Chapter Seven

Optimal Risky
Portfolios

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 Chapter Overview
• The investment decision:
• Capital allocation (risky vs. risk-free)
• Asset allocation (construction of the risky
portfolio)
• Security selection
• Optimal risky portfolio
• The Markowitz portfolio optimization model
• Long- vs. short-term investing

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 The Investment Decision
• Top-down process with 3 steps:
1. Capital allocation: risky portfolio and risk-free asset
2. Asset allocation: across broad asset classes
3. Security selection: individual assets within asset
class

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 Diversification and Portfolio Risk
• Market risk
• Marketwide risk sources
• Remains even after diversification
• Also called: Systematic or Nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also Called: Diversifiable or Nonsystematic

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 Portfolio Risk and
the Number of Stocks in the Portfolio

Panel A: All risk is firm specific Panel B: Some risk is systematic

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Portfolio Diversification

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 Portfolios of Two Risky Assets
• Expected Return:

• Portfolio risk:

• Covariance:

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 Portfolios of Two Risky Assets:
Expected Return
Consider a Portfolio made up of Equity (stocks) and Debt (bonds)

rp  wD rD  wE rE
where wD 
wE 
rD 
rE 

E (rp )  w D E (rD )  wE E (rE )

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 Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
  w   w   2wD wE Cov  rD , rE 
2
p
2
D
2
D
2
E
2
E

2
•  D = Bond variance

2
•  E = Equity variance

Cov  rD , rE 
• = Covariance of returns for bond
and equity
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 Portfolios of Two Risky Assets:
Covariance
• Covariance of returns on bond and equity:
Cov(rD , rE )  rDE D E
• D,E = Correlation coefficient of returns
• D = Standard deviation of bond returns
• E = Standard deviation of equity returns

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 Portfolios of Two Risky Assets:
Correlation Coefficients (1 of 2)
• Range of values for 1,2

 1.0    1.0
• If r = 1.0  perfectly positively correlated securities
• If r = 0  the securities are uncorrelated
• If r = - 1.0  perfectly negatively correlated securities

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 Portfolios of Two Risky Assets:
Correlation Coefficients (2 of 2)
• When ρDE = 1, there is no diversification

 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
D  E

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 Portfolios of Two Risky Assets:
Example — 50%/50% Split

Expected Return: E (rp )  w D E (rD )  wE E (rE )

 .50  8%  .50  13%  10.5%
Variance:  p2  wD2  D2  wE2 E2  2wD wE Cov  rD , rE 
 .502  122  .502  202  2  .5  .5  72  172
 P  172  13.23%
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Portfolio Expected Return

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Computation of Portfolio Variance
from the Covariance Matrix

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Portfolio Standard Deviation

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 Portfolio Expected Return as a
Function of Standard Deviation

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 The Minimum Variance Portfolio
• The minimum variance portfolio: the portfolio
composed of risky assets with smallest standard
deviation

• Risk reduction depends on the correlation:

• If r = +1.0, no risk reduction is possible
• If r = 0, σP may be less than the standard deviation of
either component asset
• If r = -1.0, a riskless hedge is possible

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The Opportunity Set of the Debt and
Equity Funds and Two Feasible CALs
Portfolio A
E (rA )  8.9%
 A  11.45%

Portfolio B
E (rB )  9.5%
 B  11.70%

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 The Sharpe Ratio
• Maximize the slope of the CAL for any possible
portfolio, P
• The objective function is the slope:

E rp  rf
Sp 
p

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The Sharpe Ratio:
Example
Portfolio A
E (rA )  8.9%
 A  11.45%
E  rA   rf 8.9%  5%
SA    .34
A 11.45%
Portfolio B
E (rB )  9.5%
 B  11.70%
E  rB   rf 9.5%  5%
SB    .38
B 11.70%
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Debt and Equity Funds with the
Optimal Risky Portfolio

Optimal Risky Portfolio

E (rP )  11%
 P  14.2%
E  rP   rf
SP 
P
11%  5%

14.2%
 .42

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Determination of the Optimal
Overall Portfolio

Optimal Allocation to P
A4
E  rP   rf
y
A P2
11%  5%
 2
 .7439
4  (14.2%)

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 The Proportions of the
Optimal Complete Portfolio
Overall Portfolio
E (rP )  11% y  .7439
 P  14.2% rf  5%

E (rOverall )  y  E (rp )  (1  y )  rf
 .7439 11%  .2561 5%
 9.46%
 Overall  .7439 14.2%  10.56%
9.46%  5%
SOverall   .42
10.56%
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 Markowitz Portfolio Optimization
Model (1 of 6)
• Security selection
• Step 1: Determine the risk-return opportunities
available
• All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations

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The Minimum-Variance
Frontier of Risky Assets

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 Markowitz Portfolio Optimization
Model (2 of 6)
• Search for the CAL with the highest reward-to-
variability ratio
• Everyone invests in P, regardless of their
degree of risk aversion
• More risk averse investors put less in P
• Less risk averse investors put more in P

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 The Efficient Frontier of
Risky Assets with the Optimal CAL

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 Markowitz Portfolio Optimization
Model (3 of 6)
• Capital Allocation and the Separation Property
• Portfolio choice problem may be separated into
two independent tasks
• Determination of the optimal risky portfolio is purely
technical
• Allocation of the complete portfolio to risk-free versus
the risky portfolio depends on personal preference

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Capital Allocation Lines with Various
Portfolios from the Efficient Set

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 Markowitz Portfolio Optimization
Model (4 of 6)
• The Power of Diversification
• Remember: n n
 p2   wi w j Cov  ri , rj 
i 1 j 1
• If we define the average variance and average
covariance of the securities as:
1 n 2
   i
2

n i 1
1 n n
Cov   Cov  ri , rj 
n  n  1 j 1 i 1
j i

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 Markowitz Portfolio Optimization
Model (5 of 6)
• The Power of Diversification
• We can then express portfolio variance as
21 2 n 1
   
p Cov
n n
• Portfolio variance can be driven to zero if the
average covariance is zero

• The irreducible risk of a diversified portfolio

depends on the covariance of the returns
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 Risk Reduction of
Equally Weighted Portfolios

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 Markowitz Portfolio Optimization
Model (6 of 6)
• Optimal Portfolios and Nonnormal Returns
• Fat-tailed distributions can result in extreme
values of VaR and ES  smaller allocations

• If other portfolios provide sufficiently better VaR

and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions

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 Risk Pooling and
the Insurance Principle
• Risk pooling
• Merging uncorrelated, risky projects as a means to
reduce risk
• It increases the scale of the risky investment by
adding additional uncorrelated assets
• The insurance principle
• Risk increases less than proportionally to the
number of policies when the policies are
uncorrelated
• Sharpe ratio increases
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 Risk Sharing
• As risky assets are added, a portion of the
pool is sold to maintain a risky portfolio of
fixed size
• Risk sharing combined with risk pooling is the
key to the insurance industry
• True diversification means spreading a
portfolio of fixed size across many assets, not
merely adding more risky bets

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 Investment for the Long Run

Long-Term Strategy Short-Term Strategy

• Invest in the risky • Invest in the risky
portfolio for 2 years portfolio for 1 year and
– Long-term strategy is in the risk-free asset for
riskier the second year
– Risk can be reduced by
selling some of the risky
assets in year 2
– “Time diversification” is
not true diversification

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