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You are on page 1of 67

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

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

W1 = 0.6

W2 = 0.4

r1 = 9.28%

r2 = 11.97%

Wi = % of total money invested in security i

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

Q The total number of stocks in the portfolio

Cov(rI , rJ ) Covariance of the returns of Stock I and Stock J

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

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.

6-7

Covariance and Correlation

The problem with covariance

of the stock returns, only the direction.

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

coefficient or .

Cov(r 1, r2 )

(1,2)

1 2

6-9

and Diversification in a 2 Stock Portfolio

is always in the range -1.0 to +1.0 inclusive.

The two are perfectly positively correlated. Means?

If (1,2) = +1, then (1,2) = W11 + W22

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

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)

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

itself is simply the variance of Stock 1,

together.

6-12

The Effects of Correlation & Covariance

on Diversification

6-13

The Effects of Correlation & Covariance

on Diversification

6-14

The Power of Diversification

eliminated at 25 or so stocks

6-15

Two-Security Portfolio: Risk

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

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

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

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

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

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%

Stock A Stock B 6-22

Summary: Portfolio Risk/Return Two

Security Portfolio

correlations or covariances.

reduction.

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

6-23

Minimum Variance Combinations

-1< < +1

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%

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

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

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

Many Risky Assets

6-34

Including Riskless Investments

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

P

E(rP) called the Capital

Market Line or CML

E(rP&F) o The CML dominates

the EF

F

Risk Free

Dominant CAL with a Risk-Free Investment (F)

CAL(P) = Capital Market Line or CML dominates other lines

because it has the largest slope

(CML maximizes the slope or the return per unit of risk or it

equivalently maximizes the Sharpe ratio)

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

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.

then any risk that remains must be systematic.

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

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

or Index Risk Prem

i = the stocks expected excess return if the markets excess

return is zero, i.e., (rm - rf) = 0

in the market index

market movements

6-46

Risk Premium Format

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

Risk not related to the macro factor or market index

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

i2 m2 / i2 = 2

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

square of the correlation coefficient between the asset

and the market.

6-53

Advantages of the Single Index Model

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

must consider both return & risk

Sharpe ratios:

Sharpe = (rp rf) / p

individual stock if the investor does not diversify

6-55

Sharpe Ratios and Alphas

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

of the passive portfolio M can be found as:

2

G

SO2 SM2 G ;

(e G ) (e G )

function of

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

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

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

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?

and then annualizing:

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

appropriate for short-term portfolios

years

6-66

The Fly in the Time Diversification Ointment

periods:

Examine risk of the total rate of return rather than

average sub-period returns

probabilities of such returns occurring

6-67

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