviation point is shown in a worked example later.

The risk-return line drawn, sometimes called the opportunity set, or feasible set, has two
sections. The first, with a solid line, from point K to point B, represents all the efficient
portfolios. This is called the efficiency frontier. Portfolios between K and A are
dominated by the efficient portfolios. Take L and J as examples: they have the same risk
levels but portfolio L dominates portfolio J because it has a better return. All the
portfolios between K and A are inefficient because for each possibility there is an
alternative combination of Augustus and Brown on the solid line K to B which provides a
higher return for the same risk.

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Risk-return profile for alternative portfolios of Augustus and Brown

21 B

20 N

19 Efficiency
Return M frontier
R p % 18
17
L
16
K
15 J
A

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

σp Standard Deviation

An efficient portfolio is a combination of investments which maximizes the expected

return for a given standard deviation.

Worked example for finding the minimum standard deviation for combination of
two securities:

This answers your question on how we decided to put 571 into Ace and 429 into Bravo to
get 0 standard deviation of the resulting portfolio. Try substituting the values for Ace and
Bravo you have with you and check! The portfolio will give a fixed return of 5% under
all states of the economy.

If a fund is to be split between two securities, A and B, and a is the fraction to be

allocated to A, then the value of “a” which results in the lowest standard deviation is
given by:
 B 2  covR A , RB 
a 2
 A   B 2  2 covR A , RB 

In the case of Augustus and Brown:

297.6   54 
a  0.846or 84.6%
10  297.6  2 x  54

To obtain the minimum standard deviation (or variance), we will place 84.6 per cent of
the fund in Augustus and 15.4 per cent in Brown. This is precisely the formula that we
used at the beginning to work out how Rs.1000 could be divided between Ace and Bravo
to achieve a possibly “0” variance portfolio.

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We can now calculate the minimum standard deviation:

 p  a 2 2 A  1  a 2  2 B  2a1  a  covR A , RB 

 p  0.846 2 x10  0.154 2 x297.6  2 x0.846 x0.154 x  54

 p  0.38%

Thus, an extremely risk-averse individual who was choosing a combination of shares in

Augustus and Brown can achieve a very low variation of income of a tiny standard
deviation of 0.38 per cent by allocating 84.6 per cent of the investment fund to Augustus.

Identifying the efficient portfolios helps in the quest to find the optimal portfolio for an
investor as it eliminates a number of inferior possibilities from further consideration.
However, there remains a large range of risk-return combinations available in the
efficient zone and we need a tool to enable us to find the best portfolio for an individual
given that person’s degree of risk aversion. For instance a highly risk-averse person will
probably select a portfolio with a high proportion of Augustus (but not greater than 84.6
per cent) perhaps settling for the low-return and low-risk combination represented by
portfolio L. A less risk-averse investor may be prepared to accept the high standard
deviation of portfolio N if compensated by the expectation of greater reward. To be more
accurate in choosing between efficient portfolios we need to be able to represent the
decision-makers’ attitude towards risk. Indifference curves help us to do this.

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