An Introduction to

Portfolio Management

Dr. Amir Rafique

The Basics
Definition of Risk

 Uncertainty of future outcomes

or

 Probability of an adverse outcome

Risk Aversion

Given a choice between two assets

with equal rates of return, most
investors will select the asset with the
lower level of risk
Measuring and Reducing Risk
 Diversification
 Strategy designed to reduce risk by spreading the
portfolio across many investments

 Unique Risk
 Risk factors affecting specific firms
 Also called “diversifiable risk” “unsystematic risk”

 Market Risk
 Economy-wide sources of risk that affect the overall
stock market
 Also called “systematic risk”
 Breakdown of Risk
Total Risk = Diversifiable Risk + Non Diversifiable Risk

Diversifiable Risk = Company specific risk

Nondiversifiable Risk = Market risk

Company
Total Risk () specific or
diversifiable
risk
Total Risk Market risk or Non-
diversifiable risk

Stand-Alone Risk, p

Number of
Securities
Diversification
Diversification is the financial equivalent of the cliche “Don’t put all your eggs in
one basket”

Diversification results in reduced risk

We think of “risk” as being linked to the

This is because of the averaging effect
volatility of returns – so averaging tends
Price to smooth volatility

Time
Portfolio Theory
Markowitz Portfolio Theory
 Quantifies risk

 Derives the expected rate of return for a portfolio

of assets and an expected risk

 Shows that the variance of the rate of return is a

meaningful measure of portfolio risk

 Derives the formula for computing the variance of

a portfolio
Assumptions of
Markowitz Portfolio Theory
 As an investor you want to maximize the returns for a
given level of risk and…...

 Portfolio includes all assets and liabilities

 A good portfolio is not simply a collection of

individually good investments

 The relationship between the returns for assets in the

portfolio is important
Assumptions of
Markowitz Portfolio Theory
 Using these assumptions, a single asset or
portfolio of assets is considered to be efficient if
no other asset or portfolio of assets offers higher
expected return with the same (or lower) risk, or
lower risk with the same (or higher) expected
return
Portfolio Expected Return and
Risk
Expected Rates of Return
 For an individual asset - sum of the potential
returns multiplied with the corresponding
probability of the returns/ or historical returns

 For a portfolio of investments - weighted

average of the expected rates of return for
the individual investments in the portfolio
Expected Return for an
Individual Investment
Arithmetic Mean/ Expected Return

Where:
R1  R2  ...  RN
AM  AM = Arithmetic Mean
N Ri = Annual Rs
N = Number of years
Portfolio Expected Return
 A weighted average of the expected returns of individual
securities in the portfolio

 The weights are the proportions of total investment in

each security
n
E(Rp) =  wi x E(Ri)
i=1
 Where n is the number of securities in the portfolio
Expected Return for a Portfolio
of Risky Assets
(Percent of Portfolio) Return (Ri )
0.20 0.10
0.30 0.11
0.30 0.12
0.20 0.13

n
E(Rport)   Wi R i
i 1

where :
Wi  the percent of the portfolio in asset i
E(R i )  the expected rate of return for asset i
Expected Return for a Portfolio
of Risky Assets
Weight (Wi) Expected Security Expected Portfolio
(Percent of Portfolio) Return (Ri) Return (Wi X Ri)
0.20 0.10 0.0200
0.30 0.11 0.0330
0.30 0.12 0.0360
0.20 0.13 0.0260
E(Rport) 0.1150
n
E(Rport)   Wi R i
i 1

where :
Wi  the percent of the portfolio in asset i
E(R i )  the expected rate of return for asset i
Variance (Standard Deviation)
of an Individual Investment
 Variance is a measure of the variation of
possible rates of return Ri, from the
expected rate of return [E(Ri)]

 Standard deviation is the square root of

the variance
Variance (Standard Deviation) of
an Individual Investment

n Where:
R  E  Ri  
2

2  i 1
i
 2 = Variance
N R = Return i
E(R)i = Expected R*
N = Number of years

* The E(R) is equal to the arithmetic mean of the series of returns.

Portfolio Risk
 Measured by portfolio standard deviation

 Not a simple weighted average of the

standard deviations of individual securities in
the portfolio. Why?

 How to compute portfolio standard deviation?

Covariance and Correlation
Covariance of Returns
 A measure of the degree to which two variables
“move together” relative to their individual mean
values over time

 For two assets, i and j, the covariance of rates of

return is defined as:
n
Cov ij   [R i - E(R i )][R j - E(R j )]/n
i 1
Significance of Covariance
 An absolute measure of the degree of
association

 The direction in which two variables co-vary

over time

 The magnitude of the covariance depends on

the variances of the individual return series,
as well as the relationship between the series
Covariance and Correlation
 The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Covariance and Correlation
Correlation coefficient varies from -1 to +1
Covij
rij 
 i j
where :
rij  the correlation coefficient of returns
 i  the standard deviation of R it
 j  the standard deviation of R jt
Why Correlation?
 What is correlation?

 Perfect positive correlation

 The returns have a perfect direct linear relationship
 Knowing what the return on one security will allow an investor to
forecast what the other security will do

 Perfect negative correlation

 Perfect inverse linear relationship

 Zero correlation
 No relationship between the returns on two securities
Why Correlation?
 Combining securities with perfect positive
correlation or high positive correlation does not
reduce risk in the portfolio

 Combining two securities with zero correlation

reduces the risk of the portfolio

 Combining two securities with perfect negative

correlation could eliminate risk altogether
Why Correlation?
Portfolio Standard Deviation
Portfolio Standard Deviation
Formula
n n n
 port  w 
i 1
2
i i
2
  w i w j Cov ij
i 1 i 1

where :
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Cov ij  the covariance between the rates of return for assets i and j,
where Cov ij  rij i j
Portfolio Standard Deviation
Formula
 The standard deviation for a portfolio of assets is a
function of the weighted average of the individual
variances
and
 The weighted covariance between all the assets in
the portfolio

 There are two effects (Two considerations)

 Asset’s own variance of returns
 Covariance of the asset with every other asset
Portfolio Standard Deviation
Formula
 Return variance is a security’s total risk

 2p  x A2 A2  xB2 B2  2 x A xB  AB A B

Total Risk Risk from A Risk from B Interactive Risk
Summary
 Any asset of a portfolio may be described by two
characteristics:
 The expected rate of return
 The expected standard deviations of returns

 The correlation/ covariance, affect the portfolio

standard deviation

 Low correlation reduces portfolio risk while not

affecting the expected return
Portfolio Expected Return and Risk

Expected Return Risk

The Expected
The The Risk The The
Returns
Portfolio of the Portfolio Correlation
of the
Weights Securities Weights Coefficients
Securities
Examples
Combining Stocks with
Different Returns and Risk
 Assets may differ in expected rates of return
and individual standard deviations

 Combining two assets with -1.0 correlation

reduces the portfolio standard deviation to
zero only when individual standard deviations
are equal
Combining Stocks with Different
Returns and Risk
Asset E(R i ) Wi  2
i i
1 .10 .50 .0049 .07
2 .20 .50 .0100 .10

Case Correlation Coefficient Covariance

a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070
Constant Correlation
with Changing Weights
Asset E(R i ) i
1 .10 .07 rij = 0.00
2 .20 .10
2
Case W1 W E(Ri ) E(αport)

f 0.00 1.00
g 0.20 0.80
h 0.40 0.60
i 0.50 0.50
j 0.60 0.40
k 0.80 0.20
l 1.00 0.00
Constant Correlation
with Changing Weights

Case W1 W2 E(Ri ) E(F port)

f 0.00 1.00 0.20 0.1000

g 0.20 0.80 0.18 0.0812
h 0.40 0.60 0.16 0.0662
i 0.50 0.50 0.15 0.0610
j 0.60 0.40 0.14 0.0580
k 0.80 0.20 0.12 0.0595
l 1.00 0.00 0.10 0.0700
Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 g 2
With uncorrelated assets it
h
is possible to create a two
asset portfolio with lower i
0.15 j
risk than either single Rij = +1.00
asset
k
0.10 1
Rij = 0.00

0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R)

0.20 2
With two perfectly
correlated assets, it is only
0.15 possible to create a two
asset portfolio with risk- Rij = +1.00
return along a line
0.10 between either single
1
asset

0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12

Standard Deviation of Return

Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 g 2
With correlated assets it is
h
possible to create a two
asset portfolio between i
0.15 j
the first two curves Rij = +1.00

k Rij = +0.50
0.10 1
Rij = 0.00

0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) Rij = -0.50 f
0.20 g 2
h
i
0.15 j
Rij = +1.00
With negatively
correlated assets it k Rij = +0.50
0.10 is possible to create 1
a two asset Rij = 0.00
portfolio with much
0.05 lower risk than
either single asset

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) Rij = -0.50 f
0.20 Rij = -1.00 g 2
h
i
0.15 j
Rij = +1.00

k Rij = +0.50
0.10 1
Rij = 0.00
With perfectly negatively correlated assets it is
0.05 possible to create a two asset portfolio with almost no
risk

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
The Efficient Frontier
 The maximum rate of return for every given
level of risk, or the minimum risk for every level
of return

 Frontier will be portfolios of investments rather

than individual securities
 Exceptions being the asset with the highest return
and the asset with the lowest risk
Efficient Frontier
for Alternative Portfolios
Would we prefer A or B and C or D?

Return

A has a higher return

than B for the same
A
risk and C has the
same return as D for a
B lower risk. So we
prefer A and C

C D

Risk
Concept of Dominance
 A portfolio dominates all others if:
 For its level of expected return, there is no other
portfolio with less risk

 For its level of risk, there is no other portfolio with

a higher expected return
Portfolio Management
 Passive management has the following
characteristics:

 Follow a predetermined investment strategy

that is invariant to market conditions
Or
 Do nothing
Portfolio Management
 Active management:

 Requires the periodic changing of the

portfolio components as the manager’s
outlook for the market changes
Issues