Week 4 - Efficient Diversification

BAO3403 Investment and Portfolio
Management
Week 4
Chapter 6
Efficient Diversification (Part A)
1
6.1 DIVERSIFICATION AND
PORTFOLIO RISK
6.2 ASSET ALLOCATION

WITH TWO RISKY ASSETS
Copyright © 2013 McGraw-Hill Education

(Australia) Pty Ltd
Bodie, Drew, Basu, Kane and Marcus Principles
of Investments, 1e 6-2
Diversification and Portfolio Risk
• Market/Systematic/Non-diversifiable Risk
• Incorporates risk factors common to whole
economy
• Unique/Firm-Specific/Nonsystematic/
Diversifiable Risk
• Risk that can be eliminated by
diversification
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the 3
Risk as Function of Number of Stocks in
Portfolio
Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the 4
Consider a bond fund and a share fund
Using the data from spreadsheet 6.1, p.148 of book. Consider
2 assets you can invest in, a stock fund and a bond fund. The
bond fund traditionally offers lower risk but also lower returns.
This is Spread-sheet 6.1 from text

book
Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Bodie, Drew, Basu, Kane and Marcus Principles of Investments,
1e
6-5
Example of bond & share funds – cont.
* If we choose one of these funds/assets and go ahead and invest,
what risk are we taking on?
*Firstly, observe the Variance and SD of the individual funds. There is quite
some stand-alone risk in the bond fund and more than double that in the stock
fund.
Table 6.2 Variance of Returns

1e
6-6
Example of bond & share funds – cont.
Table 6.2 Variance of Returns
Consider a simple risk-return trade-off measure, the coefficient of variation

coefficient (CV)
- Stock fund 1/r1= 18.63/10 = 1.863
- Bond fund 2/r2 = 8.27/5 = 1.652
- The Bond fund has the best risk-return trade-off (as it is the lowest CV) but, as
stand-alone assets, both funds have a lot of risk per unit of return.
- What could we do to cut our risk ? The answer is to diversify by having more than
one risky asset. We could invest in both funds.

1e 6-7
Example of bond & share fund – cont.
Lets look at portfolio return if we were to invest 40% of our funds in the
stock fund and the balance in the bond fund
E(rp) = W1r1 + W2r2

W1 = 0.4 … stock fund W2 = 0.6 …
bond fund r1 = 10% … stock fund r2
= 5% … bond fund
E(rp) % = (0.4*0.10) + (0.6*0.05) =
0.07 = 7%
* This is simply the weighted average
of the
n
expected returns n of the 2 individual  Wi = 1
funds. n  # securities in the
E(r p )  
i=1
* These i1W i r i ; portfolio
mathematics can be applied to
any number of assets
1e
6-8
Example of bond & share fund - cont
On the basis we are happy enough with a 7% return from this theoretical
2-asset portfolio, what does risk look like?
Could we expect to pro-rata (or weight average) the risk, just like we did
with the expected returns of the individual funds?
Unless we have 2 assets that are perfectly positively correlated

(and these 2 assets are not), we will be able to obtain diversification
benefits by combining the 2 risky assets (the stock fund and the
bond fund in this example)
That means that the SD of the combined portfolio will not be equal
0.4  1 + 0.6  2 = 0.4 * 18.63% + 0.6 * 8.27% = 12.4%
Instead it will be something less, in fact much less.

Let’s calculate it…..
1e
6-9
Table 6.3 Performance of a portfolio invested in the share and bond funds
The portfolio SD turns out to be only 6.65%, much less than the 12.4% on the
previous page. It is even less than the bond-fund SD of 8.27%.
Stock fund CV = 1/r1= 6.65/7 = 0.95
This is a clear case of substantial diversification benefits being

obtained via portfolio design. Risk has been cut almost in half.
1e
6-
How else could we have derived the portfolio variance (and SD)?
Yes – we could calculate covariance and then insert that into the
following formula for a 2-asset portfolio
 p 2  W )2 W
2  2W W
2 2Cov(r
1 1 ,r1 2
1 2 2 2
Table 6.4 Covariance between the returns of the share and bond funds
-74.8%
covariance

Bodie, Drew, Basu, Kane and Marcus Principles of Investments, 1e
 p 2  W )2 W
2  2W W
2 2Cov(r
1 1 ,r1 2
1 2 2 2
So variance of our portfolio 40% in a stock fund and 60% in a
bond fund is 2 p as a percentage =
0.42 *18.632 + 2*0.4*0.6*-74.8 + 0.62 *8.272 = 44.26
Now p as a percentage = 44.260.5 = 6.65 (as we saw earlier)
Covariance describes the direction of the relationship
between the returns of the 2 risky assets.
-74.8 means that the returns are negatively correlated (and this is a
good thing from a risk mitigation viewpoint) but we do not know the
strength of the relationship.

Bodie, Drew, Basu, Kane and Marcus Principles of Investments, 6-12
1e
A more useful number to use rather than covariance is
correlation coefficient. This standardizes the covariance.
We then see not only the direction but also are provided with
a scale to estimate the degree to which the shares move
together.
Correlation coefficient = ρ (1,2)  Cov(r1,r2 )

o1  2
Let’s try it σ
(1,2) = -74.8/(18.6306*8.2704) = - 0.49
This is also indicated on spreadsheet 6.4

1e 6-13
 and diversification in a two-share portfolio
•  is always in the range –1.0 to +1.0 inclusive.

• What does (1,2) = +1.0 imply?
The two are perfectly positively correlated. That means that if
(1,2) = +1, then (1,2) = ± (W11 + W22). There are no diversification
benefits in that case.
What does (1,2) = -1.0 imply? The two are perfectly negatively
correlated. If (1,2) = -1, then (1,2) = ±(W11 – W22)
There are very large diversification benefits from combining 1 and 2
in that case.
In general it is difficult to find 2 stocks with (1,2) < 0 or =
0

1e 6-14
 and diversification in a two-share portfolio
(cont.)
• What does –1 < (1,2) < 1 imply?
If –1 < (1,2) < 1 then
There are some diversification benefits from combining shares 1 and 2 into a
portfolio.
 p 2 = W12 12 + W 2 2 2 + 2W1W2 Cov(r1r2)
2
And since Cov(r1r2) = 12

 p 2 = W12 12 + W 22 2 + 2W1W2 1,2 12
2

1e 6-15
 and diversification in a two-share
portfolio (cont.)
Typically  is greater than zero and less than 1.0
(1,2) = (2,1) and the same is true for the COV
The covariance between any share such as share 1 and itself

is simply the variance of share 1,
(1,1) = +1.0 by definition
We have no measure for how three or more shares move

together.

1e 6-16
The effects of correlation and covariance on
diversification
Asset A
Asset B
Portfolio AB

6-17
1e
The effects of correlation and covariance
on diversification
Asset C
Asset D
Portfolio CD
Copyright © 2013 McGraw-Hill Education

(Australia) Pty Ltd
Bodie, Drew, Basu, Kane and Marcus Principles
of Investments, 1e
6-18
Naïve diversification
The power of diversification
Most of the diversifiable risk

eliminated at 25 or so stocks

1e 6-19
Two-security portfolio: risk
 p = W 1
2

2W1W2Cov(r1r2)2
2
+ W 2
2
 2
2
+
2
1 2 = Variance of security 1
 2 = Variance of security 2
2
Cov(r1r2) = Covariance of
returns for
Security 1 and security 2
1e 6-20
Ex-post covariance calculations
N (r  r 1 )  (r  r 2)
n
Cov(r1,r 2 ) 
n 
T1
1,T
n
2,T
1
r 1  average or expected return for stock 1
r 2  average or expected return for stock 2

n  # of observations
You need to account for one degree of freedom lost. That

is the reason we use n-1.

1e 6-21
Two-security portfolio: risk (cont.)
Squared
Returns from
deviations
ABC XYZ average XYZ
ABC Calculating
1 0.2515 -0.2255 0.025192 0.119156 individual
2 0.4322 0.3144 0.115206 0.037912 SD’s from
3 -0.2845 -0.0645 0.14234 0.033926
4 -0.1433 -0.5114 0.055734 0.398275 population
5 0.5534 0.3378 0.212171 0.047572 data
6 0.6843 0.3295 0.349896 0.04402
7 -0.1514 0.7019 0.059624 0.338968
8 0.2533 0.2763 0.025767 0.024527
9 -0.4432 -0.4879 0.287275 0.369166
10 -0.2245 0.5263 0.100667 0.165332
AAR 0.09278 0.11969 Sum 1.37387 1.578853
Average 0.137387 0.157885 You need to
allow for one
2ABC = 1/9 (1.37387) = 0.15265
degree of
ABC = 39.07% freedom lost)
2XYZ = 1/9 (1.57885) = 0.17543
XYZ Copyright
= 41.88%
© 2013 McGraw-Hill Education (Australia) Pty Ltd
Bodie, Drew, Basu, Kane and Marcus Principles of Investments, 6-22
1e
Two-security portfolio: risk (cont.)
Deviation Produc
Returns from t of Calculating
ABC XYZ ABC average
deviations
1 0.2515 -0.2255 0.1587
XYZ -0.34519 -0.05479 covariance
2 0.4322 0.3144 0.3394 0.19471 0.066088
3 -0.2845 -0.0645 -0.3772 -0.18419 and correlation
0.069491
4 -0.1433 -0.5114 -0.2360 -0.63109 0.148988 coefficient
5 0.5534 0.3378 0.4606 0.21811 0.100466
6 0.6843 0.3295
from 2
0.5915 0.2098 0.124107
7 -0.1514 0.7019 2 1 - populations
8 0.2533 0.2763 -0.16052 0.15661
0.5822 0.1421 of asset
0.02513
9 -0.4432 -0.4879 0.2441 -0.60759
-0.53598 1 6
0.32565 returns
10 -0.2245 0.5263 8
-0.31728 0.40661 0.12901
AAR 0.09278 0.11969 Sum 0.53397
Averag 0.05339
e 7 You need
to allow
COV(ABC,XYZ) = 1/9 (0.53397) = 0.059330 for one
) = 0.059330 / (0.3907 x 0.4188) degree of
ABC,XYZ = COV / (ABCXYZ
freedom
ABC,XYZ = 0.3626 N (r 1,T  r 1 )  (r2,T  r 2 ) lost)
Cov(r1,r2 ) 
n
n
 n
T1
1
1e 6-23
Ex-ante covariance calculation
Using scenario analysis with probabilities the

covariance can be calculated with the
following formula:
S
Cov(rS , rB )   p (Si )[rS (i )  E (rS )][rB (i )  E (rB )]
i 1
Cov(rS , rB )  
i1 p(i) rS (i)  rS  rB (i) 
rB 

1e
6-24
Two-security portfolio risk
2ABC = 0.15265
QQ
 2 XYZ = 0.17543
2
σp    [W I WJ Cov(I, J)]
I1J1 COV(ABC,XYZ) = 0.05933
ABC,XYZ = 0.3626
 p 2 = W1212 + 2W1W2 Cov(r1r2) + W2222

Let W1 = 60% and W2 = 40% Share 1 = ABC; Share 2= XYZ
 p22 = 0.36(0.15265) + 2(.6)(.4)(0.05933) + 0.16(0.17543)
 p = 0.1115019 = variance of the portfolio
p = 33.39%
p This is demonstrated below
< W1 1 + W 2 2
33.39% < [0.60(0.3907) + 0.40(0.4188)] =40.20%
This means there has been some risk
mitigation via the pairing of the stocks

Bodie, Drew, Basu, Kane and Marcus Principles of Investments, 1e 6-25
Three-security portfolio n or Q = 3
Q Q
o p 2    [WI WJ Cov(rI ,rJ )]
I1J1
2 2 2 2  2 2
p= W1  1 + W2   + W3
3
For an n security portfolio + 2W1W2 Cov(r1r2)
there would be n
variances and n(n–1) + 2W1W3 Cov(r1r3)
covariance terms.
The covariances are the + 2W2W3 Cov(r1r3)
dominant effect on 2 p

1e 6-26
Two-security portfolios with different
correlations
E(r)
13% WA = 0% WB = 100%
 = -1
50%A
=0 50%B
 = .3
8%  = +1
WA = 100%
WB = 0%
St. dev
12% 20%
Stock A Stock B
Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd 6-27
1e
Summary: portfolio risk/return two security
portfolio
• Amount of risk reduction depends critically on
correlations or covariances.
• Adding securities with correlations < 1 will result in risk

reduction.
• To sum up the idea: the less correlated, the greater the

risk reduction possible through diversification.

1e
6-28
Minimum variance combinations –1< r < +1
Choosing weights to minimise the portfolio variance
 22 – Cov(r1r 2)
W1 =
 21 + 22 – 2Cov(r1r )
E(r)
2
W2 = (1 - W1) 13%
 = -1
TWO-SECURITY PORTFOLIOS WITH
DIFFERENT
=0 CORRELATIONS
 = .3
8% =1
12% 20% St. Dev

1e 6-29
Minimum variance combinations – 1< r < +1
Stk 1 E(r1) = .10  = .15 1
Stk 2 E(r2) = .14  = .20  = .2 1,2
2
 22 - Cov(r1r2) (.2)2 - (.2)(.15)(.2)
W1 =  12 +  22 - 2Cov(r1r 2) W1 =
(.15)2 + (.2)2 - 2(.2)(.15)(.2)
W2 = (1 - W1)
W1 = .6733
Cov(r1r2) = 12 W2 = (1 - .6733) = .3267

1e 6-30
Minimum variance: return and risk with  =
0.2
Stk 1 E(r1) = .10  1 = .15
12 = .2
Stk 2 E(r2 ) = .14  2 = .20
W1 = .6733
W2 = (1 - .6733) = .3267
E[rp] = .6733(.10) + .3267(.14) = .1131 or 11.31%

p2 = W1212 + W222 + 2W1W2 1,212
2
o p  (0.67332 ) (0.152 )  (0.32672 ) (0.22 )  2 (0.6733) (0.3267) (0.2) (0.15)


1/2
(0.2) 

 p  0.01711 / 2  13.08%
1e 6-31
Minimum variance combination with  = –
0.3
Stk 1 E(r1) = .10  1= .15

Stk 2 E(r2) = .14  2 = .20 12 =-.3
 22- Cov(r1r2) (.2)2 - (-.3)(.15)(.2)

W1 = W1 =
 12 + 2
2
- 2Cov(r r
1 2) (.15)2 + (.2)2 - 2(-.3)(.15)(.2)

W2 = (1 - W1)
W1 = .6087
Cov(r1r2) = 12 W2 = (1 - .6087) = .3913

1e 6-32
Minimum variance combination with  = –0.3
Stk 1 E(r1) = .10 1 = .15
12 =-.3
Stk 2 E(r2 ) = .14  2 = .20
W1 = .6087
W2 = (1 - .6087) = .3913
E[rp] = 0.6087(.10) + 0.3913(.14) = .1157 =

11.57% W1212 + W222 + 2W1W2 1,2 12
p2 = 2
o p   (0.6087 2 ) (0.15 2 )  (0.3913 2 ) (0.2 2 )  2 (0.6087) (0.3913) (-0.3) (0.15)


1/2
(0.2)   12 = .2

Notice lower portfolio
standard deviation E(rp) = 11.31%
 p 0.01021/ 2  10.09%
but higher expected  p = 13.08%
return with smaller 

1e 6-33
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.
THIS LECTURE WILL CONTINUE IN WEEK 5 AFTER THE

TEST. REFER TO LECTURE PACK B.
1e 6-34

Week 4 - Efficient Diversification

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BAO3403 Investment and Portfolio

6.2 ASSET ALLOCATION

Copyright © 2013 McGraw-Hill Education

This is Spread-sheet 6.1 from text

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Table 6.2 Variance of Returns

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Consider a simple risk-return trade-off measure, the coefficient of variation

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

E(rp) = W1r1 + W2r2

Unless we have 2 assets that are perfectly positively correlated

Instead it will be something less, in fact much less.

Stock fund CV = 1/r1= 6.65/7 = 0.95

This is a clear case of substantial diversification benefits being

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Correlation coefficient = ρ (1,2)  Cov(r1,r2 )

This is also indicated on spreadsheet 6.4

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

•  is always in the range –1.0 to +1.0 inclusive.

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

And since Cov(r1r2) = 12

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

(1,2) = (2,1) and the same is true for the COV

The covariance between any share such as share 1 and itself

(1,1) = +1.0 by definition

We have no measure for how three or more shares move

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education

Most of the diversifiable risk

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

r 2  average or expected return for stock 2

You need to account for one degree of freedom lost. That

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Using scenario analysis with probabilities the

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

 p 2 = W1212 + 2W1W2 Cov(r1r2) + W2222

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

• Adding securities with correlations < 1 will result in risk

• To sum up the idea: the less correlated, the greater the

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

12% 20% St. Dev

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

Stk 1 E(r1) = .10  = .15 1

Stk 2 E(r2) = .14  = .20  = .2 1,2

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

E[rp] = .6733(.10) + .3267(.14) = .1131 or 11.31%

o p  (0.67332 ) (0.152 )  (0.32672 ) (0.22 )  2 (0.6733) (0.3267) (0.2) (0.15)

Stk 1 E(r1) = .10  1= .15

 22- Cov(r1r2) (.2)2 - (-.3)(.15)(.2)

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

E[rp] = 0.6087(.10) + 0.3913(.14) = .1157 =

o p   (0.6087 2 ) (0.15 2 )  (0.3913 2 ) (0.2 2 )  2 (0.6087) (0.3913) (-0.3) (0.15)

Copyright © 2013 McGraw-Hill Education (Australia) Pty Ltd

THIS LECTURE WILL CONTINUE IN WEEK 5 AFTER THE

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