COMM371 - Lecture 4 - Portfolio Theory

COMM371/COEC371 – Investment Theory
Lecture 4
Portfolio Theory
Instructors
Prof.LOGO
Alberto Mokak Teguia
VERSIONS
The UBC Sauder logo should always appear in its full colour version. The door frame is in green and the door
wordmark are in blue. However, there may be special circumstances where the logo has to appear on a colou
Jose Pizarro
background, in which case:
When the background is light, the logo should appear in the preferred full colour; however, there must be sig
contrast between the background and both the blue and green of the logo. Using grey as an example, the bac
James Shou
must be no darker than 15% black to use the full colour logo.
FULL COLOUR ON WHITE FULL COLOUR ON LIGHT

BACKGROUND (15% BLACK)
When the background is black or dark, the logo reverses to white.

1/79
Overview
Big question: How do we choose a portfolio of assets?
1. Return on a Portfolio of Assets
2. Expected Return and Variance of a Portfolio
3. Benefits of Diversification
4. Mean-Variance Criterion and the Portfolio Frontier
5. Portfolio Frontier with Multiple Risky Assets
6. Stock Market Indices
7. Limits of Diversification
2/79
Return on a Portfolio of Assets
3/79
Return on a Portfolio of Assets

Task: determine the return on a portfolio of assets given the returns
on the individual assets
Consider a portfolio consisting of VKO dollars in Coca-Cola
(ticker: KO) and VIBM dollars in IBM (ticker: IBM) and assume, for
simplicity, that no dividends are paid
The value of the portfolio at date 0 is Vp = VKO + VIBM
The value of the portfolio at date 1 is
VKO (1 + RKO ) + VIBM (1 + RIBM ),
where RKO is the net return on Coca-Cola and RIBM the net return
on IBM between dates 0 and 1
The net return on the portfolio is
VKO (1 + RKO ) + VIBM (1 + RIBM ) − Vp
Rp =
Vp
VKO VIBM
= RKO + RIBM
Vp Vp
4/79
Portfolio Weights
The portfolio weights on Coca-Cola and IBM are
VKO VIBM
wKO = and wIBM = .
Vp Vp
The portfolio weights represent the fractions of portfolio value
invested in the assets involved and, as such, they sum to 1.
The (net) portfolio return is
Rp = wKO RKO + wIBM RIBM .
The portfolio return is a weighted average of the returns on the
individual assets.
More generally, the return on a portfolio with N assets is
XN
Rp = wi Ri ,
i=1
Vi
where wi = Vpand Vi is the amount invested in the i-th asset.
PN
The weights still sum to one: i=1 wi = 1.
5/79
Example 1
Compute the return on a portfolio consisting of $3,000 in Coca-Cola

and $1,000 in IBM
We have
3, 000
wKO = = 0.75
4, 000
and
1, 000
wIBM = = 0.25.
4, 000
The return on this portfolio is
Rp = 0.75RKO + 0.25RIBM .
6/79
Example 2
Start with the same amount of initial capital $4,000. Instead of buying
$1,000 of IBM stock, we sell short $1,000 worth of the IBM stock.
Compute the return on the portfolio.
What are short sales?
How to compute the return on a portfolio that involves short

sales?
7/79
What are Short Sales?
A short sale consists of selling a stock that we do not own
Steps:
t = 0: borrow the stock from a broker
sell the stock on the market
t ∈ (0, 1): compensate the broker for any paid dividends
t = 1: buy the stock on the market

return the stock to the broker
A short sale is profitable if the stock price goes down
8/79
Portfolio Return with Short Sales

t = 0: borrow $1,000 worth of IBM stock and get $1,000 from selling it.
Invest $1,000+$4,000=$5,000 in Coca-Cola.
t = 1: – The Coca-Cola shares are worth $5,000(1 + RKO )

– Pay $1,000(1 + RIBM ) to buy the IBM shares back to return them to
the broker (why is it so?)
– Portfolio value is $5,000(1 + RKO )- $1,000(1 + RIBM )
Return on the portfolio is
5, 000(1 + RKO ) − 1, 000(1 + RIBM ) − 4, 000

Rp =
4, 000
= 1.25 × RKO − 0.25 × RIBM
Conclusion: Portfolio return is still weighted average of returns

on the individual stocks. However, weights of stocks that are sold
short are negative. The weights still sum to 1.
9/79
Expected Return and Variance of

a Portfolio
10/79
Expected Return and Variance of a Portfolio

Investors care about the average performance (i.e., expected
return) and the risk (i.e., volatility) of their investments
We already know how to estimate the expected return and the

volatility for a single asset
– But what to do for a portfolio?
– Can we apply that same approach?
Let’s say you want to hold an equally-weighted portfolio of

Coca-Cola and IBM
– What return can you expect to earn in one year from now?
– What is the volatility of that return?
What if we wish to compare many different portfolios?
11/79
Two-Asset Portfolio: Expected Return and Variance

Portfolio returns: Rp = wA RA + wB RB
– wi : proportion of funds invested in the asset i, where i = A, B
– Ri : return on the asset i, i = A, B
– Weights sum to 1: wA + wB = 1
Expected return:
E(Rp ) = wA E(RA ) + wB E(RB )

Alternative notation for expected return:
µp = wA µA + wB µB
Variance:
Var(Rp ) = wA2 Var(RA ) + wB2 Var(RB ) + 2wA wB Cov(RA , RB )
Alternative notation for variance:
σp2 = wA2 σA2 + wB2 σB2 + 2ρA,B wA wB σA σB
where ρA,B = ρ(RA , RB ) is the correlation between RA and RB
12/79
Portfolio Expected Return and Variance

Portfolio expected return is a weighted average of the expected
returns of the individual assets
In practice, we do not know the individual asset expected returns,
but can estimate them using sample averages
The variance of a portfolio return depends not only on the return
variances of the individual assets, but also on their covariances
of the individual asset returns
The variance of a portfolio return is greater when the covariances
are positive rather than negative and vice versa
The equations for portfolio return variance can be written in
terms of standard deviations and correlations, rather than
variances and covariances
In practice, we do not know the individual asset standard
deviations and correlations, but can estimate them using sample
standard deviations and correlations
13/79
KO & IBM Portfolio: Expected Return

Task: compute (an estimate of) the expected return of the portfolio
consisting of $3,000 in Coca-Cola and $1,000 in IBM.
Recall that the portfolio weights are: wKO = 0.75 and wIBM = 0.25
The expected returns µKO = E(RKO ) and µIBM = E(RIBM ) are

unknown but can be estimated by return sample averages
Estimating the (annualized) expected returns E(RKO ) and E(RIBM )

using the 1962/01-2022/12 monthly return sample, we obtain
µ̂KO = R KO = 14.84% and µ̂IBM = R IBM = 10.90%
The estimated portfolio expected return E(Rp ) is
µ̂p = R p = 0.75 × R KO + 0.25 × R IBM = 13.86%
14/79
KO & IBM Portfolio: Standard Deviation
Task: compute (estimates of) the variance and the standard deviation
of the portfolio consisting of $3,000 in Coca-Cola and $1,000 in IBM
The portfolio weights are: wKO = 0.75 and wIBM = 0.25

2 2
The variances σKO = Var(RKO ) and σIBM = Var(RIBM ) and the
correlation ρ(RKO , RIBM ) are unknown but can be estimated by
return sample variances
We estimate the (annualized) standard deviations σ(RKO ) and

σ(RIBM ) and the correlation ρ(RKO , RIBM ) using the
1962/01-2022/12 monthly return sample by
s(RKO ) = 23.49%, s(RIBM ) = 26.75%, ρ(RKO , RIBM ) = 27.56%
15/79
KO & IBM Portfolio: Standard Deviation (cont’d)
The estimated variance and standard deviation of the portfolio

return are:
s(Rp )2 = (0.75)2 × s(RKO )2 + (0.25)2 × s(RIBM )2

+2 × (0.75) × (0.25) × ρ(RKO , RIBM ) × s(RKO ) × s(RIBM )
= 0.0420
and
s(Rp ) = 20.49%
16/79
Benefits of Diversification
17/79
KO & IBM Portfolio: Benefits of Diversification
What if we consider other mixes of KO and IBM?
The table below represents the estimates of the expected return and
standard deviation of a KO/IBM portfolio, as we vary the weight, wKO ,
on Coca-Cola
wKO 0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0
E(Rp )[%] 10.90 11.30 11.69 12.08 12.48 12.87 13.27 13.66 14.06 14.45 14.84
σ(Rp )[%] 26.75 24.83 23.14 21.75 20.71 20.09 19.91 20.19 20.91 22.03 23.49
What do you notice?
18/79
A Useful Graph: The Portfolio Frontier

We can represent the previous information graphically, in the
standard deviation/expected return space. The set of portfolios that
we can generate by changing the portfolio weights is called the
portfolio frontier.
19/79
Portfolio Frontier and Diversification: Summary
The key observation from the table and the graph is that
diversification can reduce risk substantially
Many portfolios have a lower standard deviation than a pure

Coca-Cola or IBM investment
A diversified portfolio can have lower risk because the individual

stocks do not always move together
A second observation from the table and the graph is that

diversification does not necessarily reduce expected return
By including Coca-Cola in a pure IBM portfolio, we can raise

expected return
20/79
Portfolio Risk Reduction: Correlation Effects
Recall that the portfolio variance is given by
σp2 = wA2 σA2 + wB2 σB2 + 2ρA,B wA wB σA σB
The magnitude of risk reduction depends on the correlation
The smaller the correlation, the greater the risk reduction

potential
Maximum possible risk reduction when ρA,B = −1
No risk reduction possible when ρA,B = 1
21/79
Portfolio Risk Reduction: Correlation Effects
Extreme case 1: ρA,B = −1 (perfectly negative correlation)
σp2 = wA2 σA2 + wB2 σB2 − 2wA wB σA σB = (wA σA − wB σB )2

σB
σp2 = 0 if wA =
σA + σB
– Resulting portfolio is riskless
Extreme case 2: ρA,B = 1 (perfectly positive correlation)
σp2 = wA2 σA2 + wB2 σB2 + 2wA wB σA σB = (wA σA + wB σB )2

σp = wA σ A + wB σ B
– Both portfolio expected return and standard deviation are simple

weighted averages
22/79
Effect of Change in Correlation
E(R_A)= 18% sigma(R_A)= 28.00%

E(R_B)= 14% sigma(R_B)= 20.00%
rho(R_A,R_B)= -0.5 Portfolio Portfolio rho(R_A,R_B)= 0.5 Portfolio Portfolio

expected standard expected standard
return deviation return deviation
w_A= 0 14.00% 20.00% w_A= 0 14.00% 20.00%
0.1 14.40% 16.78% 0.1 14.40% 19.55%
0.2 14.80% 14.06% 0.2 14.80% 19.42%
0.3 15.20% 12.20% 0.3 15.20% 19.60%
0.4 15.60% 11.62% 0.4 15.60% 20.10%
0.5 16.00% 12.49% 0.5 16.00% 20.88%
0.6 16.40% 14.55% 0.6 16.40% 21.92%
0.7 16.80% 17.39% 0.7 16.80% 23.19%
0.8 17.20% 20.69% 0.8 17.20% 24.64%
0.9 17.60% 24.26% 0.9 17.60% 26.26%
1 18.00% 28.00% 1 18.00% 28.00%
23/79
The investment opportunity set consists of two stocks, A and B
We will consider portfolios of A and B for different values of the

correlation coefficient ρA,B
Stock Mean µ StdDev σ

A 18% 28%
B 14% 20%
24/79

Portfolio Expected Return:
µp = wA µA + (1 − wA )µB
0.2
0.19
0.18
Portfolio Return Mean
0.17
0.16
0.15
0.14
0.13
0.12
0 0.2 0.4 0.6 0.8 1
Portfolio Weight wA
25/79

Portfolio Volatility:
q
σP = wA2 σA2 + (1 − wA )2 σB2 + 2wA (1 − wA )ρA,B σA σB
0.3
Portfolio Return Standard Deviation
0.25
0.2
0.15
0.1
0.05 = -1
=0
=1
0
0 0.2 0.4 0.6 0.8 1
Portfolio Weight wA
26/79
The Portfolio Frontier – Volatility vs Expected Return

Putting the two previous graphs together
0.2
0.19
0.18
Portfolio Return Mean
0.17
0.16
0.15
0.14
= -1
0.13 =0
=1
0.12
0 0.05 0.1 0.15 0.2 0.25 0.3
Diversification crucially depends on correlation BACKGROUND MATERIAL
27/79
Mean-Variance Criterion and the

Portfolio Frontier
28/79
Mean-Variance Criterion
Attractive portfolios are represented by points that lie to the

"northwest" of the expected-return/standard-deviation graph
These portfolios have high expected return and low volatility
Mean-variance criterion:
Portfolio A dominates portfolio B if E(RA ) ≥ E(RB ) and σA ≤ σB
If portfolio A dominates portfolio B then all investors prefer A to B
Portfolios on the downward sloping portion of the portfolio frontier

are inefficient (as they are dominated by portfolios in the upward
sloping portion)
The upward sloping portion of the portfolio frontier is called the

efficient frontier
29/79
KO-IBM Example: Efficient Frontier
30/79
Optimal Portfolio Selection with Two Risky Assets

How do we optimally choose a portfolio of assets?
According to the mean-variance criterion, any investor would

optimally select a portfolio on the efficient frontier
The particular portfolio on the efficient frontier depends on the

investor’s risk preferences, in particular on how they trade off risk
and return
What happens if, in addition to the two risky assets, there is

a risk-free asset?
It turns out that there exists a unique portfolio on the efficient

frontier that any investor would optimally combine with the
risk-free asset. To determine this portfolio (we will do this later),
we first need to consider combinations of the risk-free asset and
risky portfolios, called complete portfolios.
31/79
Combining a Risky Asset Portfolio with the Risk-free

Asset
A combination of a risky asset portfolio, with return Rp , and the
risk-free asset, with return Rf , is called a complete portfolio
Allocating more to the risk-free asset leads to risk reduction
Let wp be the fraction of funds invested in the risky portfolio.
Then, the complete portfolio return is
Rc = wp Rp + (1 − wp )Rf
Expected return of the complete portfolio:
E(Rc ) = wp E(Rp ) + (1 − wp )Rf
Variance and standard deviation of the complete portfolio return
Var(Rc ) = wp2 Var(Rp ), σ(Rc ) = wp σ(Rp )
assuming a long position in the risky portfolio
32/79
Capital Allocation Line

wp : fraction invested in the risky asset portfolio
Complete portfolio expected excess return:

E(Rc ) − Rf = wp (E(Rp ) − Rf )
Complete portfolio standard deviation:

σ(Rc ) = wp σ(Rp ) ⇒ wp = σ(Rc )/σ(Rp )
So, for every complete portfolio
E(Rc ) − Rf E(Rp ) − Rf
=
σ(Rc ) σ(Rp )
or
E(Rp ) − Rf
E(Rc ) = Rf + Sp σ(Rc ), where Sp =
σ(Rp )
33/79
Capital Allocation Line: Graph

Suppose the risk-free rate is Rf = 0.02 and the risky portfolio P has
expected return µp = 0.07 and volatility σp = 0.16. The following
graph depicts the Capital Allocation Line for the portfolio P.
Capital Allocation Line (CAL)
0.1
0.09
w p=1.25
0.08
Portfolio Expected Return
p
=0.07
0.07 P
0.06
0.05
w p=0.5
0.04
0.03
F
0.02
R f =0.02
0.01
p
=0.16
0
0 0.05 0.1 0.15 0.2 0.25
Portfolio Standard Deviation
34/79
Slope of the Capital Allocation Line
The slope of the Capital Allocation Line associated with Rp is
E(Rp ) − Rf
Sp =
σ(Rp )
Sp is the increase in expected return per unit of additional

standard deviation
Sp is called the reward-to-variability ratio or Sharpe ratio
35/79
Risk Tolerance and Asset Allocation
All complete portfolios on the CAL offer the same

reward-to-variability ratio
Risk tolerance determines the mix between risk-free and risky

assets
More risk averse investors pick a point on CAL closer to the point
(0, Rf )
Less risk averse investors pick a point on CAL closer to the point
(σ(Rp ), E(Rp ))
Investors willing to accept high levels of risk for high levels of

returns would invest in leveraged portfolios
36/79
Choosing the Optimal Complete Portfolio

An investor can select a complete portfolio in a number of ways
For example, the investor might have a target expected portfolio
return. Using the CAL, one can easily determine the unique
complete portfolio that achieves the investor’s goal.
Similarly, the investor might have a target portfolio return
volatility. Again, using the CAL, one can easily determine the
unique complete portfolio that achieves the investor’s goal.
In general, the optimal complete portfolio for an investor will
depend on the investor’s preferences, and her/his attitude
towards risk in particular.
A simple and intuitive way to formalize a risk averse investor’s
preferences is to use the so-called mean-variance utility function.
Note that risk averse investors prefer higher expected returns
and lower return volatility
37/79
Mean-variance Utility Function

The mean-variance utility function of a risk averse investor is
– increasing in expected return (µ)
– decreasing in volatility (σ)
γ 2
U =µ− σ
2
– γ: coefficient of risk aversion
Recall that
– µc = Rf + wp (µp − Rf )
– σc = wp σp
Plug into U to get

γ 2 2
U = Rf + wp (µp − Rf ) − w σ
2 p p
The investor’s optimal portfolio is the one that gives the highest
utility
38/79
Mean-variance Utility Function (cont’d)

Let Rf = 0.02, µp = 0.07, σp = 0.16, γ = 5. The following graph
depicts the mean-variance utility and the optimal weight that
maximizes it.
0.035
0.03
0.025
0.02
U
0.015
0.01
0.005
0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
wP
Mathematically, set first derivative equal to 0

γ 2 2
max U = max Rf + wp (µp − Rf ) − wp σp
wp wp 2
∂U 2 ∗ 1 µp − Rf
= µp − Rf − γwp σp = 0 =⇒ wp =
∂wp γ σp2
For the example above, the optimal risky share is wp∗ = 0.39
39/79
Optimal Risky Share and Risk Attitude

1 µp −Rf
The optimal risky share wp∗ = γ σp2 is (a) increasing in the risky
asset expected return µp , (b) decreasing in the risky asset volatility
σp , and (c) decreasing in the investor’s risk aversion γ. The following
graph depicts the optimal risky share as a function of the risk
aversion γ (for the example on the previous slide).
0.9
0.8
Optimal Risky Share
0.7
0.6
0.5
0.4
0.3
0.2
0.1
2 3 4 5 6 7 8 9 10
Risk aversion
40/79
Combining Risky Assets with the Risk-free Asset

Let the investment opportunity set consist of two risky assets, one
stock fund and one bond fund. The expected returns, standard
deviations, and the correlation are given by
µs = E(Rs ) = 11%, µb = E(Rb ) = 5%,

σs = σ(Rs ) = 22%, σb = σ(Rb ) = 10%,
ρsb = ρ(Rs , Rb ) = 0.3
Consider forming complete portfolios using the risk-free asset

(Rf = 2%) and risky portfolios based on stocks and bonds. We start
by considering the portfolio with the smallest possible variance.
The minimum variance portfolio is determined by solving the
optimization problem
min ws2 σs2 + (1 − ws )2 σb2 + 2ws (1 − ws )ρsb σs σb

ws
41/79
Minimum Variance Portfolio
Portfolio MV is the minimum variance portfolio and uses weights

wsMV = 7.52% and wbMV = 92.48%. In general, the
minimum variance portfolio weights are given by:
σb2 − ρsb σs σb σs2 − ρsb σs σb

wsMV = , w MV
b = .
σs2 + σb2 − 2ρsb σs σb σs2 + σb2 − 2ρsb σs σb
The expected return and standard deviation of portfolio MV are

E(RMV ) = 5.45% and σ(RMV ) = 9.87%. The reward-to-variability
ratio for portfolio A is
E(RMV ) − Rf 5.47 − 2.00

SMV = = = 0.350.
σ(RMV ) 9.87
42/79
Capital Allocation Line of the MV Portfolio

Stock-Bond Portfolio Frontier
0.14
0.12
S
0.1
CAL MV
0.08
0.06
MV
B
0.04
0.02 F
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4

43/79
Can we Do Better than the MV portfolio?

The stock fund offers a higher expected return than the bond fund.
So, it is worth examining a portfolio that allocates more to the stock
fund compared to the MV portfolio. Consider an alternative portfolio Q
with weights wsQ = 20% and wbQ = 80%. The expected return and
standard deviation of portfolio Q are E(RQ ) = 6.20% and
σ(RQ ) = 10.22%. The reward-to-variability ratio for Q is
E(RQ ) − Rf 6.20 − 2
SQ = = = 0.411.
σ(RQ ) 10.22
Which risky portfolio is better, MV or Q?

Portfolio Q is better than MV because it offers higher expected
return for every percentage point increase in standard deviation
CALQ is steeper than CALMV
Risk averse investors prefer risky portfolios with high
reward-to-variability ratios
44/79
Tangent Portfolio
Question: Can we do better than portfolio Q? That is, can we

make the CAL slope even higher?
Remember: every risky portfolio should be located on the

mean-variance frontier
The optimal risky portfolio choice is the tangent portfolio
Tangent portfolio weights:
wsTP = 1 − wbTP
(E(Rb )−Rf )σs2 −(E(Rs )−Rf )ρsb σs σb

wbTP = (E(Rb )−Rf )σs2 +(E(Rs )−Rf )σb2 −(E(Rb )−Rf +E(Rs )−Rf )ρsb σs σb
45/79
Tangent Portfolio (cont’d)
The portfolio weights for the tangent portfolio are wsTP = 45% and
wbTP = 55%.
The expected return and standard deviation of the optimal
portfolio, denoted by TP, are E(RTP ) = 7.70% and
σ(RTP ) = 12.69%.
The CAL that corresponds to the optimal portfolio TP has a slope
of
E(RTP ) − Rf 7.70 − 2
STP = = = 0.449.
σ(RTP ) 12.69
This slope is higher than the slope of any other feasible risky
portfolio
The tangent portfolio is also called the optimal risky portfolio
46/79
Capital Allocation Line of the Tangent Portfolio

CALTP
0.14
0.12
S
0.1
CAL MV
0.08
TP
0.06
MV
B
0.04
0.02 F
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4

47/79
Forming a Complete Portfolio
We can now use the mean-variance utility approach to determine the

optimal complete portfolio. For risk aversion coefficient γ = 5, we
obtain that the complete portfolio invests w ∗ = γ1 µTPσ−R
2
f
= 70.84% on
TP
∗
the tangent portfolio and 1 − w = 29.16% on the risk-free asset.
The expected return and the standard deviation of the complete
portfolio C are:
E(RC ) = Rf + w ∗ (E(RTP ) − Rf ) = 2% + 0.7084 × (7.70% − 2%) = 6.04%
σ(RC ) = w ∗ σ(RTP ) = 0.7084 × 12.69% = 8.99%
The overall asset allocation of the complete portfolio is

Weight on risk-free asset 1 − w∗ = 1 − 70.84% = 29.16%
Weight on stock portfolio wsTP w ∗ = 45% × 70.84% = 31.88%
Weight on bond portfolio wbTP w ∗ = 55% × 70.84% = 38.96%
Total 100%
48/79
Optimal Complete Portfolio

CALTP
0.14
0.12
S
0.1
0.08
TP
0.06 C
MV
B
0.04
0.02 F
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4

49/79
Portfolio Frontier with Multiple

Risky Assets
50/79
Portfolios of Multiple Risky Assets: Expected Return
Suppose there are N risky assets to be combined in a portfolio
wi : fraction of funds invested in asset i, where i = 1, . . . , N
The portfolio expected return is
E(Rp ) = w1 E(R1 ) + · · · + wN E(RN )
That is, the expected return of the portfolio is the weighted

average of expected returns of individual assets in the portfolio
51/79
Portfolios of Multiple Risky Assets: Variance
In the case of two assets the variance of the portfolio return is the
sum of the following four boxes:
Variance components
Asset 1 Asset 2
Asset 1 w12 σ(R1 )2 w1 w2 Cov(R1 , R2 )
Asset 2 w2 w1 Cov(R2 , R1 ) w22 σ(R2 )2
Recall that Cov(R1 , R2 ) = Cov(R2 , R1 ).

So, we get the usual formula
σp2 = w12 σ(R1 )2 + w22 σ(R2 )2 + 2w1 w2 Cov(R1 , R2 )
52/79
Portfolios of Multiple Risky Assets: Variance

In the case of N risky assets the variance of the portfolio return is the
sum of the following N 2 boxes:
Variance components
Asset 1 Asset 2 ··· Asset N
Asset 1 w12 σ(R1 )2 w1 w2 Cov(R1 , R2 ) ··· w1 wN Cov(R1 , RN )
Asset 2 w2 w1 Cov(R2 , R1 ) w22 σ(R2 )2 ··· w2 wN Cov(R2 , RN )
.. .. .. .. ..
. . . . .
Asset N wN w1 Cov(RN , R1 ) wN w2 Cov(RN , R2 ) ··· wN2 σ(RN )2
The terms on the diagonal are variances and the terms off the
diagonal are covariances
The portfolio return variance is the sum of all terms:

XN XN
σ(Rp )2 = wrow wcol Cov(Rrow , Rcol )
row=1 col=1
53/79
Portfolio Frontier for Multiple Risky assets

Optimal combinations of individual assets result in minimum level
of risk for a given level of expected returns
So, for a given target value of E(Rp ), we solve for the weights wi ,
i = 1, . . . , N, to minimize the portfolio return variance
The optimal expected return-risk trade-off is described as the

Efficient frontier is the set of portfolios with maximum expected

return for a given level of variance
The efficient frontier is the upward-sloping part of the

Complete portfolios using the risk-free asset are formed as in the

case of two risky assets
54/79
The Portfolio Allocation Optimization Problem

Among all portfolios that have a given expected return, denoted
by µ, which one is the portfolio with the minimum variance?
Choose portfolio weights wi , i = 1, . . . , N, to minimize

N
X X
Var(Rp ) = wi2 Var(Ri ) + 2 wi wj Cov(Ri , Rj )
i=1 1≤i<j≤N
subject to the constraints

N
X
wi = 1
i=1
and
N
X
E(Rp ) = wi E(Ri ) = µ.
i=1
55/79
Simulated Portfolios of 3 ETFs
Randomly simulated weights are used to generate portfolios of 3

assets: SPY (US equity ETF), TLT (US long-term bond ETF),
and GLD (gold ETF). The inputs (i.e., annualized expected
returns, volatilities, and correlations) are estimated using monthly
data from January 2005 to June 2023. The results appear on the
following slide.
The mean-variance frontier (boundary in the graph, in blue)

contains the portfolios with the lowest volatility for a given level of
expected return. Any portfolio in the interior (in red) is dominated
by some portfolio on the frontier.
56/79
Simulated Portfolios of 3 ETFs
57/79
Example: International Diversification

We examine the benefits of international diversification by comparing three sets of ETFs: (a)
(SPY,EWC), (b) (SPY,EWC,EFA), and (c) (SPY,EWC,EFA,EEM), where SPY is a US equity ETF,
EWC is a Canadian equity ETF, EFA is an equity ETF representing Europe, Australia, Asia and Far
East, and EEM is an Emerging Markets equity ETF. The graph presents the three frontiers using
inputs (i.e., annualized expected returns, volatilities, and correlations) estimated using monthly data
from January 2006 to June 2023.
58/79
Example: Correlation Dynamics

The benefits of diversification depend on the correlation among the selected assets. That said, it’s
worth noting that as returns evolve, the correlation between them may change. To illustrate this
point, we estimate the sample correlation using a 5-year “rolling window”. That is, for later month in
the sample, we use the 60 prior monthly returns to estimate the correlation. This analysis allows us
to visualize how the sample correlation between SPY (US equity ETF) and TLT (US long-term bond
ETF) changed from between January 2005 and June 2023.
59/79
Stock Market Indices
60/79
Stock Market Indices
Indices are stock portfolios (“baskets”) typically based on a large

number of stocks
Stock Indices can be constructed in various ways

– Price-weighted
Dow Jones Industrial Average (DJIA)
– Value-weighted
Standard and Poor’s Composite 500 (S&P 500)
– Equally-weighted
Center for Research in Security Prices (CRSP) Index
61/79
Price-weighted (PW) indices
Computed by averaging prices of all securities in the index

1
P30
– Example: DJIAt = 30 i=1 Pit
Return to a PW index is equivalent to return on a portfolio with

equal shares of each firm in the index
– Price-weighted indices correspond to buy-and-hold strategies
Gives high weights to high-price stocks
The divisor used in the averaging (e.g., 30 for DJIA) has to be

adjusted for splits and replacements
62/79
Value-weighted (VW) indices

Calculated by adding the market value of the firms in the index
Example (3 stocks):
– It = n1t P1t + n2t P2t + n3t P3t = MV1t + MV2t + MV3t
– nit : number of outstanding shares for firm i at time t
– MVit : market value of firm i at time t
Return to a VW index is equivalent to the return on a portfolio

with weights proportional to the market capitalizations of the
firms in the index
– Value-weighted indices correspond to buy-and-hold strategies
Example: S&P 500

– More broadly based index than DJIA
– Unaffected by stock splits

63/79
Equally-weighted (EW) indices

Return to an EW index is computed as the equally-weighted
average of returns of all stocks in the index
Example (3 stocks):
EW
Rt+1 = 13 (R1,t+1 + R2,t+1 + R3,t+1 ) (weights still sum to 1)
Corresponds to a portfolio strategy that places equal dollar value

in each stock
Does not correspond to a buy-and-hold strategy. In other words,

it requires rebalancing
Example: CRSP index
64/79
Example of Stock Index Construction
A B C Market
Price $20 $15 $25
# of Shares Outstanding 1250 2000 1800
Capitalization $25,000 $30,000 $45,000 $100,000
Index Portfolio Value $10,000
Price-Weighted Index A B C Total

Number of Shares 166.67 166.67 166.67 500.00
Dollar Amount $3,333.33 $2,500.00 $4,166.67 $10,000.00
Portfolio Weight 0.33 0.25 0.42 1
Value-Weighted Index A B C Total

Dollar Amount $2,500.00 $3,000.00 $4,500.00 $10,000.00
Number of Shares 125.00 200.00 180.00 505.00
Equal-Weighted Index A B C Total

Dollar Amount $3,333.33 $3,333.33 $3,333.33 $10,000.00
Number of Shares 166.67 222.22 133.33 522.22
65/79
Various Stock Market Indices

US Stock Market Indices
– New York Stock Exchange Index (VW)
– American Stock Exchange Index (VW)
– NASDAQ Composite, NASDAQ 100 (VW)
– Russell 2000 (VW, small capitalization firms)
– Wilshire 5000 (VW, "total market index")
International Stock Market Indices

– S&P/TSX Composite Index (Canada)
– Nikkei (Japan)
Tokyo Stock Exchange
Nikkei 225, Price-weighted, 225 largest stocks
Nikkei 300, Value-weighted
– FTSE (U.K.)
London Stock Exchange
Value-weighted, 100 largest stocks
– DAX (Germany)
– Hang Seng (Hong Kong)
– MSCI (Morgan Stanley Capital International) stock indices
66/79
Limits of Diversification
67/79
Limits of Diversification
Adding assets to a portfolio reduces the variance that can be

achieved for a given expected return
This is simply another way to say that diversification reduces risk
Question: How much can risk be reduced? Can it be reduced to

zero, by adding a very large number of assets?
68/79
Theory . . .
Consider an equally-weighted portfolio of N assets
Assume that
a. all assets have the same standard deviation (σ)
b. all assets are equally correlated with each other (correlation ρ ≥ 0).
The portfolio return variance is equal to

2 2 1 N −1
σp = σ + ρ
N N
The portfolio volatility relative to the individual asset volatility is

r
σp 1 N −1
= + ρ
σ N N
69/79
Theory . . .
σp √ √ √
As N increases, we have σ → ρ ( 0.1 = 0.316, 0.2 = 0.447)
σ(Portfolio Return)/σ(Individual Asset Return)
1
ρ=0
0.9 ρ = 0.1
ρ = 0.2
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 20 40 60 80 100 120 140 160 180 200
Number of Assets
70/79
. . . and some Evidence

Consider an equally weighted portfolio of randomly selected NYSE-listed stocks.
Standard Ratio of Portfolio Std. Dev.

Number of Stocks
Deviation of to
in Portfolio
Portfolio Single Stock Std. Dev.
1 49.2% 1.00
2 37.4 0.76
4 29.7 0.60
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.
This is consistent with the theory, under the assumption that the
average correlation is around 0.2.
71/79
The Power of Diversification
Most of the diversifiable risk eliminated at 25 or so stocks (from

different industries)
72/79
Systematic vs. Idiosyncratic Risk

Consider a group of assets
Systematic Risk: Risk which affects all assets

– If, for instance, the assets are Canadian stocks, systematic risk
corresponds to events affecting the Canadian economy
Idiosyncratic Risk: Risk which affects only one asset

– For stocks, it corresponds to events affecting only the particular
company
Diversification within the group of assets reduces, and eventually

eliminates, idiosyncratic risk
However, it cannot reduce systematic risk
Diversification outside the group of assets (if it is possible) is

more effective in reducing risk
73/79
Background Material: Covariance

and Correlation
MAIN TEXT
74/79
Covariance and Correlation
Why does diversification work? The answer is related to

correlation which is a measure of how two returns comove in the
same or opposite direction.
Consider two assets with returns RA and RB . The correlation

between RA and RB is defined by:
Cov (RA , RB )
ρ (RA , RB ) = ,
σ (RA ) σ (RB )
where the covariance is defined by
Cov (RA , RB ) = E ([RA − E (RA )] [RB − E (RB )]) .
75/79
Properties of Covariance and Correlation

Covariance and correlation have the same sign. They are:
– positive, if RA and RB tend to increase or decrease at the same time
– zero, if RA and RB are unrelated (uncorrelated)
– negative, if RA tends to be high when RB is low or vice versa
Covariance is a linear operator. Let X , Y and Z be random

variables and a, b constants. Then
Cov (aX + bY , Z ) = aCov (X , Z ) + bCov (Y , Z )
The same rule does not apply to correlation!
Covariance of a random variable with itself is its variance:
Cov (X , X ) = Var (X )
76/79
Properties of Correlation
Correlation is “normalized” covariance
Correlation is easier to interpret as it is always a number

between -1 and 1
Correlation is:
– equal to 1 if there is an exact linear relation with positive slope
between the two random variables (perfectly positively
correlated)
– equal to -1 if there is an exact linear relation with negative slope

between the two random variables (perfectly negatively
correlated)
77/79
How to Interpret Correlation of Returns
If returns of two assets are positively correlated,

ρ(RA , RB ) ∈ (0, 1), a positive return of one asset is more likely to
be accompanied by a positive return by the other asset
(compared to the likelihood of a negative return)
It is also true that if two assets are positively correlated,

ρ(RA , RB ) ∈ (0, 1), a negative return on one asset is more likely
to be accompanied by a negative return on the other asset
(compared to the likelihood of a positive return)
Correlation is a probabilistic statement about the extent to

which prices co-move.
Correlation only measures a linear dependence between asset

returns.
78/79
Sample Correlation
Consider two time series of returns RA and RB : RA,1 , . . . , RA,T

and RB,1 , . . . , RB,T
The (population) correlation ρ (RA , RB ) is estimated by the

sample correlation
1
PT
T −1 t=1 RA,t − R A RB,t − R B
r (RA , RB ) =
s (RA ) s (RB )
The numerator is the sample covariance while s (RA ) and s (RB )

are the two sample standard deviations
In Excel, sample covariance is computed through the

“COVARIANCE.S(·, ·)” function and sample correlation through
the “CORREL(·, ·)” function.
79/79

COMM371 - Lecture 4 - Portfolio Theory

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

COMM371 - Lecture 4 - Portfolio Theory

Uploaded by

Copyright:

Available Formats

COMM371/COEC371 – Investment Theory

FULL COLOUR ON WHITE FULL COLOUR ON LIGHT

When the background is black or dark, the logo reverses to white.

Big question: How do we choose a portfolio of assets?

1. Return on a Portfolio of Assets

2. Expected Return and Variance of a Portfolio

4. Mean-Variance Criterion and the Portfolio Frontier

5. Portfolio Frontier with Multiple Risky Assets

6. Stock Market Indices

Return on a Portfolio of Assets

Return on a Portfolio of Assets

Compute the return on a portfolio consisting of $3,000 in Coca-Cola

The return on this portfolio is

What are short sales?

How to compute the return on a portfolio that involves short

What are Short Sales?

A short sale consists of selling a stock that we do not own

t ∈ (0, 1): compensate the broker for any paid dividends

t = 1: buy the stock on the market

A short sale is profitable if the stock price goes down

Portfolio Return with Short Sales

t = 1: – The Coca-Cola shares are worth $5,000(1 + RKO )

Return on the portfolio is

5, 000(1 + RKO ) − 1, 000(1 + RIBM ) − 4, 000

Conclusion: Portfolio return is still weighted average of returns

Expected Return and Variance of

Expected Return and Variance of a Portfolio

We already know how to estimate the expected return and the

– Can we apply that same approach?

Let’s say you want to hold an equally-weighted portfolio of

– What is the volatility of that return?

What if we wish to compare many different portfolios?

Two-Asset Portfolio: Expected Return and Variance

E(Rp ) = wA E(RA ) + wB E(RB )

Portfolio Expected Return and Variance

KO & IBM Portfolio: Expected Return

The expected returns µKO = E(RKO ) and µIBM = E(RIBM ) are

Estimating the (annualized) expected returns E(RKO ) and E(RIBM )

µ̂KO = R KO = 14.84% and µ̂IBM = R IBM = 10.90%

The estimated portfolio expected return E(Rp ) is

µ̂p = R p = 0.75 × R KO + 0.25 × R IBM = 13.86%

KO & IBM Portfolio: Standard Deviation

The portfolio weights are: wKO = 0.75 and wIBM = 0.25

We estimate the (annualized) standard deviations σ(RKO ) and

s(RKO ) = 23.49%, s(RIBM ) = 26.75%, ρ(RKO , RIBM ) = 27.56%

KO & IBM Portfolio: Standard Deviation (cont’d)

The estimated variance and standard deviation of the portfolio

s(Rp )2 = (0.75)2 × s(RKO )2 + (0.25)2 × s(RIBM )2

KO & IBM Portfolio: Benefits of Diversification

What if we consider other mixes of KO and IBM?

What do you notice?

A Useful Graph: The Portfolio Frontier

Portfolio Frontier and Diversification: Summary

Many portfolios have a lower standard deviation than a pure

A diversified portfolio can have lower risk because the individual

A second observation from the table and the graph is that

By including Coca-Cola in a pure IBM portfolio, we can raise

Portfolio Risk Reduction: Correlation Effects

Recall that the portfolio variance is given by

σp2 = wA2 σA2 + wB2 σB2 + 2ρA,B wA wB σA σB

The magnitude of risk reduction depends on the correlation

The smaller the correlation, the greater the risk reduction