INVESTMENT ANALYSIS

&
PORTFOLIO MANAGEMENT

Lecture # 36
Dr.Shahid A. Zia 1
 Portfolio Selection
• Diversification is key to optimal risk
management.
• Analysis required because of the infinite number
of portfolios of risky assets.
• How should investors select the best risky
portfolio?
• How could riskless assets be used?

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 An Efficient Portfolio
• Smallest portfolio risk for a given level of
expected return.
• Largest expected return for a given level of
portfolio risk.
• From the set of all possible portfolios:
– Only locate and analyze the subset known as
the efficient set.
• Lowest risk for given level of return.

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 Building a Portfolio
• Step 1:
• Use the Markowitz portfolio selection model to
identify optimal combinations.
– Estimate expected returns, risk, and each
covariance between returns.
• Step 2:
• Choose the final portfolio based on your
preferences for return relative to risk.

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 Portfolio Theory
• Optimal diversification takes into account all
available information.
• Assumptions in portfolio theory:
– A single investment period (one year).
– Liquid position (no transaction costs).
– Preferences based only on a portfolio’s
expected return and risk.

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 Selecting an Optimal Portfolio
of Risky Assets
• Assume investors are risk averse.
• Indifference curves help select from efficient
set:
– Description of preferences for risk and return.
– Portfolio combinations which are equally
desirable.
– Greater slope implies greater the risk
aversion.

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 Selecting an Optimal Portfolio
of Risky Assets
• Markowitz portfolio selection model:
– Generates a frontier of efficient portfolios
which are equally good.
– Does not address the issue of riskless
borrowing or lending.
– Different investors will estimate the efficient
frontier differently.
• Element of uncertainty in application.

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 The Single Index Model
• Relates returns on each security to the returns
on a common index, such as the S&P 500 Stock
Index.

Ri  α i  βi RM  ei
• Divides return into two components:
– a unique part, i
– a market-related part, iRM

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 The Single Index Model

– It measures the sensitivity of a stock to stock

market movements.
– If securities are only related in their common
response to the market.
– Several covariances depend only on market
risk.

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 The Single Index Model
• Single index model helps split a security’s total
risk into:
– Total risk = market risk + unique risk
• Multi-Index models as an alternative:
– Between the full variance-covariance method
of Markowitz and the single-index model.

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 Selecting Optimal Asset Classes
• Another way to use Markowitz model is with
asset classes.
– Allocation of portfolio assets to broad asset
categories.
• Asset class rather than individual security
decisions most important for investors.
– Different asset classes offers various returns
and levels of risk.
• Correlation coefficients may be quite low.

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 Asset Allocation
• Decision about the proportion of portfolio assets
allocated to equity, fixed-income, and money
market securities.
– Widely used application of Modern Portfolio
Theory.
– Because securities within asset classes tend
to move together, asset allocation is an
important investment decision.
– Should consider international securities, real
estate, and U.S. Treasury TIPS.

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 Implications of Portfolio Selection
• Investors should focus on risk that cannot be
managed by diversification.
• Total risk =systematic (non-diversifiable) risk +
nonsystematic (diversifiable) risk
– Systematic risk:
• Variability in a security’s total returns
directly associated with economy-wide
events.

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Asset Pricing Models

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 Capital Asset Pricing Model
• CAPM focuses on the equilibrium relationship
between the risk and expected return on risky
assets.
• It builds on Markowitz portfolio theory.
• Each investor is assumed to diversify his or her
portfolio according to the Markowitz model.

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 CAPM Assumptions
• All investors:
– Use the same information to generate an
efficient frontier.
– Have the same one-period time horizon.
– Can borrow or lend money at the risk-free rate
of return.

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 CAPM Assumptions
• No transaction costs, no personal income taxes,
no inflation.
• No single investor can affect the price of a stock.
• Capital markets are in equilibrium.

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Borrowing and Lending Possibilities
• Risk free assets:
– Certain-to-be-earned expected return and a
variance of return of zero.
– No correlation with risky assets.
– Usually proxied by a Treasury security.
• Amount to be received at maturity is free of
default risk, known with certainty.
• Adding a risk-free asset extends and changes
the efficient frontier.
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 Risk-Free Lending
• Riskless assets can
L be combined with
B any portfolio in the
efficient set AB.
E(R) T
– Z implies lending
Z X
RF
• Set of portfolios on
A line RF to T
dominates all
portfolios below it.
Risk
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 Impact of Risk-Free Lending
• If wRF placed in a risk-free asset.
– Expected portfolio return:
E(Rp )  w RF RF  ( 1-w RF )E(R X )
– Risk of the portfolio:
σ p  ( 1-w RF )σ X

• Expected return and risk of the portfolio with

lending is a weighted average.

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 Borrowing Possibilities
• Investor no longer restricted to own wealth.
• Interest paid on borrowed money.
– Higher returns sought to cover expense.
– Assume borrowing at RF.
• Risk will increase as the amount of borrowing
increases.
– Financial leverage

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 The New Efficient Set
• Risk-free investing and borrowing creates a new
set of expected return-risk possibilities.
• Addition of risk-free asset results in:
– A change in the efficient set from an arc to a
straight line tangent to the feasible set without
the riskless asset.
– Chosen portfolio depends on investor’s risk-
return preferences.

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 Portfolio Choice
• The more conservative the investor the more is
placed in risk-free lending and the less
borrowing.
• The more aggressive the investor the less is
placed in risk-free lending and the more
borrowing.
– Most aggressive investors would use leverage
to invest more in portfolio T.

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 Market Portfolio
• Most important implication of the CAPM:
– All investors hold the same optimal portfolio of
risky assets.
– The optimal portfolio is at the highest point of
tangency between RF and the efficient
frontier.
– The portfolio of all risky assets is the optimal
risky portfolio.
• Called the market portfolio.

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 Characteristics of the
Market Portfolio
• All risky assets must be in portfolio, so it is
completely diversified.
– Includes only systematic risk.
• All securities included in proportion to their
market value.
• Unobservable but proxied by S&P 500.
• Unobservable but proxied by KSE 100 index.
• Contains worldwide assets.
– Financial and real assets.
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 Capital Market Line
• Line from RF to L
L is capital market
line (CML).
M
E(RM) • x = risk premium
=E(RM) - RF
x • y =risk =M
RF • Slope =x/y
y
=[E(RM) - RF]/M
M
• y-intercept = RF
Risk
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 The Separation Theorem
• Investors use their preferences (reflected in an
indifference curve) to determine their optimal
portfolio.
• Separation Theorem:
– The investment decision, which risky portfolio
to hold, is separate from the financing
decision.
– Allocation between risk-free asset and risky
portfolio separate from choice of risky
portfolio, T.
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 Separation Theorem
• All investors:
– Invest in the same portfolio.
– Attain any point on the straight line RF-T-L by
by either borrowing or lending at the rate RF,
depending on their preferences.
• Risky portfolios are not tailored to each
individual’s taste.

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 Capital Market Line
• Slope of the CML is the market price of risk for
efficient portfolios, or the equilibrium price of risk
in the market.
• Relationship between risk and expected return
for portfolio P (Equation for CML):

E(RM )  RF
E(R p )  RF  σp
σM

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 Security Market Line
• CML Equation only applies to markets in
equilibrium and efficient portfolios.
• The Security Market Line depicts the tradeoff
between risk and expected return for individual
securities.
• Under CAPM, all investors hold the market
portfolio.
– How does an individual security contribute to
the risk of the market portfolio?

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 Security Market Line
• A security’s contribution to the risk of the
market portfolio is based on beta.
• Equation for expected return for an individual
stock:

E(Ri )  RF  βi  E(RM )  RF 

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 Security Market Line
• Beta = 1.0 implies
SML
as risky as market.
E(R)
• Securities A and B
A are more risky than
kM B the market.
C – Beta >1.0
kRF
• Security C is less
risky than the
0 0.5 1.0 1.5 2.0
market.
BetaM – Beta <1.0

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 Security Market Line
• Beta measures systematic risk:
– Measures relative risk compared to the
market portfolio of all stocks.
– Volatility different than market.
• All securities should lie on the SML:
– The expected return on the security should be
only that return needed to compensate for
systematic risk.

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