Lecture5 2017-18 Upload

Lecture 5: Portfolio theory
BEAM047A Fundamentals of Financial

Management
Panagiotis Couzo↵
Autumn Term, 2017/18

Outline
Portfolio Theory
Diversification
Optimal portfolio including a riskless asset
Implications on asset risk

Portfolio Theory
Outline
Portfolio Theory
Diversification

Portfolio Theory
Portfolio theory
I In Lecture 4 we talked about portfolio construction, and specifically

about what combinations of expected return and standard variance
investors can create using two assets.
I It is now time to discuss portfolio choice, i.e. how does an investor
choose in which of these combinations to invest.
I The optimal combination of risky assets in a portfolio has been
determined by Harry Markowitz (Nobel Memorial Prize in Economic
Sciences, 1990) in 1952.
I His research is the basis of all professional fund management to date
and is widely known as the Markowitz Portfolio Theory (or also
Modern Portfolio Theory).
Portfolio Theory
The assumptions of portfolio theory
I The underlying assumptions of the MPT are:

I Investors consider each investment alternative as being represented
by a probability distribution of returns over some holding period.
I Investors maximize one-period expected utility, and their utility
curves demonstrate diminishing marginal utility of wealth. In other
words, it expresses
i) Non-satiation (increasing in wealth), and
ii) Risk aversion (concave function wrt wealth).
I Investors estimate risk on the basis of the variability of expected
returns.
I Investors base their decisions on expected return and risk.
I All else equal, investors prefer higher return and lower variance.
Portfolio Theory
Preference for higher return and lower variance

E[R]
higher return
lower variance
0
Portfolio Theory
Dominating investments
I Consider two investments I1 and I2 which are mutually exclusive, i.e.
you can only invest in one of the two:
E[R]
I1
I2
0
Portfolio Theory
Dominating investments
I I1 dominates I2 as it has both higher expected return and lower
standard deviation.
E[R]
I1
I2
0
Portfolio Theory
Risk aversion teasers

I Example 1: Suppose you are o↵ered a gamble paying $2M or $0
with equal probabilities. Are you willing to pay $1M to play?
I Example 2: Are you willing to pay the same amount for these two
gambles?
£120K £500K
0.5 0.5
p= p=
1 1
p p
£100K £280K
I Answers to these questions can characterise the risk attitude of an

individual.
Portfolio Theory
Risk aversion
I Risk aversion is the basis of portfolio theory.

I It reflects the reluctance of individuals to accept deals with an
uncertain payo↵ rather than deals with certain (and possibly lower)
expected payo↵s.
I In a nutshell, one dollar lost is worth more to a risk averse individual
than one dollar gained.
I It is reasonable to assume that investors are generally risk averse
over the typical size of investments made in the financial markets.
Portfolio Theory
Utility functions
I Risk aversion is typically expressed through the concavity of utility

functions (i.e. the “utility” individuals derive from di↵erent levels of
wealth).
I Denoting the utility function of an agent by u(w ),
I The non-satiation assumption is captured by
du
>0
dw
I The risk-aversion assumption is fulfilled by
d 2u
>0
dw 2
Portfolio Theory
Indi↵erence curves
I Incorporating utility functions into the standard deviation/expected

return space can be achieved via (multiple) indi↵erence curves.
I Indi↵erence curves represent equally preferable combinations of
expected return and standard deviation for the investor.
I Unlike utility functions (one per individual), investors’ preferences are
captured by infinite indi↵erence curves, i.e. one for each utility level.
Portfolio Theory
Indi↵erence curves (graphically)

Portfolio Theory
The shape of indi↵erence curves (cont’d)
I The shape, and most importantly the slope, of an investor’s

indi↵erence curves are determined by his/her degree of risk aversion.
I A more risk averse investor requires a larger increase in expected
return to compensate for extra risk (steeper indi↵erence curves).
I Investors would like to achieve the highest possible indi↵erence
curve, i.e. the highest possible utility.
Portfolio Theory

Portfolio Theory
Choosing a portfolio
I Therefore, the optimal portfolio for an investor is the one that

reaches to the highest possible indi↵erence curve.
I The highest investor “satisfaction” is achieved at the point where an
indi↵erence curve is tangent to the set of feasible portfolios.
I Note that as investors have di↵erent indi↵erence curve slopes, they
have di↵erent optimal portfolios.
Portfolio Theory

Diversification
Outline
Portfolio Theory
Diversification

Diversification
Adding risky assets
I So far, we have considered the case of only two risky assets.

I What happens if we start adding stocks?
I Consider that on top of Disney and IBM of last week’s lecture, you
have the opportunity to also invest in Coca-Cola which has
I an expected return of 18.4%
I a standard deviation of returns of 32.6%.
I a correlation of returns with Disney of 0.2
I a correlation of returns with IBM of 0.1
I What portfolios can you create using these three stocks?
Diversification
Feasible sets of three assets (by pairs)

Diversification
Feasible sets of three assets (combined)

Diversification
Feasible set with many assets
I Note that the feasible set of portfolios is no longer a line, but an

area.
I This means that any point in the shaded area can be constructed
using the three assets.
I Based on the assumptions of the portfolio theory, most of these
portfolios are unattractive to investors.
I The dominating portfolios in terms of expected return and standard
deviation are going to be preferred.
Diversification
Portfolio and efficient frontiers
I The line formed by the portfolios with the lowest variance (or
standard deviation) for a given expected return is called the
minimum-variance frontier.
I The left-most point on the minimum-variance frontier is called the
global minimum-variance portfolio.
I The set of portfolios with the highest expected return for a given
level of risk is called the efficient frontier.
Diversification
Portfolio and efficient frontiers (graph)

Diversification
Adding many assets

I Adding assets shifts the portfolio frontier to the left. The variance
that can be achieved for a given expected return decreases.
Diversification
Limits to diversification
I We have seen that diversification (adding non-perfectly correlated

assets to a portfolio) reduces risk.
I Question: How much can risk be reduced? Can it go down to zero
if we add an infinite number of assets?
Diversification
Theory
I To answer this question, recall the formula for the variance of a

portfolio.
XN XN X N
2 2 2
P = w i i + wi wj ⇢ij i j
i=1 i=1 j=1
j6=i
I Consider an equally-weighted portfolio consisting of N assets

w = N1 with equal return variance 2 and equal pairwise return
correlation ⇢.
Diversification
Theory (cont’d)
I Substituting into the portfolio variance formula yields

✓ ◆2 ✓ ◆2
2 1 2 1 2
P =N + N (N 1) ⇢
N N
1 2 N 1 2
= + ⇢
N N
I Notice that the first term decreases with N while the second doesn’t.
I With a bit of algebraic manipulation, the above becomes
2
2 (1 ⇢) 2
P = +⇢
N
I Hence, even if N approaches infinity, the variance of an
equally-weighted portfolio is di↵erent than zero!
Diversification
A graph
I Equally-weighted portfolio of assets where all assets have the same
standard deviation of returns and their returns are equally correlated
to each other:
Diversification
And some evidence

I Equally-weighted portfolio of randomly selected NYSE stocks.
Number of stocks St.dev. Ratio of pflio st.dev.
in portfolio of portfolio to st.dev. of single stock
1 49.2% 1
2 37.4% 0.76
4 29.7% 0.6
8 25.0% 0.51
20 21.7% 0.44
50 20.2% 0.41
200 19.4% 0.39
500 19.2% 0.39
1000 19.2% 0.39
Source: Statman, Meir, 1987. How many stocks make a diversified portfolio? Journal of Financial and Quantitative Analysis, 22,
353-364.
I The evidence is very much consistent with the theoretical standard

deviation if ⇢ = 0.15.
Diversification
Systematic vs Idiosyncratic Risk
I Consider a group of assets.

I Systematic Risk: Risk which a↵ects all assets.
I If the group consists of US stocks, systematic risk corresponds to
events a↵ecting the US economy (and in particular the stock market).
I Idiosyncratic Risk: Risk which a↵ects only one asset.
I Idiosyncratic risk corresponds to events a↵ecting only a particular
company or industry.
I Diversification within the group of assets reduces, and eventually
eliminates, idiosyncratic risk.
I However, it cannot reduce systematic risk.
I Diversification outside the group of assets (if possible) is more
e↵ective in reducing risk.
Outline
Portfolio Theory
Diversification

Portfolio with a riskless and a risky asset
I Up to now, we have considered portfolios that consisted of risky

assets only.
I What happens if we include a riskless asset into the picture?
I Let’s have a look first into a portfolio consisting of only two assets,
a risky (weight of w 0) and a riskless one (weight of 1 w ).
Portfolio with a riskless and a risky asset

I Denoting the return of the risk-free asset by rf and the expected
return of the risky by E [Ri ], the expected return of this portfolio is
⇥ ⇤
E rP = rf + w E [Ri ] rf
I Noting that the variance (and also the standard deviation) of the
risk-free asset is zero and its covariance with the risky asset is also
zero:
2 2 2
P =w i =) P = w i
I To represent the set of efficient portfolios in the standard

deviation/expected return space, we can write the expected return
of a portfolio as a function of the portfolio’s standard deviation:
⇥ ⇤ P
E rP = rf + (E [Ri ] rf )
i
Portfolio with a riskless and a risky asset (graph)

I The graph consisting of the risk-free asset and the stock of
Coca-Cola:
Portfolio with the riskless and more than one risky asset
I We can easily add risky assets, simply by combining the risk-free
with portfolios from the feasible portfolio set of risky assets:
Portfolio with the riskless and more than one risky asset
I Notice that the portfolio with the steepest slope dominates all other
portfolios. Hence, this is in fact the efficient frontier!
Which portfolio to choose?
I When we take the riskless asset into consideration, the efficient

frontier is the set of portfolios consisting of a non-negative weight
invested in the Tangent Portfolio M and the remainder invested in
the riskless asset.
I The portfolios lying on the efficient frontier dominate all other
feasible portfolios.
I Therefore, investors are better o↵ choosing a portfolio that is part of
the efficient frontier:
I More risk averse investors would choose a portfolio closer to the
riskless asset;
I Less risk averse investors would choose a portfolio closer to (or
above) the tangent portfolio M.
Efficient frontier and investor preferences

Properties of the Portfolio Frontier
I An interesting consequence of the MPT is that, in theory, all

investors should hold (in di↵erent proportions relative to their
wealth) the same portfolio of risky assets!
I Portfolios with an expected return lower than M involve a
combination of less than 100% of the investor’s wealth (w < 1)
invested in the Tangent Portfolio and, hence, a positive weight on
the riskless asset (lending).
I Portfolios with an expected return higher than M involve a
combination of more than 100% of the investor’s wealth (w > 1)
invested in the Tangent Portfolio and a negative weight on the
riskless asset (borrowing).
Outline
Portfolio Theory
Diversification

What is so special about the Tangent Portfolio?
I Suppose that we hold the Tangent Portfolio M and decide to

I increase the weight of a risky asset n
I decrease the weight of the riskless asset (by the same amount)
I What is the change in the expected return and the variance?
Change in Expected Return and Variance
I The change in the expected return is

⇥ ⇤
d E rP ⇥ ⇤
= E rn rf
d wn
I The change in the variance is
d P2 X
2
= 2 wn n +2 wm Cov rn , rm
d wn
m6=n
= 2 Cov rn , rM
where rM denotes the return of the tangent portfolio.

I Notice that the change in variance involves the covariance of asset n
with the tangent portfolio, but not its variance.
Measuring asset risk
I We have seen that when an asset is examined in isolation, the asset

risk is measured as the variance of its return.
I However, when an asset is examined as part of a portfolio, the risk
that matters is the covariance of the asset’s return with the
return of the portfolio.
I We are going to build on this in the next lecture.
The Buck for the Bang Ratio
I Define the Buck for the Bang Ratio as the ratio of change in the
expected return (buck) to the change in variance (bang).
I We have found this ratio to be
d E[ rP ] ⇥ ⇤
d wn E rn rf
d P2
=
2 Cov (rn , rM )
d wn
An important feature of the Tangent Portfolio
I The important property of the Tangent Portfolio M is that the Buck

for the Bang Ratio is the same for each asset n in the portfolio!
I Intuition:
I Suppose that the buck for the bang ratio is higher for asset n than
for asset m.
I Then, by buying n and selling m, we can increase the portfolio’s
return while its variance constant.
I Since an expected return higher than the efficient frontier is not
feasible, the buck for the bang ratios of assets n and m have to be
equal.
Takeaways
I Portfolio theory and the choice of an optimal portfolio under risk

aversion
I The limits of the benefit of diversification
I Optimal portfolio choice in the presence of a riskless asset
I Reconceptualise risk
Appendix: proof for the Buck for the Bang formula
I The change in the portfolio return being straightforward, I show

below the change in the portfolio variance in detail:
d P2 X
2
= 2 wn n +2 wm Cov rn , rm
d wn
m6=n
0 1
X
= 2 Cov rn , wn rn + 2 Cov @rn , wm r m A
m6=n
0 1
X
= 2 Cov @rn , wn rn + wm r m A
m6=n
= 2 Cov rn , rM

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Lecture 5: Portfolio theory

BEAM047A Fundamentals of Financial

Autumn Term, 2017/18

Optimal portfolio including a riskless asset

Implications on asset risk

Optimal portfolio including a riskless asset

Implications on asset risk

I In Lecture 4 we talked about portfolio construction, and specifically

The assumptions of portfolio theory

I The underlying assumptions of the MPT are:

Preference for higher return and lower variance

Risk aversion teasers

I Answers to these questions can characterise the risk attitude of an

I Risk aversion is the basis of portfolio theory.

I Risk aversion is typically expressed through the concavity of utility

I Incorporating utility functions into the standard deviation/expected

Indi↵erence curves (graphically)

The shape of indi↵erence curves (cont’d)

I The shape, and most importantly the slope, of an investor’s

Indi↵erence curves (graphically)

I Therefore, the optimal portfolio for an investor is the one that

Indi↵erence curves (graphically)

Optimal portfolio including a riskless asset

Implications on asset risk

Adding risky assets

I So far, we have considered the case of only two risky assets.

Feasible sets of three assets (by pairs)

Feasible sets of three assets (combined)

Feasible set with many assets

I Note that the feasible set of portfolios is no longer a line, but an

Portfolio and efficient frontiers

Portfolio and efficient frontiers (graph)

Adding many assets

I We have seen that diversification (adding non-perfectly correlated

I To answer this question, recall the formula for the variance of a

I Consider an equally-weighted portfolio consisting of N assets

I Substituting into the portfolio variance formula yields

And some evidence

I The evidence is very much consistent with the theoretical standard

Systematic vs Idiosyncratic Risk

I Consider a group of assets.

Optimal portfolio including a riskless asset

Implications on asset risk

Portfolio with a riskless and a risky asset

I Up to now, we have considered portfolios that consisted of risky

Portfolio with a riskless and a risky asset

I To represent the set of efficient portfolios in the standard

Portfolio with a riskless and a risky asset (graph)

Which portfolio to choose?

I When we take the riskless asset into consideration, the efficient

Efficient frontier and investor preferences

Properties of the Portfolio Frontier

I An interesting consequence of the MPT is that, in theory, all

Optimal portfolio including a riskless asset

Implications on asset risk

What is so special about the Tangent Portfolio?

I Suppose that we hold the Tangent Portfolio M and decide to

Change in Expected Return and Variance

I The change in the expected return is

where rM denotes the return of the tangent portfolio.

Measuring asset risk

I We have seen that when an asset is examined in isolation, the asset