Lecture 3

Portfolio theory
 Main insight
• A properly constructed portfolio can:
– „ increase expected return with no increase in
expected risk
– „reduce expected risk with no reduction in
expected return
• „For example, company X has standard
deviation of 4% and company Y has 6%.
When combined together in a portfolio,
the portfolio standard deviation is 2.4%
Which investment
would you choose?
What is the expected
return?
Risk and Return
How risky is each
investment?
What type of investor
are you?
Risk Attitudes or
Preferences
Which stocks would a risk-
averse investor avoid?
Measuring Risk and
Return
Estimating Return from
Historical Data
Estimating Risk from
Historical Data
Portfolio Risk and Return
The Portfolio Effect
Correlation & the
Portfolio Effect
Covariance and
Correlation
Maths of Covariance
and Correlation
 Covariance and
Correlation Example
 Covariance and
Correlation Example
 Covariance and
Correlation Example
Measuring Return for a
Portfolio
Portfolio Return
Calculation
Portfolio Risk
Portfolio Risk
Portfolio Risk Calculation
 What if there is
erfect correlation?
 Gains from
Diversification
 Gains from
Diversification
Quiz Break
 weighted
portfolio with constant
covariance, then
 The importance of
covariance as a
portfolio becomes large
 The importance of
covariance as a
portfolio becomes large
General principles
The components of risk
Unsystematic Risk
Systematic Risk
The components of risk
In summary…
But…
Investment Opportunity
Set
What’s Efficient?
Efficient Frontier
The efficient frontier
 Efficient Frontier
and Risky Portfolios
Dominant Portfolios in the
Investment Opportunity
Set
Adding the Risk-Free
Asset
 Return & Risk when the
Risk-Free Asset is Added
Investing in Portfolio A and
the Risk-free Asset
Would a Risk Averse
Investor
Take this Position?
 Not when ‘B’ Offers
Greater
Return for the Same Risk
 Investor
Take Any Position on Line
‘A’?
Not when Line ‘B’ Offers
Greater
Return for the Same Risk
B is preferred to A
 The Line with the
Greatest Slope - Dominates
Quiz Break