15.

401

15.401 Finance Theory

MIT Sloan MBA Program

Andrew W. Lo
Harris & Harris Group Professor, MIT Sloan School

Lecture 13–14: Risk Analytics and Portfolio Theory

© 2007–2008 by Andrew W. Lo
 Critical Concepts 15.401

ƒ Motivation
ƒ Measuring Risk and Reward
ƒ Mean-Variance Analysis
ƒ The Efficient Frontier
ƒ The Tangency Portfolio

Readings:
ƒ Brealey, Myers, and Allen Chapters 7 and 8.1

© 2007–2008 by Andrew W. Lo Slide 2

Lectures 13–14: Risk Analytics and
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 Motivation 15.401

What Is A Portfolio and Why Is It Useful?

ƒ A portfolio is simply a specific combination of securities, usually
defined by portfolio weights that sum to 1:

ƒ Portfolio weights can sum to 0 (dollar-neutral portfolios), and weights

can be positive (long positions) or negative (short positions).
ƒ Assumption: Portfolio weights summarize all relevant information.

© 2007–2008 by Andrew W. Lo Slide 3

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 Motivation 15.401

Example:
ƒ Your investment account of $100,000 consists of three stocks: 200
shares of stock A, 1,000 shares of stock B, and 750 shares of stock C.
Your portfolio is summarized by the following weights:

Dollar Portfolio
Asset Shares Price/Share Investment Weight
A 200 $50 $10,000 10%
B 1,000 $60 $60,000 60%
C 750 $40 $30,000 30%
Total $100,000 100%

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Lectures 13–14: Risk Analytics and
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 Motivation 15.401

Example (cont):
ƒ Your broker informs you that you only need to keep $50,000 in your
investment account to support the same portfolio of 200 shares of stock
A, 1,000 shares of stock B, and 750 shares of stock C; in other words,
you can buy these stocks on margin. You withdraw $50,000 to use for
other purposes, leaving $50,000 in the account. Your portfolio is
summarized by the following weights:

Dollar Portfolio
Asset Shares Price/Share Investment Weight
A 200 $50 $10,000 20%
B 1,000 $60 $60,000 120%
C 750 $40 $30,000 60%
Riskless Bond −$50,000 $1 −$50,000 −100%
Total $50,000 100%

© 2007–2008 by Andrew W. Lo Slide 5

Lectures 13–14: Risk Analytics and
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 Motivation 15.401

Example:
ƒ You decide to purchase a home that costs $500,000 by paying 20% of
the purchase price and getting a mortgage for the remaining 80% What
are your portfolio weights for this investment?

Dollar Portfolio
Asset Shares Price/Share Investment Weight
Home 1 $500,000 $500,000 500%

Mortgage 1 −$400,000 −$400,000 −400%

Total $100,000 100%

ƒ What happens to your total assets if your home price declines by 15%?

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Lectures 13–14: Risk Analytics and
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 Motivation 15.401

Example:
ƒ You own 100 shares of stock A, and you have shorted 200 shares of
stock B. Your portfolio is summarized by the following weights:

Dollar Portfolio
Stock Shares Price/Share Investment Weight
A 100 $50 $5,000 ???
B −200 $25 − $5,000 ???

ƒ Zero net-investment portfolios do not have portfolio weights in

percentages (because the denominator is 0)—we simply use dollar
amounts instead of portfolio weights to represent long and short
positions

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Lectures 13–14: Risk Analytics and
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 Motivation 15.401

Why Not Pick The Best Stock Instead of Forming a Portfolio?

ƒ We don’t know which stock is best!
ƒ Portfolios provide diversification, reducing unnecessary risks.
ƒ Portfolios can enhance performance by focusing bets.
ƒ Portfolios can customize and manage risk/reward trade-offs.

How Do We Construct a “Good” Portfolio?

ƒ What does “good” mean?
ƒ What characteristics do we care about for a given portfolio?
ƒ Risk and reward
ƒ Investors like higher expected returns
ƒ Investors dislike risk

© 2007–2008 by Andrew W. Lo Slide 8

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 Measuring Risk and Reward 15.401

ƒ Reward is typically measured by return

ƒ Higher returns are better than lower returns.
ƒ But what if returns are unknown?
ƒ Assume returns are random, and consider the distribution of returns.

Several possible measures:

ƒ Mean: central tendency.
ƒ 75%: upper quartile.
ƒ 5%: losses.

5%

Mean 75%

© 2007–2008 by Andrew W. Lo Slide 9

Lectures 13–14: Risk Analytics and
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 Measuring Risk and Reward 15.401

ƒ How about risk?

ƒ Likelihood of loss (negative return).
ƒ But loss can come from positive return (e.g., short position).
ƒ A symmetric measure of dispersion is variance or standard deviation.

Variance Measures Spread:

ƒ Blue distribution is “riskier”.
ƒ Extreme outcomes more likely.
ƒ This measure is symmetric.

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 Measuring Risk and Reward 15.401

Assumption
ƒ Investors like high expected returns but dislike high volatility
ƒ Investors care only about the expected return and volatility of their
overall portfolio
– Not individual stocks in the portfolio
– Investors are generally assumed to be well-diversified

Key questions: How much does a stock contribute to the risk and
return of a portfolio, and how can we choose portfolio weights to
optimize the risk/reward characteristics of the overall portfolio?

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 Mean-Variance Analysis 15.401

Objective
ƒ Assume investors focus only on the expected return and variance (or
standard deviation) of their portfolios: higher expected return is good,
higher variance is bad
ƒ Develop a method for constructing optimal portfolios

Higher Utility
Expected Return E[Rp]

MRK MOT

MCD
GM

T-Bills

Standard Deviation of Return SD[Rp]

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 Mean-Variance Analysis 15.401

Basic Properties of Mean and Variance For Individual Returns:

Basic Properties of Mean And Variance For Portfolio Returns:

© 2007–2008 by Andrew W. Lo Slide 13

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 Mean-Variance Analysis 15.401

Variance Is More Complicated:

© 2007–2008 by Andrew W. Lo Slide 14

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Portfolio variance is the weighted sum of all the variances and

covariances:

ƒ There are n variances, and n2 − n covariances

ƒ Covariances dominate portfolio variance
ƒ Positive covariances increase portfolio variance; negative covariances
decrease portfolio variance (diversification)

© 2007–2008 by Andrew W. Lo Slide 15

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 Mean-Variance Analysis 15.401

Consider The Special Case of Two Assets:

ƒ As correlation increases, overall portfolio variance increases

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 Mean-Variance Analysis 15.401

Example: From 1946 – 2001, Motorola had an average monthly return of

1.75% and a std dev of 9.73%. GM had an average return of 1.08%
and a std dev of 6.23%. Their correlation is 0.37. How would a
portfolio of the two stocks perform?

wMot wGM E[RP] var(RP) stdev(RP)

0 1 1.08 38.8 6.23
0.25 0.75 1.25 36.2 6.01
0.50 0.50 1.42 44.6 6.68
0.75 0.25 1.58 64.1 8.00
1 0 1.75 94.6 9.73
1.25 -0.25 1.92 136.3 11.67

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 Mean-Variance Analysis 15.401

Mean/SD Trade-Off for Portfolios of GM and Motorola

2.1%

1.7% Motorola
Expected Return

1.3%

GM
0.9%

0.5%
2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0%
Standard Deviation of Return

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 Mean-Variance Analysis 15.401

Example (cont): Suppose the correlation between GM and Motorola

changes. What if it equals –1.0? 0.0? 1.0?

Std dev of portfolio

wMot wGM E[RP] corr = -1 corr = 0 corr = 1
0 1 1.08% 6.23% 6.23% 6.23%
0.25 0.75 1.25 2.24 5.27 7.10
0.50 0.50 1.42 1.75 5.78 7.98
0.75 0.25 1.58 5.74 7.46 8.85
1 0 1.75 9.73 9.73 9.73

© 2007–2008 by Andrew W. Lo Slide 19

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Mean/SD Trade-Off for Portfolios of GM and Motorola

2.2%

1.8%
Expected Return

corr=-1
1.4%
corr=-.5 corr=1
corr=0

1.0%

0.6%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Return

© 2007–2008 by Andrew W. Lo Slide 20

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Example: In 1980, you were thinking about investing in GD. Over the
subsequent 10 years, GD had an average monthly return of 0.00%
and a std dev of 9.96%. Motorola had an average return of 1.28% and
a std dev of 9.33%. Their correlation is 0.28. How would a portfolio of
the two stocks perform?

wMot wGD E[RP] var(RP) stdev(RP)

0 1 0.00 99.20 9.96
0.25 0.75 0.32 71.00 8.43
0.50 0.50 0.64 59.57 7.72
0.75 0.25 0.96 64.92 8.06
1 0 1.28 87.05 9.33

© 2007–2008 by Andrew W. Lo Slide 21

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 Mean-Variance Analysis 15.401

Mean/SD Trade-Off for Portfolios of GD and Motorola

2.0%

1.5%

Motorola
1.0%
Expected Return

0.5%

GD
0.0%
4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

-0.5%

Standard Deviation of Return

-1.0%

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Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Example: You are trying to decide how to allocate your retirement

savings between Treasury bills and the stock market. The T-Bill rate
is 0.12% monthly. You expect the stock market to have a monthly
return of 0.75% with a standard deviation of 4.25%.

wStk wTbill E[RP] var(RP) stdev(RP)

0 1 0.12 0.00 0.00
0.33 0.67 0.33 1.97 1.40
0.67 0.33 0.54 8.11 2.85
1 0 0.75 18.06 4.25

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 Mean-Variance Analysis 15.401

Mean/SD Trade-Off for Portfolios of T-Bills and The Stock Market

1.0%

0.8%
Stock Market
Expected Return

0.6%

50/50 portfolio
0.4%

0.2%

T-Bills
0.0%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0%
Standard Deviation of Return

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Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Summary

Observations
ƒ E[RP] is a weighted average of stocks’ expected returns
ƒ SD(RP) is smaller if stocks’ correlation is lower. It is less than a
weighted average of the stocks’ standard deviations (unless perfect
correlation)
ƒ The graph of portfolio mean/SD is nonlinear
ƒ If we combine T-Bills with any risky stock, portfolios plot along a
straight line

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 Mean-Variance Analysis 15.401

The General Case:

ƒ Portfolio variance is the sum of weights times entries in the

covariance matrix

© 2007–2008 by Andrew W. Lo Slide 26

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

The General Case:

ƒ Covariance matrix contains n2 terms
– n terms are variances
– n2 – n terms are covariances
ƒ In a well-diversified portfolio, covariances are more important than
variances
ƒ A stock’s covariance with other stocks determines its contribution to
the portfolio’s overall variance
ƒ Investors should care more about the risk that is common to many
stocks; risks that are unique to each stock can be diversified away

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 Mean-Variance Analysis 15.401

Special Case:
ƒ Consider an equally weighted portfolio:

ƒ For portfolios with many stocks, the variance is determined by the

average covariance among the stocks

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 Mean-Variance Analysis 15.401

Example: The average stock has a monthly standard deviation of 10%

and the average correlation between stocks is 0.40. If you invest the
same amount in each stock, what is variance of the portfolio? What if
the correlation is 0.0? 1.0?

© 2007–2008 by Andrew W. Lo Slide 29

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Example (cont):

12%

10%
ρ = 1.0
8%
SD of Portfolio

6%
ρ = 0.4

4%

2% ρ = 0.0

0%
1 11 21 31 41 51 61 71 81 91
Number of Stocks

© 2007–2008 by Andrew W. Lo Slide 30

Lectures 13–14: Risk Analytics and
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 Mean-Variance Analysis 15.401

Eventually, Diversification Benefits Reach A Limit:

ƒ Remaining risk known as

systematic or market risk

Portfolio Variance
ƒ Due to common factors Risk eliminated
that cannot be diversified by diversification

ƒ Example: S&P 500

ƒ Other sources of Total risk
Undiversifiable or
systematic risk may exist: of typical
stock systematic risk
ƒ Credit
ƒ Liquidity Number of Stocks in Portfolio
ƒ Volatility
ƒ Business Cycle
ƒ Value/Growth
ƒ Provides motivation for
linear factor models

© 2007–2008 by Andrew W. Lo Slide 31

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Given Portfolio Expected Returns and Variances:

How Should We Choose The Best Weights?

ƒ All feasible portfolios lie inside a bullet-shaped region, called the
minimum-variance boundary or frontier
ƒ The efficient frontier is the top half of the minimum-variance
boundary (why?)
ƒ Rational investors should select portfolios from the efficient frontier

© 2007–2008 by Andrew W. Lo Slide 32

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

2.4%

Efficient Frontier

1.8%
Expected Return

Minimum-Variance Boundary
1.2%

0.6%

0.0%
2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Return

© 2007–2008 by Andrew W. Lo Slide 33

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example: You can invest in any combination of GM, IBM, and MOT.
What portfolio would you choose?

Variance / covariance
Stock Mean Std dev GM IBM Motorola
GM 1.08 6.23 38.80 16.13 22.43
IBM 1.32 6.34 16.13 40.21 23.99
Motorola 1.75 9.73 22.43 23.99 94.63

© 2007–2008 by Andrew W. Lo Slide 34

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example: You can invest in any combination of GM, IBM, and MOT.
What portfolio would you choose?

Variance / covariance
Stock Mean Std dev GM IBM Motorola
GM 1.08 6.23 38.80 16.13 22.43
IBM 1.32 6.34 16.13 40.21 23.99
Motorola 1.75 9.73 22.43 23.99 94.63

© 2007–2008 by Andrew W. Lo Slide 35

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example: You can invest in any combination of GM, IBM, and MOT.
What portfolio would you choose?

Variance / covariance
Stock Mean Std dev GM IBM Motorola
GM 1.08 6.23 38.80 16.13 22.43
IBM 1.32 6.34 16.13 40.21 23.99
Motorola 1.75 9.73 22.43 23.99 94.63

E[RP] = (wGM × 1.08) + (wIBM × 1.32) + (wMot × 1.75)

© 2007–2008 by Andrew W. Lo Slide 36

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example: You can invest in any combination of GM, IBM, and MOT.
What portfolio would you choose?

Variance / covariance
Stock Mean Std dev GM IBM Motorola
GM 1.08 6.23 38.80 16.13 22.43
IBM 1.32 6.34 16.13 40.21 23.99
Motorola 1.75 9.73 22.43 23.99 94.63

E[RP] = (wGM × 1.08) + (wIBM × 1.32) + (wMot × 1.75)

var(RP) = (wGM2 × 38.80) + (wIBM × 40.21) + (wMot2 × 94.23) +

(2 × wGM × wIBM × 16.13) + (2 × wGM × wMot × 22.43) +
(2 × wIBM × wMot × 23.99)

© 2007–2008 by Andrew W. Lo Slide 37

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example: You can invest in any combination of GM, IBM, and MOT.
What portfolio would you choose?

Variance / covariance
Stock Mean Std dev GM IBM Motorola
GM 1.08 6.23 38.80 16.13 22.43
IBM 1.32 6.34 16.13 40.21 23.99
Motorola 1.75 9.73 22.43 23.99 94.63

E[RP] = (wGM × 1.08) + (wIBM × 1.32) + (wMot × 1.75)

var(RP) = (wGM2 × 38.80) + (wIBM × 40.21) + (wMot2 × 94.63) +

(2 × wGM × wIBM × 16.13) + (2 × wGM × wMot × 22.43) +
(2 × wIBM × wMot × 23.99)

© 2007–2008 by Andrew W. Lo Slide 38

Lectures 13–14: Risk Analytics and
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 The Efficient Frontier 15.401

Example (cont): Feasible Portfolios

2.1%

1.8%
Motorola
Expected Return

1.5%

IBM
1.2%
GM

0.9%

0.6%
3.0% 5.0% 7.0% 9.0% 11.0%
Standard Deviation of Return

© 2007–2008 by Andrew W. Lo Slide 39

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 The Tangency Portfolio 15.401

The Tangency Portfolio

ƒ If there is also a riskless asset (T-Bills), all investors should
hold exactly the same stock portfolio!
ƒ All efficient portfolios are combinations of the riskless asset
and a unique portfolio of stocks, called the tangency portfolio.*
– In this case, efficient frontier becomes straight line

* Harry Markowitz, Nobel Laureate

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 The Tangency Portfolio 15.401

2.4%

1.8% Motorola
Expected Return

IBM P
1.2%
GM

0.6%

Tbill

0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Return

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 The Tangency Portfolio 15.401

2.4%

1.8% Motorola
Tangency
Expected Return

portfolio
IBM
1.2%
GM

0.6%

Tbill

0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Return

© 2007–2008 by Andrew W. Lo Slide 42

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 The Tangency Portfolio 15.401

Sharpe ratio
A measure of a portfolio’s risk-return trade-off, equal to the
portfolio’s risk premium divided by its volatility:

E[Rp] − rf
Sharpe Ratio ≡ (higher is better!)
σp

ƒ The tangency portfolio has the highest possible Sharpe

ratio of any portfolio
ƒ Aside: Alpha is a measure of a mutual fund’s risk-adjusted
performance. The tangency portfolio also maximizes the fund’s
alpha.

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 The Tangency Portfolio 15.401

Slope = Sharpe Ratio (why?)

2.4%

1.8% Motorola
Tangency
Expected Return

portfolio
IBM
1.2%
GM

0.6%

Tbill

0.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Standard Deviation of Returns

© 2007–2008 by Andrew W. Lo Slide 44

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 Key Points 15.401

ƒ Diversification reduces risk. The standard deviation of a portfolio is

always less than the average standard deviation of the individual
stocks in the portfolio.
ƒ In diversified portfolios, covariances among stocks are more
important than individual variances. Only systematic risk matters.
ƒ Investors should try to hold portfolios on the efficient frontier.
These portfolios maximize expected return for a given level of risk.
ƒ With a riskless asset, all investors should hold the tangency
portfolio. This portfolio maximizes the trade-off between risk and
expected return.

© 2007–2008 by Andrew W. Lo Slide 45

Lectures 13–14: Risk Analytics and
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 Additional References 15.401

ƒ Bernstein, 1992, Capital Ideas. New York: Free Press.

ƒ Bodie, Z., Kane, A. and A. Marcus, 2005, Investments, 6th edition. New York: McGraw-Hill.
ƒ Brennan, T., Lo, A. and T. Nguyen, 2007, Portfolio Theory: A Review, to appear in Foundations of
Finance.
ƒ Campbell, J., Lo, A. and C. MacKinlay, 1997, The Econometrics of Financial Markets. Princeton, NJ:
Princeton University Press.
ƒ Grinold, R. and R. Kahn, 2000, Active Portfolio Management. New York: McGraw-Hill.

© 2007–2008 by Andrew W. Lo Slide 46

Lectures 13–14: Risk Analytics and
Portfolio Theory
MIT OpenCourseWare
http://ocw.mit.edu

15.401 Finance Theory I

Fall 2008

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