Chapter 5

Modern Portfolio
Concepts
 Required computations (10-12)

• Various return concepts (HPR, IRR, realized return, expected

return)
• Compute the average return and standard deviation on a
time series using excel.
• Compute the mean/expected return and standard deviation
given scenarios with probabilities.
• Compute the mean return, beta of a portfolio of multiple
assets
• Compute the standard deviation of a two-asset portfolio
• Apply CAPM to compute required rate of return, return
sensitivity to market moves, and market risk premium.

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 Rank investment projects and beyond

• Suppose the riskfree rate (Rf) is 5%. We have two projects that we
can invest in. Project A has a projected mean return of 10% and
standard deviation of 20%. Project B has a projected mean return of
15% and standard deviation of 30%.
• Which project(s) should you take?
– Sharpe A=(10%-5%)/20%=1/4. B=(15%-5%)/30%=1/3. Choose B if I can only
invest in one project.
– Suppose I put half of my money in A and half in B, what’s my Sharpe?
– Return=average return of the two =0.5*10%+0.5*15%=12.5%.
– Standard deviation depends on correlation!
– If the two move perfectly together, std=0.5*20%+0.5*30%=25%.

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 Correlation (r)

– Correlation is a standardized measure of comovement between two securities:

– Between -1 and 1.
– -1 Move perfectly in opposite directions
– 1 move perfectly together
– 0 do not move together
– Standard deviation of a 2-asset portfolio =Sqrt(w1^2 *s1^2 + w2^2 *s2^2 +
2*w1*s1*w2*s2*r)
– Example: r=0, std=sqrt(0.5^2*0.2^2+0.5^2*0.3^2)=18%. Sharpe=(12.5%-
5%)/18%=0.42
– The benefit of diversification: The risk of a portfolio is smaller than the average
risk of the individual names in the portfolio
• S1=s2, w1=w2=0.5, std=sqrt(0.5^2 s^2+0.5^2
s^2)=sqrt(0.5)*s=s/sqrt(2)

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 What is a Portfolio?

• Portfolio is a collection of investments

assembled to meet one or more investment
goals.

• Efficient portfolio
– A portfolio that provides the highest return for a
given level of risk

– Requires search for investment alternatives to

get the best combinations of risk and return

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 Portfolio Return and Risk Measures

• The return on a portfolio is simply the

weighted average of the individual assets’
returns in the portfolio

• The standard deviation of a portfolio’s

returns is more complicated, and is a
function of the portfolio’s individual assets’
weights, standard deviations, and
correlations with all other assets

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 Return on Portfolio

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 Correlation:
Why Diversification Works!

• Correlation is a statistical measure of the

relationship between two series of numbers
representing data
• Positively Correlated items tend to move in the
same direction
• Negatively Correlated items tend to move in
opposite directions
• Correlation Coefficient is a measure of the
degree of correlation between two series of
numbers representing data

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 Correlation Coefficients

• Perfectly Positively Correlated describes two

positively correlated series having a
correlation coefficient of +1
• Perfectly Negatively Correlated describes
two negatively correlated series having a
correlation coefficient of -1
• Uncorrelated describes two series that lack
any relationship and have a correlation
coefficient of nearly zero

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 Figure 5.1 The Correlation Between
Series M, N, and P

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 Correlation:
Why Diversification Works!
• Assets that are less than perfectly positively
correlated tend to offset each others
movements, thus reducing the overall risk
in a portfolio
• The lower the correlation the more the
overall risk in a portfolio is reduced
– Assets with +1 correlation eliminate no risk
– Assets with less than +1 correlation eliminate some risk
– Assets with less than 0 correlation eliminate more risk
– Assets with -1 correlation eliminate all risk

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 Figure 5.2 Combining Negatively
Correlated Assets to Diversify Risk

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 Figure 5.3 Portfolios of IBM and Celgene

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 Figure 5.4 Risk and Return for Combinations of
Two Assets with Various Correlation Coefficients

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 Why Use International
Diversification?

• Offers more diverse investment alternatives than

U.S.-only based investing
• Foreign economic cycles may move independently
from U.S. economic cycle
• Foreign markets may not be as “efficient” as U.S.
markets, allowing true gains from superior
research

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 International Diversification

• Advantages of International Diversification

– Broader investment choices
– Potentially greater returns than in U.S.
– Reduction of overall portfolio risk

• Disadvantages of International
Diversification
– Currency exchange risk
– Less convenient to invest than U.S. stocks
– More expensive to invest
– Riskier than investing in U.S.

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 Methods of
International Diversification

• Foreign company stocks listed on U.S. stock

exchanges
– Yankee Bonds
– American Depository Shares (ADS’s)
– Mutual funds investing in foreign stocks
– U.S. multinational companies (typically not
considered a true international investment for
diversification purposes)

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 Components of Risk

• Diversifiable (Unsystematic) Risk

– Results from uncontrollable or random events
that are firm-specific
– Can be eliminated through diversification
– Examples: labor strikes, lawsuits

• Nondiversifiable (Systematic) Risk

– Attributable to forces that affect all similar
investments
– Cannot be eliminated through diversification
– Examples: war, inflation, political events

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 Components of Risk

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 Beta: A Popular Measure of Risk

• A measure of undiversifiable risk

• Indicates how the price of a security responds to market
forces
• Compares historical return of an investment to the market
return (the S&P 500 Index)
• The beta for the market is 1.0
• Stocks may have positive or negative betas. Nearly all are
positive.
• Stocks with betas greater than 1.0 are more risky than the
overall market.
• Stocks with betas less than 1.0 are less risky than the overall
market.

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 Beta as a Measure of Risk

Table 5.4 Selected Betas and Associated

Interpretations

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 Interpreting Beta

• Higher stock betas should result in higher expected

returns due to greater risk
• If the market is expected to increase 10%, a stock
with a beta of 1.50 is expected to increase 15%
• If the market went down 8%, then a stock with a
beta of 0.50 should only decrease by about 4%
• Beta values for specific stocks can be obtained
from Value Line reports or websites such as
yahoo.com

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 Interpreting Beta

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 Capital Asset Pricing Model (CAPM)

• Model that links the notions of risk and

return
• Helps investors define the required return
on an investment
• As beta increases, the required return for a
given investment increases

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 Capital Asset
Pricing Model (CAPM) (cont’d)

• Uses beta, the risk-free rate and the market

return to define the required return on an
investment

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 Capital Asset
Pricing Model (CAPM) (cont’d)

• CAPM can also be shown as a graph

• Security Market Line (SML) is the “picture”
of the CAPM
• Find the SML by calculating the required
return for a number of betas, then plotting
them on a graph

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 Figure 5.6 The Security Market Line
(SML)

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 Two Approaches to Constructing
Portfolios

Traditional Approach
versus
Modern Portfolio Theory

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 Traditional Approach

• Emphasizes “balancing” the portfolio using

a wide variety of stocks and/or bonds
• Uses a broad range of industries to diversify
the portfolio
• Tends to focus on well-known companies
– Perceived as less risky
– Stocks are more liquid and available
– Familiarity provides higher “comfort” levels for
investors

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 Modern Portfolio Theory (MPT)

• Emphasizes statistical measures to develop

a portfolio plan
• Focus is on:
– Expected returns
– Standard deviation of returns
– Correlation between returns

• Combines securities that have negative (or

low-positive) correlations between each
other’s rates of return

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 Key Aspects of MPT:
Efficient Frontier

• Efficient Frontier
– The leftmost boundary of the feasible set of
portfolios that include all efficient portfolios:
those providing the best attainable tradeoff
between risk and return
– Portfolios that fall to the right of the efficient
frontier are not desirable because their risk
return tradeoffs are inferior
– Portfolios that fall to the left of the efficient
frontier are not available for investments

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 Figure 5.7 The Feasible or Attainable
Set and the Efficient Frontier

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 Key Aspects of MPT:
Portfolio Betas

• Portfolio Beta
– The beta of a portfolio; calculated as the
weighted average of the betas of the individual
assets the portfolio includes
– To earn more return, one must bear more risk
– Only nondiversifiable risk (relevant risk)
provides a positive risk-return relationship

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 Figure 5.8 Portfolio Risk and
Diversification

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 Key Aspects of MPT: Portfolio Betas

Table 5.6 Austin Fund’s Portfolios V and W

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 Interpreting Portfolio Betas

• Portfolio betas are interpreted exactly the same

way as individual stock betas.
– Portfolio beta of 1.00 will experience a 10% increase when
the market increase is 10%
– Portfolio beta of 0.75 will experience a 7.5% increase
when the market increase is 10%
– Portfolio beta of 1.25 will experience a 12.5% increase
when the market increase is 10%

• Low-beta portfolios are less responsive and less

risky than high-beta portfolios.
• A portfolio containing low-beta assets will have a
low beta, and vice versa.

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 Interpreting Portfolio Betas

Table 5.7 Portfolio Betas and Associated Changes in Returns

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 Reconciling the Traditional
Approach and MPT

• Recommended portfolio management policy uses

aspects of both approaches:
– Determine how much risk you are willing to bear
– Seek diversification between different types of securities
and industry lines
– Pay attention to correlation of return between securities
– Use beta to keep portfolio at acceptable level of risk
– Evaluate alternative portfolios to select highest return for
the given level of acceptable risk

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 Figure 5.9 The Portfolio Risk-Return
Tradeoff

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