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The Mathematics of Diversification
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O! This learning, what a thing it is!

- William Shakespeare
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Outline
Introduction
Linear combinations
Single-index model
Multi-index model
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Introduction
The reason for portfolio theory
mathematics:
• To show why diversification is a good idea

• To show why diversification makes sense
logically
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Introduction (cont’d)
Harry Markowitz’s efficient portfolios:
• Those portfolios providing the maximum return
for their level of risk

• Those portfolios providing the minimum risk
for a certain level of return
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Linear Combinations
Introduction
Return
Variance
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Introduction
A portfolio’s performance is the result of
the performance of its components
• The return realized on a portfolio is a linear
combination of the returns on the individual
investments

• The variance of the portfolio is not a linear
combination of component variances
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Return
The expected return of a portfolio is a
weighted average of the expected returns of
the components:

1
1
( ) ( )
where proportion of portfolio
invested in security and
1
n
p i i
i
i
n
i
i
E R x E R
x
i
x
=
=
(
=
¸ ¸
=
=
¿
¿
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Variance
Introduction
Two-security case
Minimum variance portfolio
Correlation and risk reduction
The n-security case
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Introduction
Understanding portfolio variance is the
essence of understanding the mathematics
of diversification
• The variance of a linear combination of random
variables is not a weighted average of the
component variances
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Introduction (cont’d)
For an n-security portfolio, the portfolio
variance is:

2
1 1
where proportion of total investment in Security
correlation coefficient between
Security and Security
n n
p i j ij i j
i j
i
ij
x x
x i
i j
o µ o o
µ
= =
=
=
=
¿¿
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Two-Security Case
For a two-security portfolio containing
Stock A and Stock B, the variance is:

2 2 2 2 2
2
p A A B B A B AB A B
x x x x o o o µ o o = + +
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Two Security Case (cont’d)
Example

Assume the following statistics for Stock A and Stock B:







Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
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Two Security Case (cont’d)
Example (cont’d)

What is the expected return and variance of this two-
security portfolio?







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Two Security Case (cont’d)
Example (cont’d)

Solution: The expected return of this two-security
portfolio is:








| | | |
1
( ) ( )
( ) ( )
0.4(0.015) 0.6(0.020)
0.018 1.80%
n
p i i
i
A A B B
E R x E R
x E R x E R
=
(
=
¸ ¸
( (
= +
¸ ¸ ¸ ¸
= +
= =
¿
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Two Security Case (cont’d)
Example (cont’d)

Solution (cont’d): The variance of this two-security
portfolio is:








2 2 2 2 2
2 2
2
(.4) (.05) (.6) (.06) 2(.4)(.6)(.5)(.224)(.245)
.0080 .0216 .0132
.0428
p A A B B A B AB A B
x x x x o o o µ o o = + +
= + +
= + +
=
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Minimum Variance Portfolio
The minimum variance portfolio is the
particular combination of securities that will
result in the least possible variance

Solving for the minimum variance portfolio
requires basic calculus
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Minimum Variance
Portfolio (cont’d)
For a two-security minimum variance
portfolio, the proportions invested in stocks
A and B are:

2
2 2
2
1
B A B AB
A
A B A B AB
B A
x
x x
o o o µ
o o o o µ
÷
=
+ ÷
= ÷
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Minimum Variance
Portfolio (cont’d)
Example (cont’d)

Assume the same statistics for Stocks A and B as in the
previous example. What are the weights of the minimum
variance portfolio in this case?







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Minimum Variance
Portfolio (cont’d)
Example (cont’d)

Solution: The weights of the minimum variance portfolios
in this case are:







2
2 2
.06 (.224)(.245)(.5)
59.07%
2 .05 .06 2(.224)(.245)(.5)
1 1 .5907 40.93%
B A B AB
A
A B A B AB
B A
x
x x
o o o µ
o o o o µ
÷ ÷
= = =
+ ÷ + ÷
= ÷ = ÷ =
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Minimum Variance
Portfolio (cont’d)
Example (cont’d)









0
0.2
0.4
0.6
0.8
1
1.2
0 0.01 0.02 0.03 0.04 0.05 0.06
W
e
i
g
h
t

A

Portfolio Variance
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Correlation and
Risk Reduction
Portfolio risk decreases as the correlation
coefficient in the returns of two securities
decreases
Risk reduction is greatest when the
securities are perfectly negatively correlated
If the securities are perfectly positively
correlated, there is no risk reduction
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The n-Security Case
For an n-security portfolio, the variance is:
2
1 1
where proportion of total investment in Security
correlation coefficient between
Security and Security
n n
p i j ij i j
i j
i
ij
x x
x i
i j
o µ o o
µ
= =
=
=
=
¿¿
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The n-Security Case (cont’d)
The equation includes the correlation
coefficient (or covariance) between all pairs
of securities in the portfolio
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The n-Security Case (cont’d)
A covariance matrix is a tabular
presentation of the pairwise combinations of
all portfolio components
• The required number of covariances to compute
a portfolio variance is (n
2
– n)/2

• Any portfolio construction technique using the
full covariance matrix is called a Markowitz
model
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Single-Index Model
Computational advantages
Portfolio statistics with the single-index
model
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Computational Advantages
The single-index model compares all
securities to a single benchmark
• An alternative to comparing a security to each
of the others

• By observing how two independent securities
behave relative to a third value, we learn
something about how the securities are likely to
behave relative to each other
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Computational
Advantages (cont’d)
A single index drastically reduces the
number of computations needed to
determine portfolio variance
• A security’s beta is an example:

2
2
( , )
where return on the market index
variance of the market returns
return on Security
i m
i
m
m
m
i
COV R R
R
R i
|
o
o
=
=
=
=
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Portfolio Statistics With the
Single-Index Model
Beta of a portfolio:


Variance of a portfolio:

1
n
p i i
i
x | |
=
=
¿
2 2 2 2
2 2
p p m ep
p m
o | o o
| o
= +
~
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Portfolio Statistics With the
Single-Index Model (cont’d)
Variance of a portfolio component:


Covariance of two portfolio components:

2 2 2 2
i i m ei
o | o o = +
2
AB A B m
o | | o =
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Multi-Index Model
A multi-index model considers independent
variables other than the performance of an
overall market index
• Of particular interest are industry effects
– Factors associated with a particular line of business

– E.g., the performance of grocery stores vs. steel
companies in a recession
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Multi-Index Model (cont’d)
The general form of a multi-index model:

1 1 2 2
...
where constant
return on the market index
return on an industry index
Security 's beta for industry index
Security 's market beta
retur
i i im m i i in n
i
m
j
ij
im
i
R a I I I I
a
I
I
i j
i
R
| | | |
|
|
= + + + + +
=
=
=
=
=
= n on Security i