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Chapter 6

Efficient
Diversification

McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
6.1 Diversification and Portfolio Risk

6-2
6.2 Asset Allocation With Two Risky
Assets: Return

W1 = Proportion of funds in Security 1


W2 = Proportion of funds in Security 2
r1 = Expected return on Security 1
r = Expected return on Security 2
2

n n
E(r p ) W r ;i i n # securities in the portfolio Wi = 1
i1 i=1

6-3
Two-Security Portfolio Return

E(rp) = W1r1 + W2r2


W1 = 0.6
W2 = 0.4
r1 = 9.28%
r2 = 11.97%
Wi = % of total money invested in security i

E(rp) = 0.6(9.28%) + 0.4(11.97%) = 10.36%

6-4
Combinations of risky assets
When we put stocks in a portfolio, p < (Wii).
Why?
Averaging principle
When Stock 1 has a return < E[r1] it is likely that
Stock 2 has a return > E[r2] so that rp that contains
stocks 1 and 2 remains close to E[rp].
What statistics measure the tendency for r1 to be
above expected when r2 is below expected?
Covariance and Correlation

6-5
Portfolio Variance and SD
Q Q
p [WI WJ Cov(rI , rJ )]
2

I 1 J 1

WI , WJ % of the total portfolio invested in stock I and J respective ly


Q The total number of stocks in the portfolio
Cov(rI , rJ ) Covariance of the returns of Stock I and Stock J

If I J then Cov (rI , rJ ) I 2 & Cov(r I , rJ ) Cov (rJ , rI )

Variance of a Two Stock Portfolio:


p 2 W12 12 2W1W2 Cov (r1, r2 ) W2 2 2 2

6-6
Expost Covariance Calculations
N (r r 1 ) (r 2,T r 2 )

n
Cov(r 1, r2 )
1,T

n 1 T 1 n
r1 average or expected return for stock 1
r 2 average or expected return for stock 2
n # of observatio ns

If when r1 > E[r1], r2 > E[r2], and when


r1 < E[r1], r2 < E[r2], then COV will be positive.
If when r1 > E[r1], r2 < E[r2], and when
r1 < E[r1], r2 > E[r2], then COV will be negative.

Which will average away more risk?

6-7
Covariance and Correlation
The problem with covariance

Covariance does not tell us the intensity of the comovement


of the stock returns, only the direction.

We can standardize the covariance however and calculate


the correlation coefficient which will tell us not only the
direction but provides a scale to estimate the degree to
which the stocks move together.

6-8
Measuring the Correlation Coefficient

Standardized covariance is called the correlation


coefficient or .

Cov(r 1, r2 )
(1,2)
1 2

For Stock 1 and Stock 2

6-9
and Diversification in a 2 Stock Portfolio
is always in the range -1.0 to +1.0 inclusive.

What does (1,2) = +1.0 imply?


The two are perfectly positively correlated. Means?
If (1,2) = +1, then (1,2) = W11 + W22

What does (1,2) = -1.0 imply?


The two are perfectly negatively correlated. Means?
If (1,2) = -1, then (1,2) = (W11 W22)
Are there any diversification benefits from combining 1 and 2?
It is possible to choose W1 and W2 such that (1,2) = 0.
There are very large diversification benefits from combining 1 and 2.

6-10
and Diversification in a 2 Stock Portfolio

What does -1 < (1,2) < 1 imply?


If -1 < (1,2) < 1 then
There are some diversification benefits from combining
stocks 1 and 2 into a portfolio.
p2 = W1212 + W2222 + 2W1W2 Cov(r1r2)

And since Cov(r1r2) = 1,2 1 2


p2 = W1212 + W2222 + 2W1W2 1,212

6-11
and Diversification in a 2 Stock Portfolio
Typically is greater than zero and less than 1.0

(1,2) = (2,1) and the same is true for the COV

The covariance between any stock such as Stock 1 and


itself is simply the variance of Stock 1,

(1,1) = +1.0 by definition

We have no measure for how three or more stocks move


together.

6-12
The Effects of Correlation & Covariance
on Diversification

Asset A, Asset B, Portfolio AB


6-13
The Effects of Correlation & Covariance
on Diversification

Asset C, Asset D, Portfolio CD


6-14
The Power of Diversification

Most of the diversifiable risk


eliminated at 25 or so stocks

6-15
Two-Security Portfolio: Risk

p2 = W1212 + W2222 + 2W1W2 Cov(r1r2)

12 = Variance of Security 1
22 = Variance of Security 2
Cov(r1r2) = Covariance of returns for Security 1 and
Security 2

6-16
Returns Squared deviations
ABC XYZ from average
1 0.2515 -0.2255 ABC XYZ Calculating
2 0.4322 0.3144 0.025192 0.119156
3 -0.2845 -0.0645 0.115206 0.037912
Variance and
4 -0.1433 -0.5114 0.14234 0.033926 Covariance
5 0.5534 0.3378 0.055734 0.398275
6 0.6843 0.3295 0.212171 0.047572 Ex post
7 -0.1514 0.7019 0.349896 0.04402
8 0.2533 0.2763 0.059624 0.338968
9 -0.4432 -0.4879 0.025767 0.024527
10 -0.2245 0.5263 0.287275 0.369166
AAR 0.09278 0.11969 0.100667 0.165332
Sum 1.37387 1.578853
Average 0.137387 0.157885

2ABC = 1.37387 / (10-1) = 0.15265


ABC = 39.07%
2XYZ = 1.57885 / (10-1) = 0.17543
XYZ = 41.88%
6-17
Returns Deviation from Product
ABC XYZ average of
1 0.2515 -0.2255 ABC XYZ deviations
2 0.4322 0.3144 0.15872 -0.34519 -0.05479
3 -0.2845 -0.0645 0.33942 0.19471 0.066088
4 -0.1433 -0.5114
-0.37728 -0.18419 0.069491
5 0.5534 0.3378 0.148988
-0.23608 -0.63109
6 0.6843 0.3295 0.100466
7 -0.1514 0.7019 0.46062 0.21811
0.124107
8 0.2533 0.2763 0.59152 0.20981
-0.14216
9 -0.4432 -0.4879 -0.24418 0.58221 0.025139
10 -0.2245 0.5263 0.16052 0.15661 0.325656
AAR 0.09278 0.11969 -0.53598 -0.60759 -0.12901
-0.31728 0.40661 Sum 0.533973
Average 0.053397

COV(ABC,XYZ) = 0.533973 / (10-1) = 0.059330


ABC,XYZ = COV / (ABCXYZ) = 0.059330 / (0.3907 x 0.4188)
ABC,XYZ = 0.3626 ABC = 39.07%
N (r r 1 ) (r 2,T r 2 )
XYZ = 41.88%
n
Cov(r 1, r2 )
1,T

n 1 T 1 n
6-18
Ex-ante Covariance Calculation

Using scenario analysis with probabilities the


covariance can be calculated with the following
formula:
S
Cov(rS , rB ) p (i ) rS (i ) rS rB (i ) rB
i 1

6-19
Two-Security Portfolio Risk
2ABC = 0.15265

2
Q Q ABC = 39.07% 2XYZ = 0.17543
p [WI WJ Cov(I, J)]
I 1J 1 XYZ = 41.88% COV(ABC,XYZ) = 0.05933
ABC,XYZ = 0.3626

p2 = W1212 + 2W1W2 Cov(r1r2) + W2222


Let W1 = 60%, W2 = 40%, Stock 1 = ABC; Stock 2 = XYZ
p2 = 0.36(0.15265) + 2(.6)(.4)(0.05933) + 0.16(0.17543)
p2 = 0.1115019 = variance of the portfolio
p = 33.39%
p < W11 + W22
33.39% < [0.60(0.3907) + 0.40(0.4188)] = 40.20%

6-20
Three-Security Portfolio n or Q = 3
Q Q
2
p [WI WJ Cov(r I , rJ )]
I 1J 1

2p = W1212 + W2222 + W3232


For an n security
portfolio there would be + 2W1W2 Cov(r1r2)
n variances and n(n-1)
covariance terms. The
+ 2W1W3 Cov(r1r3)
covariances are the
dominant effect on 2p. + 2W2W3 Cov(r2r3)

6-21
TWO-SECURITY PORTFOLIOS WITH
E(r)
DIFFERENT CORRELATIONS
WA = 0%
13%
WB = 100%
= -1
50%A
=0 = .3
50%B

8% = +1
WA = 100%
WB = 0%

12% 20% St. Dev


Stock A Stock B 6-22
Summary: Portfolio Risk/Return Two
Security Portfolio

Amount of risk reduction depends critically on


correlations or covariances.

Adding securities with correlations <1 will result in risk


reduction.

If risk is reduced by more than expected return, what


happens to the return per unit of risk (the Sharpe ratio)?

6-23
Minimum Variance Combinations
-1< < +1

Choosing weights to minimize the portfolio variance

6-24
Minimum Variance Combinations
-1< < +1
1

2 (.2) 2 - (.2)(.15)(.2)
2
- Cov(r1r2) (.2)2 - (.2)(.15)(.2)
W ==
W1 = W1
1
2 + (.2)2 - 2(.2)(.15)(.2)
1 + 2 - 2Cov(r1r2)
2 2 (.15)
(.15)2 + (.2)2 - 2(.2)(.15)(.2)
W2 = (1 - W1)
WW
1 = .6733
1 = .6733
Cov(r1r2) = 1,212 WW
2 = (1 - .6733) = .3267
= (1
2 - .6733) = .3267

6-25
Minimum Variance:
(.2)2 - (.2)(.15)(.2)
W1 =
Return
(.15) + (.2) and
2 2 Risk with = .2
- 2(.2)(.15)(.2)

W1 = .6733
W2 = (1 - .6733) = .3267
E[rp] = .6733(.10) + .3267(.14) = .1131 or 11.31%

p2 = W1212 + W2222 + 2W1W2 1,212


p (0.67332 ) (0.152 ) (0.3267 2 ) (0.22 ) 2 (0.6733) (0.3267) (0.2) (0.15) (0.2)
1/2

p 0.01711/ 2 13.08%

6-26
Minimum Variance Combination
with = -.3

(.2) 2 - (.2)(.15)(-.3)
2 2
- Cov(r1r2) (.2)2 - (-.3)(.15)(.2)
W1W=1 =
W1 =
2 + 22 - 2Cov(r1r2)
1
(.15) 2 2+ (.2)22 - 2(.2)(.15)(-.3)
(.15) + (.2) - 2(-.3)(.15)(.2)
W2 = (1 - W1)
W1 = .6087
Cov(r1r2) = 1,212
W2 = (1 - .6087) = .3913

6-27
Minimum 2 Variance
(.2) - (.2)(.15)(-.3) Combination
W1 =
2 2with-.3) = -.3
(.15) + (.2) - 2(.2)(.15)(

W1 = .6087
W2 = (1 - .6087) = .3913

E[rp] = 0.6087(.10) + 0.3913(.14) = .1157 = 11.57%

p2 = W1212 + W2222 + 2W1W2 1,212


p (0.6087 ) (0.15 ) (0.3913 ) (0.2 ) 2 (0.6087) (0.3913) (-0.3) (0.15) (0.2)
2 2 2 2

1

Notice lower portfolio 12 = .2


p 0.01021/ 2 10.09% SD but higher expected
E(rp) = 11.31%
return with smaller
p = 13.08%
6-28
Extending Concepts to All Securities
Consider all possible combinations of securities, with all possible
different weightings and keep track of combinations that provide
more return for less risk or the least risk for a given level of return
and graph the result.
The set of portfolios that provide the optimal trade-offs are described as
the efficient frontier.
The efficient frontier portfolios are dominant or the best diversified
possible combinations.
All investors should want a portfolio on the efficient frontier. Until
we add the riskless asset
Found by forming
Efficient Frontier is the best portfolios of securities
diversified set of investments with the lowest
with the highest returns covariances at a given
E(r) level.
6-29
The minimum-variance frontier of
E(r)
risky assets
Efficient
frontier

Individual
Global assets
minimum
variance
portfolio Minimum
variance
frontier

St. Dev.
6-30
The EF and asset allocation
E(r)
EF including
international &
alternative
investments
80% Stocks
100% Stocks Efficient
20% Bonds
60% Stocks frontier
40% Bonds
40% Stocks
60% Bonds

20% Stocks
80% Bonds

100% Stocks

Ex-Post 2000-
2002

St. Dev.
6-31
Efficient frontier for international
diversification Text Table 6.1

6-32
Efficient frontier for international
diversification Text Figure 6.11

6-33
6.3 The Optimal Risky Portfolio
With A Risk-Free Asset

6.4 Efficient Diversification With


Many Risky Assets

6-34
Including Riskless Investments

The optimal combination becomes linear.

A single combination of risky and riskless assets


will dominate.

6-35
ALTERNATIVE CALS
CAL (P) CAL (A)
E(r)
Efficient
E(rP&F) Frontier

P
E(rP)
CAL (Global
minimum variance)
E(rA) A
G

F
Risk Free

A P P&F
6-36
The Capital Market Line or CML
CAL (P) = CML
E(r)
Efficient
E(rP&F) Frontier

o The optimal CAL is


P
E(rP) called the Capital
Market Line or CML
E(rP&F) o The CML dominates
the EF

F
Risk Free

P&F P P&F 6-37


Dominant CAL with a Risk-Free Investment (F)
CAL(P) = Capital Market Line or CML dominates other lines
because it has the largest slope

Slope = (E(rp) - rf) / p


(CML maximizes the slope or the return per unit of risk or it
equivalently maximizes the Sharpe ratio)

Regardless of risk preferences some combinations of P & F


dominate

6-38
The Capital Market Line or CML
A=2
E(r) CML

Efficient
E(rP&F) Frontier

P Both investors
E(rP) choose the same well
diversified risky
E(rP&F) portfolio P and the
A=4 risk free asset F, but
they choose different
proportions of each.
F
Risk Free

P&F P P&F
6-39
Practical Implications
The analyst or planner should identify what they believe will
be the best performing well diversified portfolio, call it P.
P may include funds, stocks, bonds, international and other
alternative investments.
This portfolio will serve as the starting point for all their
clients.
The planner will then change the asset allocation between
the risky portfolio and near cash investments according to
risk tolerance of client.
The risky portfolio P may have to be adjusted for individual
clients for tax and liquidity concerns if relevant and for the
clients opinions.

6-40
6.5 A Single Index Asset
Market

6-41
Individual Securities
We have learned that investors should diversify.
Individual securities will be held in a portfolio.
Consequently, the relevant risk of an individual
security is the risk that remains when the security is
placed in a portfolio.
What do we call the risk that cannot be diversified
away, i.e., the risk that remains when the stock is put
into a portfolio? Systematic risk

How do we measure a stocks systematic risk?

6-42
Systematic risk
Systematic risk arises from events that effect the entire
economy such as a change in interest rates or GDP or a
financial crisis such as occurred in 2007 and 2008.

If a well diversified portfolio has no unsystematic risk


then any risk that remains must be systematic.

That is, the variation in returns of a well diversified


portfolio must be due to changes in systematic factors.

6-43
Individual Securities
How do we measure a stocks systematic risk?

Systematic Factors
Returns interest rates,
Returns well GDP,
Stock A diversified consumer spending,
portfolio etc.

6-44
Single Factor Model

Ri = E(Ri) + iM + ei

Two sources of Uncertainty


Ri = Actual excess return = ri rf
E(Ri) = Expected excess return
M = Some systematic factor or proxy; in this case M is
unanticipated movement in a well diversified broad
market index like the S&P500.
i = Sensitivity of a securities particular return to the factor.
ei = Unanticipated firm specific events.

6-45
Single Index Model Parameter Estimation

r r r r e
i f i i m f i

Risk Prem Market Risk Prem


or Index Risk Prem
i = the stocks expected excess return if the markets excess
return is zero, i.e., (rm - rf) = 0

i(rm - rf) = the component of excess return due to movements


in the market index

ei = firm specific component of excess return that is not due to


market movements

6-46
Risk Premium Format

Let: Ri = (ri - rf) Risk premium


format
Rm = (rm - rf)

The Model:
Ri = i + i(Rm) + ei

6-47
Estimating the Index Model

6-48
Estimating the Index Model
Scatter
Excess Returns (i)
Plot
Ri = i + iRm + ei

. .. . . . . Security
.
. . . . Characteristic

. .. . .. . . . Line

. .
. . . Excess returns
. .. .Variation
. . ..
. .
.
on market index
. in. R .explained by the line is
the. stocks
. . i
.
_____________
.. . . .Variation.in R unrelated to the market
systematic risk
i
(the line) is unsystematic
________________
risk
6-49
Components of Risk
iM + ei
Market or systematic risk:
Risk related to the systematic or macro economic factor
in this case the market index

Unsystematic or firm specific risk:


Risk not related to the macro factor or market index

Total risk = Systematic + Unsystematic


i2 = Systematic risk + Unsystematic Risk

6-50
Comparing Characteristic Security Lines

Describe


e
for each.

6-51
Measuring Components of Risk

i2 = i2 m2 + 2(ei)
where;
i2 = total variance
i2 m2 = systematic variance
2(ei) = unsystematic variance

6-52
Examining Percentage of Variance
Total Risk = Systematic Risk + Unsystematic Risk

Systematic Risk / Total Risk = 2


i2 m2 / i2 = 2
i2 m2 / (i2 m2 + 2(ei)) = 2

The ratio of the systematic risk to total risk is actually the


square of the correlation coefficient between the asset
and the market.

6-53
Advantages of the Single Index Model

Reduces the number of inputs needed to account


for diversification benefits
If you want to know the risk of a 25 stock portfolio
you would have to calculate 25 variances and
(25x24) = 600 covariance terms
With the index model you need only 25 betas,
Easy reference point for understanding stock risk.
M = 1, so if i > 1 what do we know?
If i < 1?

6-54
Sharpe Ratios and Alphas

When ranking portfolios and security performance we


must consider both return & risk

Well performing diversified portfolios provide high


Sharpe ratios:
Sharpe = (rp rf) / p

You can also use the Sharpe ratio to evaluate an


individual stock if the investor does not diversify

6-55
Sharpe Ratios and Alphas

Well performing individual stocks held in diversified


portfolios can be evaluated by the stocks alpha in
relation to the stocks unsystematic risk.

Skip Treynor-
Black Model

6-56
The Treynor-Black Model
Suppose an investor holds a passive portfolio M but
believes that an individual security has a positive alpha.
A positive alpha implies the security is undervalued.
Suppose it is Google.
Adding Google moves the overall portfolio away from the
diversified optimum but it might be worth it to earn the
positive alpha.
What is the optimal portfolio including Google?
What is the resulting improvement in the Sharpe ratio?

6-57
The Treynor-Black Model
Weight of Google in the optimal portfolio O:

WGO
W
*
; W *
1 W *
G Google, M Passive
1 WGO (1 G )
G M G

The improvement in the Sharpe ratio (S) over the Sharpe


of the passive portfolio M can be found as:

2
G
SO2 SM2 G ;
(e G ) (e G )

Notice that the improvement in the Sharpe ratio is a


function of

This ratio is called the information ratio


6-58
The Treynor-Black Model
For multiple stocks in the active portfolio:
n
i 1 2 n
i 2 (e ) 2 (e ) 2 (e ) 2 (e )
...
i 1 2 n

The optimal weight of each security in the active portfolio


is found as:
i
2 ( ei )
Wi *

i i 2 (ei )
A larger alpha increases the weight of stock i and larger
residual variance reduces the weight of stock i.

6-59
The Treynor-Black Model

If A stands for the active portfolio, the active


portfolios alpha, beta and residual risk can be
found from:
n n
A WiA iA ; A WiA iA
i i

&
n
(e A ) WiA2 iA
2 2

6-60
6-61
Treynor-Black Allocation
CAL
E(r) CML

P A

Rf

6-62
6.6 Risk of Long-Term
Investments

6-63
Are Stock Returns Less Risky in
the Long Run?
Consider the variance of a 2-year investment with
serially independent returns r1 and r2:
Var (2-year total return) = Var (r1 r2 )
Var (r1 ) Var (r2 ) 2Cov(r1 , r2 )
2 2 0
2 2 and standard deviation of the return is 2

The variance of the 2-year return is double that of the


one-year return and is higher by a multiple of the
square root of 2

6-64
Are Stock Returns Less Risky
in the Long Run?

Generalizing to an investment horizon of n years


and then annualizing:

Var(n year total return) n 2


Standard deviation( n year total return) n
One can show that for a portfolio of uncorrelat ed
stocks with identical

p
n

6-65
The Fly in the Time Diversification Ointment

The annualized standard deviation is only


appropriate for short-term portfolios

The variance grows linearly with the number of


years

Standard deviation grows in proportion to n

6-66
The Fly in the Time Diversification Ointment

To compare investments in two different time


periods:
Examine risk of the total rate of return rather than
average sub-period returns

Must account for both magnitudes of total returns and


probabilities of such returns occurring

6-67