Chapter Five

Optimal Risky Portfolios

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 PORTFOLIO SUMMARY

RISKY ASSET
E
RISKY
PORTFOLIO
P
COMPLETE RISKY ASSET
PORTFOLIO D
C
Risk free ASSET
F

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 Chapter Overview

• The investment decision:

• Capital allocation (risky vs. risk-free)
• Asset allocation (construction of the risky
portfolio)
• Security selection
• Optimal risky portfolio
• The Markowitz portfolio optimization model
• Long- vs. short-term investing

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 The Investment Decision

• Top-down process with 3 steps:

1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class

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 Diversification and Portfolio Risk
Stock price - Vingroup (VIC)

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 Diversification and Portfolio Risk

• Market risk (systematic risk)

• Risk attributable to marketwide risk sources and
remains even after extensive diversification
• Also call systematic or nondiversifiable
• Firm-specific risk (non systematic risk)
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic

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 Portfolios of Two Risky Assets

• Portfolio risk (variance) depends on the

correlation between the returns of the
assets in the portfolio
• Covariance and the correlation coefficient
provide a measure of the way returns of
two assets move together (covary)

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 Portfolios of Two Risky Assets:
Return
• Portfolio return: rp = wDrD + wErE
• wD = Bond weight
• rD = Bond return
• wE = Equity weight
• rE = Equity return

E(rp) = wD E(rD) + wEE(rE)

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 Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
 p  wD D  wE E  2wD wE Cov  rD , rE 
2 2 2 2 2

•  D2 = Bond variance

•
 2
E = Equity variance

• Cov(rD,rE) = DEDE

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 Portfolios of Two Risky Assets:
Covariance
• Covariance of returns on bond and equity:
Cov(rD,rE) = DEDE

• D,E = Correlation coefficient of returns

• D = Standard deviation of bond returns
• E = Standard deviation of equity returns

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 Portfolios of Two Risky Assets:
Correlation Coefficients
• Range of values for 1,2
- 1.0 >  > +1.0
• If  = 1.0, the securities are perfectly positively
correlated
• If  = - 1.0, the securities are perfectly negatively
correlated

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 Portfolios of Two Risky Assets:
Correlation Coefficients
• When ρDE = 1, there is no diversification

 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
 D  E

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 Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation

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 The Minimum Variance Portfolio

wB  1  wA

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 The Minimum Variance Portfolio

• The minimum variance portfolio is the portfolio

composed of the risky assets that has the smallest
standard deviation; the portfolio with least risk
• The amount of possible risk reduction through
diversification depends on the correlation:
• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of
either component asset
• If  = -1.0, a riskless hedge is possible

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 Figure 7.6 The Opportunity Set of the Debt
and Equity Funds and Two Feasible CALs

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 The Sharpe Ratio

• Maximize the slope of the CAL for any possible

portfolio, P
• The objective function is the slope:
E rp   rf
Sp 
p
• The slope is also the Sharpe ratio

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 Figure 7.7 Debt and Equity Funds with the
Optimal Risky Portfolio

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 Debt and Equity Funds with the Optimal
Risky Portfolio

E RD  E2  E RE Cov( RD , RE )

wD 
E RD  E2  E RE  D2  E RD   E RE Cov( RD , RE )

wE  1  wD

R: excess rate of return

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 Figure 7.8 Determination of the Optimal
Overall Portfolio

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 Figure 7.9 The Proportions of the Optimal
Complete Portfolio

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 Markowitz Portfolio Optimization
Model
• Security selection
• The first step is to determine the risk-return
opportunities available
• All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations

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 Figure 7.10 The Minimum-Variance
Frontier of Risky Assets

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 Markowitz Portfolio Optimization
Model
• Search for the CAL with the highest reward-to-
variability ratio
• Everyone invests in P, regardless of their
degree of risk aversion
• More risk averse investors put more in the risk-
free asset
• Less risk averse investors put more in P

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 Figure 7.11 The Efficient Frontier of
Risky Assets with the Optimal CAL

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 Markowitz Portfolio Optimization
Model
• Capital Allocation and the Separation Property
• Portfolio choice problem may be separated into
two independent tasks
• Determination of the optimal risky portfolio is
purely technical
• Allocation of the complete portfolio to risk-free
versus the risky portfolio depends on personal
preference

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 Figure 7.13 Capital Allocation Lines with
Various Portfolios from the Efficient Set

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 Markowitz Portfolio Optimization
Model
• The Power of Diversification
• Remember:
 p2   wi w j Cov  ri , rj 
n n

i 1 j 1

• If we define the average variance and average

covariance of the securities as:
1 n 2
   i
2

n i 1

Cov  ri , rj 
n n
1
Cov  
n  n  1 j 1 i 1
j i

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 Markowitz Portfolio Optimization
Model
• The Power of Diversification
• We can then express portfolio variance as
1 2 n 1
   
2
p Cov
n n
• Portfolio variance can be driven to zero if the
average covariance is zero (only firm specific risk)
• The irreducible risk of a diversified portfolio
depends on the covariance of the returns, which is
a function of the systematic factors in the
economy

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 Table 7.4 Risk Reduction of
Equally Weighted Portfolios

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 Markowitz Portfolio Optimization
Model
• Optimal Portfolios and Nonnormal Returns
• Fat-tailed distributions can result in extreme
values of VaR and ES and encourage smaller
allocations to the risky portfolio
• If other portfolios provide sufficiently better VaR
and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions

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 Risk Pooling and
the Insurance Principle
• Risk pooling
• Merging uncorrelated, risky projects as a means to
reduce risk
• It increases the scale of the risky investment by
adding additional uncorrelated assets
• The insurance principle
• Risk increases less than proportionally to the
number of policies when the policies are
uncorrelated
• Sharpe ratio increases
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 Risk Sharing

• As risky assets are added to the portfolio, a

portion of the pool is sold to maintain a risky
portfolio of fixed size
• Risk sharing combined with risk pooling is the
key to the insurance industry
• True diversification means spreading a
portfolio of fixed size across many assets, not
merely adding more risky bets to an ever-
growing risky portfolio
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 Investment for the Long Run

Long-Term Strategy Short-Term Strategy

• Invest in the risky • Invest in the risky
portfolio for 2 years portfolio for 1 year and
• Long-term strategy is
riskier in the risk-free asset for
• Risk can be reduced by the second year
selling some of the
risky assets in year 2
• “Time diversification”
is not true
diversification

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