Chap 08

Corporate Finance and Investment
Decisions and Strategies

9th edition
Chapter 8
Relationships between
investments: portfolio theory
Copyright © 2019, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Learning objectives
This chapter is designed to explore the financial equivalent of the maxim ‘don’t
put all your eggs in one basket’. In particular, it will help the reader:
• To understand the rationale behind the diversification decisions of
shareholders and companies.
• To explain the mechanics of portfolio construction with a user-friendly
approach to the key statistics, using numerical examples.
• To explore why optimal portfolio selection is a matter of personal choice.
• To examine the drawbacks of portfolio analysis as an approach to project
appraisal.
• A good grasp of the principles of portfolio analysis is an essential
underpinning to understanding the Capital Asset Pricing Model, to be
covered in Chapter 9.
Figure 8.1
Equal and offsetting fluctuations in
returns
PORTFOLIO ANALYSIS: THE BASIC
PRINCIPLES
• An investor can undertake one or both of the two investments, Apple and
Pear. Apple has a 50 per cent chance of achieving an 8 per cent return and a
50 per cent chance of returning 12 per cent. Pear has a 50 per cent chance of
generating a return of 6 per cent and a 50 per cent chance of yielding 14 per
cent. The two investments are in sectors of the economy that move in direct
opposition to each other. The investor expects the return on Apple to be
relatively high when that on Pear is relatively low, and vice versa. What
portfolio should the investor hold?
• First of all, note that the expected value (EV) of each investment’s return is
identical:
Investment Apple: EV = (0.5 * 8%) + (0.5 * 12%) = (4% + 6%) = 10%
Investment Pear: EV = (0.5 * 6%) + (0.5 * 14%) = (3% + 7%) = 10%
PRINCIPLES
• At first glance, it may appear that the investor would be indifferent
between Apple and Pear or, indeed, any combination of them. However,
there is a wide variety of possible expected returns according to how the
investor ‘weights’ the portfolio.
• For example, when Pear is the star performer, a portfolio comprising 20 per
cent of Apple and 80 per cent of Pear will offer a return of:
(0.2 * 8%) + (0.8 * 14%) = (1.6% + 11.2%) = 12.8%
When Apple is the star, the return is only:
(0.2 * 12%) + (0.8 * 6%) = (2.4% + 4.8%) = 7.2%
• Although there should be as many good years for Apple as for Pear,
resulting over the long term in an average return of 10 per cent, in the shorter
term, the investor would be over-exposed to the risk of a series of bad years
for Pear.
PRINCIPLES
• Consider a portfolio invested two-thirds in Apple and one-third in Pear.
When Apple is the star, the return on the portfolio (Rp) is a weighted
average of the returns from the two components:
Rp = (2/3 * 12%) + (1/3 * 6%) = (8% + 2%) = 10%
Conversely, when Pear is the star, the portfolio offers a return of:
Rp = (2/3 * 8%) + (1/3 * 14%) = (5.33% + 4.67%) = 10%
• With this combination, the risk-averse investor cannot go wrong! The
portfolio completely removes variability in returns as there are only two
possible states of the economy. Any rational risk-averse investor should
select this combination of Apple and Pear to eliminate risk for a guaranteed
10 per cent return.
HOW TO MEASURE PORTFOLIO RISK
• The expected return on a portfolio (ERp) comprising two assets, A and B,
whose individual expected returns are ERA and ERB, respectively, is given
by:
where 𝛼 and 1 − α are the respective weightings of assets A and B, with 𝛼 +

1 − α = 1.
• The riskiness of the portfolio expresses the extent to which the actual return
may deviate from the expected return. This may be expressed by the
variance of the return,𝜎!" , or by its standard deviation, 𝜎! .
where
𝛼 = the proportion of the portfolio invested in asset A
1 − α = the proportion of the portfolio invested in asset B
𝜎#" = the variance of the return on asset A
𝜎$" = the variance of the return on asset B
covAB = the covariance of the returns on A and B.
• The covariance, like the correlation coefficient, is a measure of the
interrelationship between random variables, in this case, the returns from
the two investments A and B. In other words, it measures the extent to
which their returns move together, i.e. their co-movement or co-
variability.
where RA is the realised return from investment A, ERA is the expected value of
the return from A, RB is the realised return from investment B, ERB is the
expected value of the return from B, and pi is the probability of any pair of
values occurring.
• The correlation coefficient between the return on A and the return on B, rAB,
is simply the covariance, normalised or standardised, by the product of
their standard deviations:
Table 8.1
Returns under different states of the
economy
Self-assessment activity 8.2
With the figures in Table 8.1, check that the expected values for both A and B
are 20 per cent, and that their respective standard deviations are 30 per cent
and 40 per cent, using the formulae presented in Chapter 7.
Table 8.2
Calculating the covariance
• If the covariance (which measures the degree of co- movement in absolute
terms) is zero, we will find the correlation coefficient (the relative measure
of co-movement) is also zero.
• When the covariance is zero, the third term is zero, and portfolio risk
reduces to:
• With zero covariance, portfolio risk is thus smaller for any portfolio
compared to cases where the covariance is positive. Even better, when the
covariance is negative, the third term becomes negative and risk falls even
further.
• The formula relating covariance and correlation coefficient (Equation 8.3)
can be rewritten as:
• Substituting into the expression for portfolio risk (Equation 8.2), we derive:
• From a risk-minimising perspective, the most advantageous value of the

coefficient is minus one, since when the portfolio is suitably weighted, the
standard deviation of the portfolio return can be reduced to zero.
• The minimum risk portfolio with two assets
• The expression for finding the weightings required to minimise the risk of a
portfolio comprising two assets, A and B, where 𝛼#∗ = the proportion
invested in asset A is:
• Substituting the figures for the AB example into Equation 8.4, we find:
• This formula tells us that, to minimise risk, we should place 64 per cent of
our funds in A and 36 per cent in B.
Verify that the standard deviation of this risk-minimising portfolio is 24 per cent.
PORTFOLIO ANALYSIS WHERE RISK
AND RETURN DIFFER
• Suppose we are offered the two investments, Z and Y, whose characteristics
are shown in Table 8.3. Which should we undertake? Or should we
undertake some combination? To answer these questions, we need to
consider the possible available combinations of risk and return. Notice that
correlation is negative.
Table 8.3
Differing returns and risks
Table 8.4
Portfolio risk–return combinations
Verify that the portfolio at B, involving 75 per cent of Z and 25 per cent of Y, is
the minimum risk combination.
PORTFOLIO ANALYSIS WHERE RISK
AND RETURN DIFFER
• For any combination along BC, we can achieve a higher return for the same
risk by moving to the combination vertically above it on AB. Point S is
clearly superior to T and, applying similar logic to the whole of BC, we are
left with the segment AB summarising all efficient portfolios, i.e. those that
maximise return for a given risk. AB is thus called the efficient frontier.
• However, we cannot specify an optimal portfolio, except for the outright
risk- minimiser, who would select the portfolio at B, and for the maximiser
of expected return, who would settle at point A (all Y). A risk-averse person
might select any portfolio along AB, depending on his or her degree of risk
aversion: that is, what additional return they would require to compensate
for a specified increase in risk.
DIFFERENT DEGREES OF
CORRELATION
• Say we are dealing with two investments, A and B, with asset A offering the
higher expected return but also carrying greater risk. These are shown in
Figure 8.3.
• Consider the following degrees of correlation:
1 Perfect positive. In this case, it is not possible to achieve a portfolio effect at all.
Combinations of A and B locate along the straight line AB. To achieve lower
risk levels, we would simply invest more in asset B, while the risk-minimising
‘portfolio’ is simply asset B alone.
2 Perfect negative. In this case, combinations along AXB all become possible.
With the returns from the two assets moving in perfect opposition to each
other, it is possible to eliminate risk by adding B to A, but only by weighting
the portfolio correctly is it possible fully to exploit the beneficial effect of
correlation. Maximum risk-reduction is achieved at point X where the portfolio
risk is zero. Combinations along XB are clearly inefficient.
DIFFERENT DEGREES OF
CORRELATION
3 Intermediate values. For correlation coefficients between + 1 and - 1, it is still
possible to generate a portfolio effect. The lower the correlation, i.e. the further
away from + 1, the greater the portfolio effect achievable. Two examples are
shown in Figure 8.3 as dotted curves between A and B.
Figure 8.3
The effect on the efficiency frontier of
changing correlation
WORKED EXAMPLE: GERRYBILD PLC
• Gerrybild plc is a firm of speculative housebuilders that builds in advance
of firm orders from customers. It has a given amount of capital to purchase
land and raw materials and to pay labour for development purposes. It is
considering two design types – a small two-bedroomed terraced town
house and a large four-bedroomed ‘executive’ residence. The project could
last a number of years, and its success depends largely on general economic
conditions, which will influence the demand for new houses. Some
information is available on past sales patterns of similar properties in
roughly similar locations – the demand is relatively higher for larger
properties in buoyant economic conditions, and higher for smaller
properties in relatively depressed states of the economy. Since there
appears to be a degree of inverse correlation between demand, and,
therefore, net cash flows, from the two products, it seems sensible to
consider diversified development. Table 8.5 shows annual net present value
estimates for various economic conditions.
Table 8.5
Returns from Gerrybild
1 Calculation of expected values.
EVL = Expected value of a large house = (0.5 * £20,000) + (0.5 * £40,000) =
£30,000
EVS = Expected value of a small house = (0.6 * £20,000) + (0.4 * £30,000) =
£24,000
2 Calculation of project risks. We now apply the usual expression for the
standard deviation. The calculations for each activity are shown in Table 8.6.
Clearly, the relative money-spinner, the large house project, is also the more
risky activity.
3 Calculation of co-variability. Table 8.7 presents the calculation of the covariance
in tabular form.
Table 8.6
Calculation of standard deviations of
returns from each investment
Table 8.7
Calculation of the covariance
• The covariance of -£20 million suggests a strong element of inverse
association. This is confirmed by the value of the correlation coefficient:
• There are clearly significant portfolio benefits to exploit. To offer concrete

advice to the builder, we would require information on his risk–return
preferences, but we can still specify the available set of portfolio
combinations.
• Using Equation 8.4, and defining 𝛼&∗ as the proportion of the portfolio (i.e.
proportion of the available capital) devoted to large houses to minimise
risk, we have:
• If Gerrybild wanted to minimise risk, it would have to invest 27 per cent of

its capital in developing large houses and 73 per cent in developing small
houses.
Verify that the lowest achievable portfolio standard deviation is £3,496 and the
expected NPV per house built from the minimum risk portfolio is £25,620.
Figure 8.4
Gerrybild’s opportunity set
Using Figure 8.4, distinguish between risk-minimisation and risk-aversion.
PORTFOLIOS WITH MORE THAN TWO
COMPONENTS
• Imagine three assets are available, A, B and C, for each of which we have
estimates of expected return and standard deviation, and also the
covariance (and hence correlation) between each pair of assets. Imagine
further that, whereas A and B are quite closely correlated, B and C are less
so, and that correlation between A and C is even weaker.
Figure 8.5
Portfolio combinations with three assets
PORTFOLIOS WITH MORE THAN TWO
COMPONENTS
• Using a technique called Quadratic Programming, developed by Sharpe
(1963), we can specify all available portfolios comprising one, two or three
assets. The full range of available portfolios, i.e. risk–return combinations, is
shown by the opportunity set in the form of an envelope, or ‘bat-wing’.
• The corners represent individual assets, while two-asset combinations are
shown by the solid curves AB and BC and the dotted profile AC. The
opportunity set thus moves inwards as assets with lower correlation are
included. However, he can now access even more attractive combinations
of A and C by combining all three assets. Points inside the envelope, or
along the outer boundary, represent all possible combinations of A, B and
C.
• Clearly, all points lying beneath the upper edge AE and those along the
segment EC are inefficient. The efficient set is therefore AE.
Draw an envelope of portfolios for the case where four assets are available to
invest in, either individually or as portfolios.
CAN WE USE THIS FOR PROJECT
APPRAISAL? SOME RESERVATIONS
• The Gerrybild example illustrates some drawbacks with the portfolio
approach to handling project risk.
1 Most projects can be undertaken only in a very restricted range of sizes or
even on an ‘all-or-nothing’ basis.
2 A more severe problem is the implication of constant returns to scale.
3 We should be wary of any approach that relies on subjective assessments of
probabilities, and wary of the probabilities themselves.
4 Since attitudes to risk determine choice, we need to know the decision-
maker’s utility function, which summarises his or her preferences for different
monetary amounts, if we wanted to pinpoint the optimal (as distinct from the
risk-minimising) portfolio.
5 The portfolio approach to analysing project risk seems unduly management-
oriented.
Question 1
Question 2
Question 3
Question 4

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Corporate Finance and Investment

Decisions and Strategies

where 𝛼 and 1 − α are the respective weightings of assets A and B, with 𝛼 +

• From a risk-minimising perspective, the most advantageous value of the

• There are clearly significant portfolio benefits to exploit. To offer concrete

• If Gerrybild wanted to minimise risk, it would have to invest 27 per cent of

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