Portfolio

Management and
Wealth Planning
SINGLE-INDEX MODEL
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
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
Efficient Frontier

 Markowitz, H. M., “Portfolio Selection,” Journal of Finance

(December 1952).
 Rather than choose each security individually, choose
portfolios that maximize return for given levels of risk
(i.e., those that lie on the efficient frontier).
 Problem: When managing large numbers of securities,
the number of statistical inputs required to use the
model is tremendous.
 The correlation or covariance between every pair of
securities must be evaluated in order to estimate
portfolio risk.
Single-Index Model

 Sharpe, W. F., “A Simplified Model of Portfolio Analysis,”

Management Science (January 1963).
 The single-index model (SIM) is a simple asset pricing
model to measure both the risk and the return of
a security. The model has been developed by William
Sharpe in 1963

 Instead of estimating the correlation between every

pair of securities, simply correlate each security with an
index of all of the securities included in the analysis.
Single-Index Model

 Most stocks have a positive covariance because they all

respond similarly to macroeconomic factors.
 However, some firms are more sensitive to these factors
than others, and this firm-specific variance is typically
denoted by its beta (β), which measures its variance
compared to the market for one or more economic
factors.
 Covariances among securities result from differing
responses to macroeconomic factors. Hence, the
covariance of each stock can be found by multiplying
their betas and the market variance:
 Rm is the return on the market portfolio

 Ri is the return on the security

 ei represents the unsystematic risk of the security due
to firm-specific factors.
 Macroeconomic analysis is used to estimate the risk Premium and risk of
the market index.

 Regression analysis is used to estimate the beta coefficients of all

securities and their residual variances.

 The slope of the regression curve is the beta of an asset.

 The intercept is the asset’s alpha during the sample period

APPLICATION ON EXCEL /
EVIEWS
 Reference
 Bodie, Z., Kane, A., & Marcus, A. J. Essentials of
Investments 8th Edition. McGraw-Hill.