Review of

Portfolio Theory

Fall 2023
Portfolio Construction
 In constructing their portfolios, individual
investors or portfolio managers seek to
achieve the best possible trade-off between
risk and return.
 To do this, individual investors or portfolio
managers have to make two decisions:
capital allocation decision and security
selection decision.

Fall 2023
Two Independent Decisions
 Capital Allocation Decision
 How do you allocate your funds in two

broad asset classes: the risk-free asset

and the risky assets?
 Security Selection Decision
 Which risky assets to choose?

 These two decisions are made

independently, according to the two-Fund
Separation Theorem.

Fall 2023
Capital Allocation between a Risk-
free Asset and a Risky Asset
 Assume the expected return of the risky asset
is E(r) and the standard deviation of the
return of the risky asset is .

 Denote the proportion of funds in the risky

asset by y, then the expected return of the
portfolio is
E(rp) = yE[r] +(1-y)rf =

Fall 2023
Capital Allocation between a Risk-
free Asset and a Risky Asset
 What about the portfolio variance?
 p2 = w12 12 + w22 22 + 2w1w212

In this case,
p 2 =
 And the standard deviation of the return of

the portfolio is simply:

p =

Fall 2023
Capital Allocation Line (CAL)
E(rp) = rf + y (E(r)-rf )
p = y 
 E(rp) = rf + p (E[r]-rf)/

Expected return is linear in the

standard deviation of the
portfolio. Graphically, it is a
straight line.
Fall 2023
 Capital Allocation Line (CAL)
 We can represent combinations of a risky asset and the
risk-free asset on a graph (this is also the investment
opportunity set):
Expected
Capital Allocation Line
Return
E(Ri) (CAL)

E(Rp) • Risky Asset

Rf •
Risk-free Asset

Fall 2023
sp s
Sharpe Ratio
 The slope of the CAL measures the excess
return being earned per unit of volatility:
(E[r] – rf)/

 This “reward-to-risk ratio” is commonly

referred to as the Sharpe ratio.

Fall 2023
Risk Aversion and Allocation
¨ Greater levels of risk aversion lead to larger
proportions of the risk-free asset
¨ Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets
 So, different investors will choose different

positions in the risky asset. In particular, the

more risk averse investors will choose to hold
less of the risky asset and more of the risk-
free asset.
Fall 2023
Utility Function
 How do we quantify risk aversion?
 We start from the utility function of the
investor:
 U = E(rp) – 0.5Ap2
 A is the risk aversion parameter
 The high A is, the more risk averse the
investor is.

Fall 2023
Portfolio of a Risk-free Asset and
a Risky Asset
 Recall the portfolio with y risky asset and 1-y
risk-free asset. Its expected return and
variance are:
2 2 2
𝜎 =𝑦 𝜎
𝐸 (𝑟 𝑝)= 𝑦𝐸 ( 𝑟 ) +( 1−𝑦 ) 𝑟 𝑓 𝑝

Fall 2023
Investor’s Objective
 The investor’s objective is to maximize her
utility level, by choosing the best allocation to
the risky asset, y.

2
𝑈=𝐸 ( 𝑟 𝑝 ) −0.5 𝐴𝜎 𝑝

Fall 2023
 Solving the Maximization
Problem
 Taking the first order derivatives of U with
respect to y and set it to zero.
For U = rf + y(E[r] – rf) – 0.5Ay22,
dU/dy =

Fall 2023
 An Example

∗ 𝐸 ( 𝑟 ) −𝑟 𝑓
𝑦 = 2
𝐴𝜎
𝑟 𝑓 =7 %, 𝐸 ( 𝑟 ) =15% ,𝜎=22% 𝑎𝑛𝑑 𝐴=4
y* =

Fall 2023
Security Selection Decision
 When making the decision of capital
allocation between a risk-free asset and a
risky portfolio, we have assumed that we
have already known the optimal risky
portfolio. That is, we know the composition,
the expected return, and the standard
deviation of the risky portfolio.
 We now look at the security selection
decision.

Fall 2023
Optimal Risky Portfolio
 Key Question: How do we find the optimal
risky portfolio?
 By choosing asset weights wi that maximize
the Sharpe Ratio:

𝐸 ( 𝑅𝑝) − 𝑅 𝑓
Max 𝑆𝑝 =
𝑤𝑖 𝜎𝑝

Fall 2023
The Optimal Risky Portfolio
(with n Risky Assets)
¨ By choosing asset weights w that maximize the
Sharpe Ratio:
′
𝐰 𝐑 −𝑅𝑓
Max 𝑆𝑝 =
𝐰 √𝐰 Σ 𝐰 ′

subject to the constraint that the weights sum to 1.

where w is the n x 1 vector of asset weights, R is
the n x 1 vector of asset returns, and  is the n x n
covariance matrix of asset returns.

Fall 2023
 Group
Visit sectorspdr.com to pick three sectors (except
for XLC, XLRE) in order of your preference, and
send me email (zhe@brocku.ca) with the
names and IDs of your group members

Fall 2023