The Portfolio Selection Problem

P. D. Nimal

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Objectives
On satisfactory completion of this topic student will be
able:

 To understand the portfolio selection problem

 To understand why investor want to maximize ER and minimize

uncertainty

 To understand the Markowitz’s solution

 To understand the Nonsatiation and Risk Aversion assumptions

of investor behavior

 To understand the behavior of utility of wealth of an investor

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The Portfolio Selection Problem
 Most securities available for investment have
uncertain outcomes and are thus risky

 The question is which risky securities to own

 Portfolio is a collection of securities

 Answer is the selection of optimal portfolio from a

set of possible portfolios

 This is called the portfolio selection problem

 One solution was suggested by Markowitz (1952)

 This is regarded as the origin of Modern Portfolio

Theory

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The Portfolio Selection Problem cont…

 Markowitz’s model is one period investment decision

 At the beginning he/she invest certain amount and realizes the

terminal wealth at the end

 Proceeds could be reinvested or consumed

 Investor knows that the return of the forthcoming period is un

known

 But investor can estimate the Expected Return and can invest in
the security that has highest ER

 And there is uncertainty in future returns which investor like to

minimize

 Thus, investor want to maximize ER and minimize uncertainty

 Markowit’s model gives a mathematical solution to this problem

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Initial and Terminal Wealth

 The question is the investor does not know what the rate of return
will be for most of the portfolios

 Thus according to Markowitz, the investor should view the return of

any portfolio as what is called in statistics a random variable

 RV can be described by their moments, two of them are Expected

Return and Standard Deviation

 Markowitz asserts that investors should base their decisions solely on

ER and STD

 Investors should estimate ER and STD of portfolios and must choose

the best on the basis of the relative magnitude of these two

 ER is regarded as the potential reward and STD is regarded as the

risk associated with it

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 Comparison of Portfolios

A comparison of Terminal wealth levels for two hypothetical portfolios

Level of terminal Percent chance of being below this level of

wealth terminal wealth
Portfolio A portfolio B
70000 0 2
80000 0 5
90000 4 14
100000 21 27
110000 57 46
120000 88 66
130000 99 82

Initial wealth is assumed to be 100,000, and both portfolios are assumed

to have normally distributed returns
The ER and STd of A are 8% and 10%
The ER and STd of B are 12% and 20%
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 Risk and Return

Let’s see whether risk have been rewarded in the past

7
Historical evidence on Risk and return of assets
The Future Value of an Investment of $1 in 1925

$1,775.34

$59.70

$17.48

Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

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Historical Returns, 1926-2002
Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.2% 20.5%

Small Company Stocks 16.9 33.2

Long-Term Corporate Bonds 6.2 8.7

Long-Term Government Bonds 5.8 9.4

U.S. Treasury Bills 3.8 3.2

Inflation 3.1 4.4

– 90% 0% + 90%

Source: © Stocks, Bonds, Bills, and Inflation 2003 Yearbook™, Ibbotson Associates, Inc., Chicago
(annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

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Assumptions on Investor Behavior
Nonsatiation and Risk Aversion
 Assumption one - Nonsatiation
 Investors will choose the portfolio that has higher ER at a given
level of risk
 That is investors are assumed to always prefer higher terminal
wealth to lower terminal wealth
 Thus, given two portfolios with the same STD, the investor will
choose the portfolio with higher ER

 However, it is not obvious what the investor will do when

two portfolios have the same ER but different STD

 This is where the second assumption enters the discussion

 Assumption two – Risk Aversion

 It is assumed that investors are risk averse, i.e., the investor
will choose the portfolio with lower STD
 It means that investor will not want to take fair gamble (or fair
bets)
 That is if the ER is 0, investor will try to avoid it
 The concept of investor Utility helps explain why

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 Utility

 The Utility is defined as the relative enjoyment or

satisfaction that people derive from economic activity such
as work, consumption, or investment

 Satisfying activities generate positive utility and

dissatisfying activities produce negative utility (or disutility)

 Since tastes are different, one person may experience more

utility from an activity than another person

 However, people are presumed to be rational and to allocate

their resources (time and money) to maximize their own
utility

 The Markowitz portfolio selection problem is viewed as that

investors are trying to maximize their expected utility of
terminal wealth

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 Utility of Wealth

 The relationship between utility and wealth is called the

investor’s utility of wealth function

 Under the nonsatiation assumption investors prefer more

wealth to less wealth

 Every extra rupee of wealth enhances an investor’s utility,

i.e., the Marginal Utility of Wealth (MUW) is always positive

 But MUW may differ among investors and it may depend on

the level of wealth that investor already owned

 A rich investor may value an extra Rupee of wealth less

than a poor investor does

 A common assumption is that risk-averse investor

experience diminishing marginal utility of wealth

 See Figure 6.1

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 Utility of Wealth cont…

 Consider a choice of two investments

 Investment Rs. 100,000 and earn a certain return
of 5% (5000), E(R) is 5%, zero risk
 Investment Rs. 100,000 and
 50% probability of earning 10% (10000)
 50% probability of earning 0% (0), E(R) is 5%, with risk

 Risk averse investor prefer the one with zero risk

if the E(R)s are equal. This can be explained by
the Utility function of an investor (See Figure 6.1)
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 Certainty Equivalents and
Risk Premiums

 Certainty Equivalent means what is the terminal

wealth that, if offered with certainty, would
provide the same amount of expected utility as
the risky investment

 Risk premium is the expected increase in

terminal wealth over the certain investment
required to compensate the investor for the risk
incurred

 See Figure 6.1

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Prospect Theory

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 Indifference Curves

 An indifference curve represents a set of risk and

expected return combinations that provide an investor
the same amount of utility

 Investor is said to be indifferent between any of the

risk-expected return combinations on the same
indifferent curve. See figure 6.2

 Since all combinations on a given indifference curve are

equally desirable, indifference curves cannot intersect.
See Figure 6.3

 Indifference curves that lie above to a given curve will

give higher utility

 Indifference curves for a given investor will depend on

his/her risk-averseness. See figure 6.5,

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