PORTFOLIO THEORY

Introduction to Portfolio Theory

 OUTLINE
• Introduction
• Calculating Two Asset Portfolio Expected
Returns and Standard Deviations
• Estimating measures of the Extent of
Interactions-Covariance and Correlations
• Efficient Portfolios
 Introduction
• Meaning of a Portfolio
• Constructing a Portfolio
• Diversification Theory
• Naïve versus Modern/Scientific or Harry
Markowitz (1952) Diversification
 Introduction to Portfolio Theory
• Holding Period Returns
The return earned from a share is defined
by the holding period returns; R.
 For one year; the holding period return =
[Dividends received + (share price at the
end of the period – purchase price)]/
Purchase price i.e. R = D1+ (P1-P0)
P0
 Introduction to Portfolio Theory
• Comparing Returns from two shares
If the return from one share is on annual
basis whilst another one is semi-annual;
the two shares need to be compared while
all of them are on annual basis.
The two returns can be related through the
Formula; (1+ s)2 = 1+ R
Where; s = semi-annual rate and R = annual
rate
 Introduction to Portfolio Theory
• One of the major concepts that most
investors should be aware of is the
relationship between the risk and the
return of a financial asset.
• The finance theory suggests that there is a
positive relationship between expected
return and risk
• Portfolio theory is therefore referred to as
Mean-Variance Optimization.
Introduction to Portfolio Theory
• The link existing between portfolio risk and
portfolio return was first quantified by Harry
Markowitz in 1952 in his journal article entitled
“Portfolio Selection”.
• He founded the so called Modern Portfolio
Theory (MPT).
• Given a choice between two assets with equal
rates of return, risk-averse investors will select
the asset with the lower level of risk.
 Meaning of a Portfolio
• An investment Portfolio means; “owning
more than one financial security”.
• The objective is to increase the portfolio's
value by selecting investments that you
believe will go up in price.
• The portfolio is built or constructed by
buying additional stocks, bonds, mutual
funds, or other investments.
 Meaning of a Portfolio
• Portfolio
– is a financial term denoting a collection of
investments held by an investment company,
hedge fund, financial institution or individual
• In principle, a portfolio is designed
according to the investor's risk tolerance,
time frame and investment objectives
 The Portfolio Concept
• The concept of portfolio is considered to
be addressing the old adage that “Do not
put all your eggs in one basket”
• That is “ Spread your eggs in different
baskets so that if one basket falls at
least you will have eggs in other
basket(s)”
• In investment world “ Do not put all your
funds in one investment – DIVERSIFY”
Modern Portfolio Theory (MPT)
• The theory was developed by Markowitz
and is based on the assumption that
investors are risk averse.
• This means that; given a choice between two
assets with equal rates of return, most investors
will select the asset with the lower level of risk.
• These portfolios are said/assumed to be
mean–variance efficient.
 Other MPT Assumptions
• To prefer higher returns all else being
equal;
• To have developed identical expectations
regarding the anticipated returns, standard
deviations, and co-variances of all
securities.
• Capital Market is assumed to be perfect,
such that:
 MPT Assumptions
Information is instantly and costless
available to all investors;
There are no taxes or transactions costs;
Investors can borrow or lend at the risk
free rate of interest; and
No market participant can exercise any
market power.
 MPT
• According to MPT, you can reduce your
investment risk by creating a well
diversified portfolio that includes enough
different types of stocks.
• Modern portfolio theory states that the risk
for individual stock returns has two
components i.e. systematic risk and
unsystematic (firms’ specific) risk.
 MPT
• Systematic Risk (Un-diversifiable risk) - These
are market or industry wide risks that cannot be
eliminated or diversified away. Interest rates,
recessions and wars are examples of systematic
risks.
• Unsystematic Risk - Also known as “firm specific
risk or diversifiable risk", this risk is specific to
individual stocks and can be diversified away as
you increase the number of stocks in your
portfolio, e.g.. Labor strike, management style, etc.
 Diversification Theory
• Naïve Diversification
 Risk can be reduced by combining as
many assets or stocks in a portfolio
The way how assets are correlated is not
important
Only unsystematic or firm's specific risks
are eliminated.
 Naïve Diversification
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 Naïve Diversification
Evidence from numerous studies indicates;
• Risk falls as the number of securities increases
but at a decreasing rate
• Virtually all the possible risk reduction is
achieved with portfolios of 15 or so securities
• About 60-67 per cent of risk can be eliminated,
but there is some residual risk that cannot be
diversified away
• The risk that cannot be diversified away reflects
the positive co-variances among securities i.e.
systematic risks
 Diversification Theory
• Modern/ Scientific/ Markowitz
Diversification
This concept was established by Harry
Markowitz in 1952.
The main issue is the correlation of assets
or stocks
That is to say; not every diversification of
investment reduces risk
 Modern Diversification
 Diversification only reduces risk when
assets or stocks are negatively correlated
 Correlation Coefficients/ Scale
• Perfect negative Correlation
This occurs when the correlation coefficient
between two assets is -1. Here, there is a
possibility of eliminating risk.
• Perfect positive Correlation
• This occurs when the correlation coefficient
between two assets is +1. Here, there is
no possibility of eliminating risk.
 Correlation Coefficients/ Scale
• No correlation (Independent assets)
This occurs when the correlation
coefficient between two assets is zero (0).
Here, there is a possibility of reducing risk
but not eliminating it all.
 MEASURING EXPECTED RETURN
AND RISK
• EXPECTED RETURN
For an Individual Asset – It is the sum of
the product of returns and the
corresponding probability of the returns.
For a Portfolio of Assets –The expected
rate of return for a portfolio of investments
is simply the weighted average of the
expected rates of return for the individual
investments in the portfolio.
 EXPECTED RETURN
Given a probability distribution of returns,
the expected return can be calculated
using the following equation:
N
E ( R)   (PR
i 1
i i )
 EXPECTED RETURN
E(R) = the expected return on the stock
N = the number of states
pi = the probability of state i
Ri = the return on the stock in state i.
 EXPECTED RETURN
Example 1
• The table below provides a probability
distribution for the returns on stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
Calculate the expected return for each stock
 EXPECTED RETURN
• The expected return for stock A and B
would be calculated as follows:
E(R)A = 0.2(5%) + 0.3(10%) + 0.3(15%) +
0.2(20%) = 12.5%
E(R)B = 0.2(50%) + 0.3(30%) + 0.3(10%) +
0.2(-10%) = 20%
• So we see that Stock B offers a higher expected return
than Stock A. However, the risk aspect is not
considered.
 EXPECTED RETURN OF TWO ASSETS

• The Expected Return on a two assets

Portfolio is computed as the weighted
average of the expected returns on each
stocks which comprise the portfolio.
• The weights reflect the proportion of the
portfolio invested in the stocks.
• This can be expressed as follows:
 EXPECTED RETURN OF TWO
ASSETS

E ( RP )  WA E ( RA )  WB E ( RB )
 EXPECTED RETURN OF TWO
ASSETS
Example 2
Given that, the expected return on stock A
is 12.5% and the expected return on stock B
is 20%. A portfolio formed on two assets A
and B, comprises of 75% on A and 25% on
B. Calculate the expected rate of return of a
portfolio.
 EXPECTED RETURN OF TWO
ASSETS
• The expected rate of return of a portfolio
is:

E ( RP )  0.75(0.125)  0.25(0.20)
E ( RP )  0.1438  14.38%
EXPECTED RETURN OF N ASSETS

• If a portfolio constitutes of N assets, an

expected return can be calculated using the
following formula:
N
E ( RP )  Wi E ( Ri )
i 1
 MEASURING RISK
• The Variance of Returns for an
Individual Investment
The standard deviation is calculated as the
positive square root of the variance:

SD ( R )    Variance
 MEASURING RISK
• Standard Deviation (δ) is a measure of
total risk. It should be in decimal places or
in percentages.
• The variance of the returns for an
individual investment is given by;
n
Variance ( R j )   2
j   P i ( R ji  E ( R j )) 2

i 1
 The Variance of Individual
Investment
Example 3
• The table below provides a probability distribution
for the returns on stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
Given that, E(RA) = 12.5% and E(RB) = 20%. Calculate the
standard deviation of stock return A and stock return B
 The Variance of Individual
Investment
• The variance and standard deviation for
stock A and B are calculated as follows:
δ2A = 0.2(.05 - 0.125)2 + 0.3(0.1 -0.125)2 +
0.3(0.15 - 0.125)2 + 0.2(0.2 - 0.125)2 = 0.002625
δA = √ (0.002625) = 0.0512 = 5.12%
δ2B = 0.2(0.50 - 0.20)2 + 0.3(0.30 - 0.20)2 +
0.3(0.10 - 0.20)2 + 0.2(-0.10 - 0.20)2 = 0.042
δB = (.042)0.5 = .2049 = 20.49%
 The Variance of Individual
Investment
• Although Stock B offers a higher expected
return than Stock A, also it is riskier since
its variance and standard deviation are
greater than Stock A's.
• Thus; which Stock is preferable? . Stock A
is preferable to stock B.
• However, this is only part of the picture
because most investors choose to hold
securities as part of a diversified portfolio.
 THE VARIANCE OF RETURNS OF A
PORTFOLIO
• Two basic concepts in statistics,
Covariance and correlation, must be
understood before we discuss the formula
for the variance of the rate of return for a
portfolio.
• Covariance is a measure of the degree to
which two variables “move together”
relative to their individual mean values
over time.
 COVARIANCE
• The Covariance between the returns on
two stocks A and B can be calculated as
follows:
N
Cov ( RA , RB )   A, B   Pi ( RAi  E ( RA ))( RBi  E ( RB ))
i 1
 COVARIANCE
 δA,B = the covariance between the returns on stocks A and B
 N = the number of states
 Pi = the probability of state i
 RAi = the return on stock A in state i
 E(RA) = the expected return on stock A
 RBi = the return on stock B in state i
 E(RB) = the expected return on stock B
 CORRELATION
• The Correlation Coefficient of Assets A and
B is obtained by standardizing (dividing)
the covariance by the product of the
individual standard deviations; i.e.

Cov( RA , RB )  A, B
Corr ( RA , RB )   A, B  
SD( RA ) SD( RB )  A B
 Covariance and Correlation
Example 4
From example 3, calculate the covariance
and correlation between stock A and B.
• The covariance between stock A and stock
B is as follows:
δA,B=0.2(.05-0.125)(0.5-0.2)+0.3(0.1-
0.125) (0.3-0.2)+0.3(.15-.125)(0.1-
0.2)+0.2(0.2-.125)(-0.1-.2) = -.0105
 Covariance and Correlation
• The correlation coefficient between stock A
and stock B is as follows:

 0.0105
 A, B   1.00
(0.0512)(0.2049)
Covariance and Correlation
From the above computation, is there a
possibility of eliminating or reducing
unsystematic risk if A and B are to form a
portfolio? Why?
 VARIANCE FORMULA
• The Variance on a Two-Asset Portfolio
can be calculated as follows:
Var ( RP )  WA  A  WB  B  2WAWB Cov( RA , RB )
2 2 2 2
 VARIANCE FORMULA
• OR;

Var ( RP )  WA  A  WB  B  2WAWB  AB A B

2 2 2 2
Variance and Standard Deviation

Example 5
From example 4, calculate the variance and
standard deviation of a portfolio consisting of
75% of stock A and 25% of stock B.
The standard deviation of a portfolio is given
by;
δ2p=(0.75)2(0.0512)2+(0.25)2(0.2049)2+
2(0.75)(0.25)(-1)(0.0512)(0.2049)= .00016
δp = .00016 = .0128 = 1.28%
 Calculations Summary
• The above calculations can be
summarized and analyzed as follows:
Expected Return Variance Standard Deviation
Security A 12.5% 0.00263 5.12%
Security B 20.0% 0.0420 20.49%
Portfolio 14.38% 0.00016 1.28%
 EFFICIENT PORTFOLIO
• An Efficient Portfolio is the one that offers
the highest return for a given level of risk or
lowest risk for a given level of return
• Efficient Portfolios are on efficient frontiers.
They are a combination of investments which
maximizes the expected return for a given
standard deviation.
• Such portfolios dominate all other possible
portfolios in an opportunity set or feasible
set.
 OPTIMAL PORTFOLIO
• Optimal Portfolio is the one which allow
investor to get onto the highest
indifference curve (IC). Graphically is a
point where IC is tangent to the efficient
frontier
Note that:
• Any two investors are likely to have
different utility functions. Thus, their
optimal portfolios are likely to differ.
 EFFICIENT PORTFOLIO
Consider two stocks - a high risk/high return
technology stock (Google) and a low
risk/low return consumer products stock
(Coca Cola)
EFFICIENT PORTFOLIO
 EFFICIENT PORTFOLIO
• Any portfolio that lies on the upper part of
the curve is efficient: it gives the maximum
expected return for a given level of risk.
• A rational investor will only hold a portfolio
that lies somewhere on the efficient
frontier.
• The maximum level of risk that the
investor will assume is determined by the
position of the portfolio on the line.
 MINIMUM STANDARD DEVIATION FOR THE
COMBINATIONS OF TWO SECURITIES

• If fund is to be split between two

securities; A and B, and x is the fraction to
be allocated to A, then the value for x
which results in the lowest standard
deviation is given by;
x=  B  COV ( R A , RB )
2

 A   B  2COV ( R A , RB )
2 2
Computing Minimum Standard Deviation
for the Combinations of Two Securities
OR;

VAR( R B ) - COV ( R A R B )
x=
VAR( R A ) + VAR( R B ) - 2 COV ( R A R B )
 THE END

THANK YOU FOR YOUR ATTENTION

 SEMINAR QUESTIONS
•1. The expected return on security A is 20 per
cent with a standard deviation of 30 per
cent, while the expected return on security
B is 16 per cent with a standard deviation
of 24 per cent. The correlation coefficient
for the returns on A and B is estimated to
be 0.75. What is the expected return and
risk of a portfolio consisting of 30 per cent
of A and 70 per cent of B?
 SEMINAR QUESTIONS
•2. The returns on X and Y are perfectly
negatively correlated. The standard
deviation on these securities are 25 and
15 per cent respectively. How much
needs to be invested in X to eliminate risk
entirely?
 SEMINAR QUESTIONS
3. Consider the distributions of returns for
two assets A and B below;
State of the Probability of Return on A Return on B
Economy the State
Depression 0.25 -20% 5%
Recession 0.25 10% 20%
Normal 0.25 30% -12%
Boom 0.25 50% 9%
 SEMINAR QUESTIONS
• Required
a)Calculate return (in each state of the
economy) and Expected Return on portfolio
made up of 60% of A and 40% of B.
b)Calculate risk (standard deviation) of a
portfolio made up of 60% of A and 40% of B
c)Calculate the correlation between A & B
 SEMINAR QUESTIONS
4. Shares in F and G are perfectly negatively
correlated.

Expected Return Standard deviation

F 17 6

G 25 10
 SEMINAR QUESTIONS
(a)Calculate the expected return and
standard deviation from a portfolio
consisting of 50% of F and 50% of G
(b)How would you allocate the fund to
achieve a zero standard deviation?
 SEMINAR QUESTIONS
5. An investor has £100,000 to invest in
shares of Trent or Severn, the expected
returns and standard deviations of which are
as follows;
Expected Return Standard Deviation

Trent 10 5

Severn 20 12
 SEMINAR QUESTIONS
• The correlation coefficient between those
two shares is -0.2.
Required
a. Calculate the portfolio expected returns and
standard deviations for the following allocations;
PORTFOLIO TRENT (%) SEVERN (%)
A 100 0
B 75 25
C 50 50
D 25 75
E 0 100
 SEMINAR QUESTIONS
b. Calculate the minimum standard deviation
available by varying the proportion of Trent
and Severn shares in the Portfolio
c. Create a diagram showing the feasible set
and the efficient frontier
d. Select an optimal portfolio for a slightly
risk-averse investor using indifference
curves