Columbia Business School

AT THE VERY CENTER OF BUSINESS

B8306 Capital Markets and Investments

Spring 2023
Professor Brian P. Lancaster

Session 11: Portfolio Choice 2 – Portfolio Optimization

blancaster.nyc@gmail.com 860-898-0436
 Where We Are

Last lecture: Asset valuation

§ Dividend discount model (DDM)
§ Market prices versus fundamental values
§ Expected returns come from valuations (continued today)
§ DDM underlies the use of valuation multiples (next slide)

Today’s topic: Portfolio optimization

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 DDM vs. Multiples
§ Prices reflect expectations of returns (risk) and growth*
D (1 + g )
P0 = 0
E (r ) - g
§ So P/E multiples reflect risk and expected growth, too
§ DDM explains why some corp P/E ratios are high and others are low

P0 Payout (1 + g ) Dividends D0 = Payout * Earnings E0

= so this equation is same as one above
E0 E (r ) - g

§ P/E is high if risk is low and/or expected growth is high

§ To apply comparable assets’ P/E multiples to an asset, the
assets must have the same risk, growth, and payout
*Assumes LT investor who doesn’t sell. See slide 24, Session 9 for further details. E(r)=k=req. return. Bigger
required return, “k” the higher the risk. Lower required return “k” lower the risk.
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 Tools for Making
Investment Decisions

§ Good investments help us achieve two goals

§ High return (Assumption 1: Investors prefer more to less)
§ Low risk (Assumption 2: Investors are risk averse)

§ Decision-making tools to achieve these goals

§ Estimating expected returns (e.g., based on valuations)
§ Helps us achieve higher returns, what we’ve done so far
§ Diversification: dividing a portfolio across assets
§ Helps us achieve lower risk
§ Portfolio optimization: finding the best reward-risk trade-off

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 Long-run US Stock Market
E(r) from Valuation
§ Model 1: one-stage DDM with infinite holding period:
D0 (1 + g ) D &P 0 0

E (r ) = +g = current S&P500
Dividend and Index Use E(r) from
P0 valuation not
historical

§ For whole US stock mkt, E(r) = 1.367% × (1.04) + 4% = 5.42%*

§ Model 2: DDM w/ long-run payout**: g = (1 – Payout)×ROE

Replacement for D0/P0 above
E(r) = (1-g/ROE)(E0/P0)(1+g)+g

§ US mkt E(r) = (1 – 0.04/0.1711) × 0.0369% × (1.04) + 4% = 6.94%

*From slide 26, Session 9, S&P500 One can use historical numbers to estimate expected returns
**Using earnings and payout instead of dividends. E(r), but this method is unreliable. Valuation method is
Slide 27 Session 9. preferred even though it requires more work and difficult
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5
 Short-run E(r) from Valuation
§ If we hold the asset for one year and its price converges
to value in that year, the one-year expected return is:

V0 (1 + k )
E (r1 ) = -1 See slide 29 Session 9
for derivation of formula
P0

§ If value is 120% of today’s price V0/P0 and required

return on the investment is k = 6%, one-year expected
return is:
𝐸 𝑟# = 1.20 (1.06) − 1 = 27.2%

§ Since value > price, we find that E(r) > k

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 Historical Returns from
1972 to 2017
§ Past annual returns of US stock and European stocks
§ Excess return benchmark: US T-bills, risk-free for 1-year horizon

Europe
2(r)
Avg = E US Stocks Stocks
Average Excess Return 7.19% 7.18%
Volat = v:ar(r)
Annualized Volatility 17.85% 21.48%
𝑆𝐸 = v:ar(r)/𝑇 Std. Err. of Average Return 2.63% 3.17% Use LR
Volatility and
2(r) ± 2×𝑆𝐸
Conf Int = E
Confid. Interval Upper Bound 12.45% 13.52%
correlations
Confid. Interval Lower Bound 1.93% 0.85%
ρ: ij = c:ov(rH , rJ )/(K
σH σ
KJ ) Correlation w/ US Stocks 1.000 0.755
Correlation w/ Europe Stocks 0.755 1.000
Volat of return = square root of variance of returns = standard deviation of returns.
Standard Error of the Mean vs. Standard Deviation: The standard deviation (SD) measures the amount of variability,
or dispersion, for a subject set of data from the mean, while the standard error of the mean (SEM) measures how far
the sample mean of the data is likely to be from the true population mean ..
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 Historical E(r) Is Imprecise

§ Volatile realized returns give rise to high standard errors

§ U.S. mkt E(r) is between 2% and 12%, an unhelpfully wide range

§ Volatilities and correlations from history can be precise

§ But volatilities and correlations can change over time
§ Often wise to use a long-run average for long-run forecast
§ E.g., US volatility = 17.85% for last 46 years
§ Best guess is that this volatility will be similar in the future
§ E.g., US-Europe correlation = 0.755 for last 46 years
§ Caveat: correlations have an apparent positive trend from globalization

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 How to Build a Portfolio

§ Step 1: Estimate the relevant properties of asset returns

§ Expected returns—e.g., from valuations
§ Volatility and correlations—by extrapolating relevant history

§ Step 2: Find the “efficient risky portfolio” for all investors

§ All investors want to maximize reward per unit of risk

§ Step 3: Find the optimal amount of risk for an investor

§ Different investors have different risk aversion

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 Optimal Portfolio:
US-Europe Example

§ 1) Estimate US and European stock and T-bill returns

§ Expected returns of stocks from valuations; Treasuries from yields
§ Volatility and correlations of stocks based on relevant history

§ 2) Find efficient combo of US and European stocks

§ Highest expected excess return over T-bills per unit of volatility

§ 3) Mix this combo with T-bills to get right amount of risk

§ More risk averse investors will hold more T-bills

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 Step 2: Weight Risky Assets

§ Find best (most efficient) mix of US and European stocks

After fees E(r)* Volatility**
US Stocks 5.94% 17.85%
Eur. Stks 7.59% 21.48%
T-bills 1.82% 0%

§ Correlation of US and European stocks’ returns is 0.755

§ Would an investor prefer to mix these stocks and or simply

hold an undiversified portfolio (all US or all Europe)?
*This E(r) differs from the model 1 E(r) on slide 5 because it was for a different time than June 2021.
**Volatility and correlation assumptions from historic data slide 8.
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 Efficient Risk Taking

§ Diversification enables us to take risk efficiently by

adjusting weights on multiple risky assets
§ Sharpe ratio measures efficiency of risk taking

§ Sharpe ratio (SR) of a risky asset is its risk premium

(expected excess return) per unit of risk (volatility)
§ Consider the reward-risk trade-off for the US stock mkt:
Risk premium or expected excess return

SRUS = (E[rUS] – rf)/sUS = (0.0594 – 0.0182)/0.1785 = 0.231

Expected return US Stock volatility
Risk free
US Stocks
return
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 Try 80-20 US-Europe Mix:
Can We Do Better?
§ Evaluate efficiency of a more diversified risky portfolio

§ Expected return of an 80-20 US-Europe portfolio mix:

E(rp) = 0.8 * 0.0594 + 0.2 * 0.0759 = 6.27%
Correlation of US and Volatility of US and
European stocks’ returns Europe stocks
§ Return variance of an 80-20 portfolio mix:
var(rp) = 0.82 * 0.17852 + 0.22 * 0.21482 + 2 * 0.8 * 0.2 * 0.755 * 0.1785 * 0.2148
= 0.03150*
var(rp ) = w 2σ12 + (1 - w)2 σ 22 + 2w(1- w) cov(r1 , r2 ) **

§ Risk: Standard Deviation (volatility) of returns of an 80-20 mix:

volatility = sp = sqrt(0.03150) = 17.75%
*Values from slide 12 table for US and Europe.
**For more details re: how to calculate return variance and covariance see Appendix slide 32 - 35.
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 Risk = Standard Deviation of Returns
§ The variance of the rate of return is a measure of volatility. It measures
the dispersion of possible outcomes around the expected value. Volatility
is reflected in deviations of actual returns from the mean return.

§ TO prevent positive deviations from cancelling negative deviations we

calculate the expected value of the SQUARED deviations from the
expected return

§ The higher the dispersion of outcomes, the higher will be the average
value of these squared deviations. Therefore variance is a natural
measure of uncertainty.

§ When we calculate variance we square deviations from the mean and

therefore change units.

§ To get back to original units, we calculate the standard deviation as

the square root of the variance.
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 Risk = Standard Deviation of Returns

§ Is this US-Europe combo a more efficient way to take risk than

just investing in US stocks?

§ Look at the Sharpe ratio (excess return/unit of risk) to evaluate it.

§ Compare with Sharpe ratio of 100% US stock investment

Risk premium or expected excess return

SR80-20mix = (E[r80-20 mix] – rf)/s80-20mix = (0.0627 – 0.0182)/0.1775 = 0.2507

Expected return Risk free Volatility of

of 80-20 mix from Return T Bill 80-20 mix from
slide 14 slide 14

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 Diversification Can
Increase Sharpe Ratios

§ US-Europe example with a risk-free rate of 1.82%:

§ US Sharpe ratio (SR) = (0.0594 – 0.0182)/0.1785 = 0.231
§ Europe Sharpe Ratio = (0.0759 – 0.0182) / 0.2148 = 0.269
§ 80 US + 20 Europe mix SR = (0.0627 – 0.0182)/0.1775 = 0.251

§ Intuition: We get more bang

for each buck at risk by
spreading our eggs across
more baskets

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 Diversification vs.
Risk-Free Arbitrage

§ Amazingly, an 80-20 diversified mix allows us to get a higher expected

return (0.0627 mix vs 0.0594 US) and decreases our risk (volatility)
(0.1775 mix vs 0.1785 US)! (from previous slide)

§ It’s not risk-free arbitrage, but it’s still a great decision

§ Difference: The US-Europe mix could have a lower return than US

§ Implication: We should not hold undiversified portfolios

§ This doesn’t rule out speculating on specific stocks

§ Diversification is easy, important, and magical. Keep “I thank my fortune for it. My
in mind though that on average a diversified portfolio ventures are not in one bottom
trusted”, Shakespeare, 1596
is doing better but not always. Merchant of Venice

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 Maximize Sharpe Ratio

§ We will choose a risky portfolio to mix with a risk-free asset

by maximizing our compensation for taking risk

§ Optimal risky portfolio has the highest Sharpe ratio

§ So it’s also called the MEAN-VARIANCE EFFICIENT (MVE) portfolio

§ All risk-averse investors want to get the biggest reward for

each dollar at risk

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 Optimal Portfolio Tool:
How to Maximize Sharpe Ratio in Excel
§ Create placeholder cell for efficient weight (wUS) e.g. 100%
§ Express portfolio expected return (E(rp)) in terms of wUS
§ Express portfolio volatility (σp) in terms of wUS
§ Express Sharpe ratio (SR) in terms of E(r) and σp
§ Solver: Adjust weight to maximize SR*
wUS E(rp) σp SR Greatest
MVE 0.261 7.16% 19.63% 0.272 Sharpe
ratio
US 1.000
Start here with place-
holder weight 100% 5.94% 17.85% 0.231
Europe 0.000 7.59% 21.48% 0.269

*See Portfolio choice 2 Portfolio Calculations.xlsx on CANVAS for a model to solve

for weights to maximize portfolio Sharpe Ratio.
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 Summary:
Optimal Risky Portfolio (MVE*)
r1 = US return
r2 = European market return

Inputs* Outputs
E(r1) 5.94% w1 in MVE 26.1%
E(r2) 7.59% w2 in MVE 73.9%
σ1 17.85% E(rMVE) 7.16%
σ2 21.48% σMVE 19.63%
US stocks correlation ρ 0.755 SRMVE 0.272
with European stocks
rf 1.82%

*Mean variance efficient portfolio and Sharpe ratio

**Assumptions from slide 12.

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 Sharpe Ratios of Risky Portfolios
§ Let’s compare risky portfolios’ Sharpe ratios:
US Stocks’ Sharpe Ratio European Stocks’ Sharpe Ratio

§ Conclusion: Mean Variance Efficient MVE is the optimal risky portfolio

§ Consists of 26.1% US and 73.9% Europe

§ Has 7.16% expected return and 19.63% volatility

Common misconception is that diversification doesn’t help us if correlations are positive. While it’s true that diversification
helps more when correlations are low (or negative), it’s also true that diversification improves SR even with positive
correlations, as long as they’re less than perfect (1.0)—which is always true for assets that aren’t redundant.
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 Step 3: Set Amount of Risk
§ Once we determine the best risky asset (MVE) mix, we then
calculate how much of this risky asset (MVE) versus a risk free
asset (T-bills) we want i.e. how much risk we want.

§ Invest or borrow using the risk-free asset, T-Bill to set amount of risk
After fees E(r) Volatility
MVE 7.16% 19.63%
T-bills 1.82% 0%

How does an investor’s risk aversion affect her optimal weight on

the MVE?
§ More risk averse investors take less risk (less MVE; more T-bills)
§ Less risk averse investors take more risk (more MVE; fewer T-bills)
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 Mean Variance Utility
§ The optimal capital allocation to an investor will depend on 1) the risk
return tradeoff offered by the MVE risky portfolio, AND 2) the
investor’s attitude towards risk. Some investors are willing to take
greater risk, more MVE less T-Bill, others less MVE portfolio more T-Bill.

§ To measure and describe different investor’s individual levels of risk

aversion, the industry* uses a utility function to rank portfolios with
different expected returns and risk.
1
U p = E(rp ) – Aσ p2
2
return risk

§ By choosing the portfolio with the highest utility score Up, investors
optimize their trade-off between risk and return that is they achieve the
optimal allocation of capital to risky versus risk free assets.
*Chartered Financial Analysts (CFA) Institute

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 Mean-Variance Utility
§ We use a utility function to represent investor preferences for
higher expected return and lower risk
§ The mean-variance (MV) utility function of an investor is:
1
U p = E(rp ) – Aσ p2
2
§ E(rp) is the expected return of the investor’s portfolio (“return”)
§ sp2 is the return variance of the investor’s portfolio (“risk”)
§ The parameter A represents the investor’s risk aversion*
§ (Mean-Variance) Utility Up: how much an investor likes a portfolio
based on its expected return and variance (see slide 38 for derivation)

§ We can infer investors’ utility rankings from their choices

§ E.g., if investors prefer all MVE to all T-bills, then UMVE > UTBill 26
Lancaster
Spring 2023 *The greater A, the greater investor aversion to risk.
 Step 3: Set Amount of Risk
§ How much the variance of risky portfolios lowers investor’s “utility”
depends on A, the investors degree of risk aversion.

§ More risk averse investors will have larger values of A which penalize risky
investments more severely, resulting in lower U (utility).

1
U p = E(rp ) – Aσ p2
2
§ Less risk averse investors will have lower A values which penalize the
same risky investments less severely and so will have greater U (utility)
from the same risky investment.

§ Investors choosing among competing investment portfolios will select the

one with highest utility level (U) based on their risk return preferences.
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 Example: Utility with A = 2
§ Consider an investor with risk aversion (A) equal to 2
§ Would this investor prefer 100% MVE or 100% T-bills?

§ Solution: Compute the utility of each asset and compare

§ Use MVE E(r) = 7.16% & volat. = 19.63%; T-bill E(r) = 1.82% & 0 volat.

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 Optimal Portfolio Weights
§ The best mix of the risky MVE and risk-free asset (greatest Up) is:
Inputs from slide 24.
*
E[rMVE ] − rf 0.0716 – 0.0182
w = = 69.29%
MVE 2
Aσ MVE 2(0.1963)2

§ US example with A = 2:
Weight of MVE * Std. Dev. Of MVE
§ 69.3% MVE and 30.7% in risk-free:
“A”
Up = (0.693 * 0.0716 + 0.307 * 0.0182) – 0.5 * 2 * (0.693 * 0.1963)2 = 0.0367
E(rp)
Formula § How does the risky weight (w*) change with increases in: Compare
From p. 27
1. Expected return of the risky asset? Increases with UMVE
and Utbill
2. Volatility of the risky asset? Decreases on p. 28
3. Risk aversion of the investor? Decreases
*See Appendix, slide 41 for derivation.
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29
 Optimal Portfolio Summary

§ 1) We value all risky assets to get their expected returns

§ Estimate risk and correlations based on relevant history

§ 2) Take risk efficiently to maximize reward-risk Sharpe Ratio

§ MVE in our example: 26.1% US stocks; 73.9% Europe stocks

§ 3) Mix the efficient risky (MVE) portfolio with risk-free T-bills

§ 69.3% MVE, 30.7% risk-free T-bills for risk aversion of A = 2
§ Overall US stock allocation: 0.693 × 0.261 = 18.1%
§ Overall Europe stock weight: 0.693 × 0.739 = 51.2%

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 Logistics and Reminders
§ Quiz 6 available after class; due on Tuesday., before 8:30am
§ Review first two Portfolio Choice lectures

§ Problem Set 1 is due on Tuesday, Feb 28

§ Problem Set 2 is due on 11:59PM Sunday, March 5
§ Q2 builds on today’s analysis of an optimal portfolio
§ Next lecture’s analysis is helpful but not needed for Q2

§ Midterm March 6 6PM – March 12 11:59PM

§ Practice midterm has been made available on Canvas
§ Best way to study is to practice and review all notes

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 Appendix:
Portfolio Vocabulary

§ Diversification: dividing a portfolio across assets

§ Sharpe ratio: ratio of expected excess return to volatility

§ Mean-variance efficient (MVE) portfolio: the risky portfolio
with the highest Sharpe ratio

§ Complete portfolio: risky portfolio mixed w/ risk-free asset

§ (Mean-Variance) Utility: how much an investor likes a
portfolio based on its expected return and variance

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 Appendix: Portfolio Notation

Suppose we have a portfolio with N stocks:

§ Stock i’s return has a mean E(ri)
§ Stock i’s return variance is var(ri) = si2
§ The covariance of stock i’s return (ri) with stock’s return
j is given by cov(ri, rj)
§ The portfolio weight of each stock, wi, is:
$ value of stock i' s position
wi =
total $ value of portfolio

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 Appendix: Portfolio Return
Definitions
N
§ The return on the portfolio is given by: rp = å w i ri
i =1

§ The expected return on this portfolio is:

N
E(rp ) = å w i E(ri )
i =1

§ If historical returns in years t = 1, …, T are r1, r2, …, rT,

we can estimate the expected return using the average
past return: T
Ê(r) = å rt / T
t =1

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 Appendix: Variance and
Covariance of Returns
§ The variance of the return on this portfolio is:
N æ N ö
var(rp ) = å w i çç å w jcov(ri , rj ) ÷÷
i =1 è j=1 ø
N N N
var(rp ) = å w σ + 2åå w i w jcov(ri , rj )
2
i
2
i
i =1 i =1 j>i
§ For N = 2:
var(rp ) = w 2σ12 + (1 - w)2 σ 22 + 2w(1- w) cov(r1 , r2 )
§ We denote the correlation coefficient by ρ, where:
cov(ri , rj ) = ρ ijσ i σ j
§ Using historical returns as before, we can estimate the
covariance and correlation (using Excel or stats formula)
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 Appendix:
Estimating Return Variance

§ We can also estimate the return variance using historical

returns: T

å (r - Eˆ (r ))
2
t t
vâr(r ) = t =1
T
§ Estimate the volatility using the square root of var(r)
§ To annualize variance or average returns, multiply by the
number of periods per year
§ E.g., multiply by 52 for weekly return observations
§ To annualize volatility, multiply by the square root of the
number of periods per year (e.g., sqrt(12) for monthly)

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 Appendix: Risk in
Diversified Portfolios

§ Suppose we have an equally weighted portfolio (holding

weights 1/N) of N stocks
§ What is the variance of the portfolio’s return?
N N N
1 1
σ 2p = 2 å σ i2 + 2 åå cov(ri , rj )
N i =1 N i =1 j¹i

1 é 1 N 2 ù é 1 ùé 1 N N ù
σ = ê å σ i ú + ê1 - ú ê
2
p åå cov(ri , rj )ú
N ë N i =1 û ë N û ë N(N - 1) i =1 j¹i û
1 éaverage ù é 1 ù éaverage ù
σ = ê
2
+ ê1 - ú ê
N ë varianceû ë N û ëcovarianceúû
ú
p

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 Appendix: Risk in
Diversified Portfolios

§ What happens when N (# of stocks) goes to infinity?

§ Portfolio return variance = average return covariance

§ Risk of portfolio = Non-diversifiable risk

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 Appendix: Risk Reduction
in Diversified Portfolios
§ Suppose we initially hold a typical US stock: avg volatility = 40%
§ Now suppose we add US stocks to our portfolio with pairwise
correlations of 0.4, equally weighting all stock positions
45.0%
§ Top Line: How does portfolio risk
Stocks within a Country
decline as we divide (diversify) 40.0%
Stocks across Countries
our portfolio across more stocks 35.0%

Portfolio Volatility
in a single country? 30.0%

§ Diversified country portfolio has 25.0%

volatility of about 25% 20.0%

§ Bottom Line: How does portfolio 15.0%

risk decline as we diversify across 10.0%
stocks in multiple countries? 5.0%
§ Assumed correlations of 0.5 0.0%
0 10 20 30 40 50
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 Appendix: Step 2:
Efficient Risk Taking

Intuitive Problem (get the most bang for each $1 at risk):

§ Find the risky portfolio with the maximum Sharpe ratio:
æ E[rp ] - rf ö
max ç ÷
ç sp ÷
§ where w è ø
E[rp ] = w1 × E[r1 ] + (1 - w1 ) × E[r2 ]
σ p = w12 σ12 + (1 - w1 ) 2 σ 22 + 2 w1 (1 - w1 )ρσ1σ 2
§ Solution:
( E[r1 ] - rf ) × σ 22 - ( E[r2 ] - rf ) × ρσ1σ 2
w1MVE =
( E[r1 ] - rf )σ 22 + ( E[r2 ] - rf )σ12 - ( E[r1 ] - rf + E[r2 ] - rf ) ρσ1σ 2

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 Appendix: Step 3:
Optimal Complete Portfolio

§ Intuition: Find best mix of risky and risk-free asset

§ Math: Maximize utility given investment opportunities
[
max U(E[rp ], σ p2 ) = max E[rp ] - 1 2 A σ p2
w w
]
Inv. Opp: E[rp ] = rf + w × (E[r1 ] - rf ) and σ p2 = w 2 × σ12

§ How do we solve for the optimal weight?

§ Find the derivative with respect to weight (w), set it equal to
zero, and solve for w* (the optimal weight)
E[r1 ] - rf
w* =
Aσ12
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