Session: Risky Portfolios

Risky Portfolios
For this discussion:
The investor is NOT ALLOWED to borrow or lend or place any of his
wealth in a risk-free asset.
Risky Portfolio – Two Risky Assets
Investment Expected Return E(r) Risk (σ)
X E(rx) = 10% σx = 7%
Y E (ry) = 20% σy = 10%

Portfolio E(rp)= wx*E(rx) + wy*E(rx) σp2 = wx2σx2 + wy2σy2 + 2wxwy σxσy ρxy

= wx0.1+ wy0.2 =wx2(0.07)2 + wy2(0.1)2 + 2wxwyρxy (0.07*0.1)

E(rp) of the Portfolio will depend on: σp2 of the Portfolio will depend on:

Individual Returns Individual Risks

WEIGHTS WEIGHTS
CORRELATIONS
For different weights of assets and for different correlation of return between them,
we will have different risk-return combinations of two assets.
Varying the Portfolio Weights gives:
The Investment Opportunity Set
• The set of feasible expected return and standard deviation pairs of all RISKY portfolios
resulting from different values of “W”.
• We represent the portfolio (of X and Y) graphically, defined by its return and risk
• Investment Opportunity Set : Each point within this area, represents a possible
combination of risky assets X, Y.
Y

X
Minimum Variance Frontier/ Boundary

• The curve in the graph is called

the minimum-variance boundary
or the minimum-variance
frontier.
 Varying both Weights and Correlations
Portfolio E(rp)= Wx0.1+ Wy0.2 σp2 = wx2(0.07)2 + wy2(0.1)2 + 2wxwyρxy (0.07*0.1)

-1 ≤ Correlation (ρxy ) ≤ +1 Wx + Wy = 1, Thus, Wy = 1- Wx

Expected Returns [E(rp)]

(Wx)

Standard Deviation [σp = σp2 ]

(Wx)
Varying Correlations and Weights: Different MV
Frontiers

(Wx= 0, Wy=1)

(Wx= 0.2, Wy=0.8)

(Wx= 0.4, Wy=0.6) Portfolio Risk-Return

Plots for Different
(Wx= 0.6, Wy=0.4) Weights

(Wx= 0.8, Wy=0.2)

(Wx= 1, Wy=0)
Graph: Two Points to Note
• When the correlation changes, only
σp changes. E(rp) for a given W does
not change. WHY?
• As ρxy decreases from +1 to -1, the
plot goes further to the left. We
have portfolios with lower σp for the
same E(rp) as ρxy decreases. In fact,
for some combinations, σp are far
lower than σx and σy . This is the
idea of diversification
Risk at +1 and -1 correlation
• Black Line (IOS at +1 ρxy): standard
deviation of all combinations of x and y are
always greater than that of asset
x. Diversification is not possible when the
asset returns are perfectly positively
correlated.
• Diversification is possible only when asset
returns are less than perfectly positively
correlated, that is, ρxy < +1.
• Pink curve (IOS at -1 ρxy): At one point the
curve touches y-axis- σp = 0. Completely
diversifies away all risk.
 Risky Portfolio-Three Risky Asset Portfolio
• If X, Y, and Z are assets, wa, wy, and wz are the portfolio weights on each
asset, and wx + wy + wz = 1, then:
• The expected return of the portfolio is
E(rp) = wxE(rx) + wyE(ry) + wzE(rz )
• The variance of the portfolio is
σ2p = wx2 σ2x + w2y σ2y + w2zσ2 z + 2wxwyσxσy ρxy+ 2wxwzσxσz ρxz + 2wywzσyσz ρyz
• The standard deviation of the portfolio is
σp = σ2p
Risky Portfolio-Three Risky Asset Portfolio
Investment Expected Return E(r) Risk (σ)
X E(rx) = 10% σx = 7%
Y E (ry) = 20% σy = 10%
Z E (rZ) = 15% σZ = 12%
CORRELATIONS X Y Z
X 1 0.1 0
Y 0.1 1 0.9
Z 0 0.9 1
Risk-Return Plot: Three Risky Assets

Minimum Variance Frontier for Each Pair: X and Y; Y and Z;

X and Z
Minimum-Variance Frontier
Investing in all three assets at the
same time?
• The Investment Opportunity Set
is the entire area within the black
curve (the curve and the area to
the right of the curve). Each point
within this area, represents all
possible combination of X, Y and
Z.
• The black curve is called a
Minimum-Variance Frontier
and plots the minimum variance
combinations of X, Y and Z.
Efficient Frontier and Minimum-Variance Portfolio
• The E(r) on top part of MV frontier is
always greater than the E(r) on the bottom
part of MV frontier
• The top part is called the Efficient
Frontier. It represents that set of portfolios
that has the maximum rate of return for
every given level of risk, or the minimum
risk for every level of return.
• In terms of risk return combinations, no risk
return combination to the left of, or above
the efficient frontier, is feasible.
• Important: Note the portfolio called
MVP, it stands for the global minimum-
variance portfolio. Using X, Y and Z, this is
the one portfolio that has the least
variance of risk across all portfolios in the
investment opportunity set.
Portfolio Terminology
• The investment opportunity set
• The Minimum-Variance Frontier
• An efficient portfolio
• The efficient frontier
• The minimum variance portfolio (MPV)
Diversification
• Diversification : Don't put all your eggs in one basket. If you drop the basket, all
the eggs break.
• Don’t put all your money in one asset. If that asset performs poorly, you will lose
all your wealth.
• Spread you wealth across various assets. The less than perfect positive collation
between these assets will help reduce your risk.
Three asset portfolio: E(rp) and σp
• E(rp) : Just a weighted sum of the individual security expected returns.
• σp : a bit more complicated
σ2p = wx2 σ2x + w2y σ2y + w2zσ2 z + 2wxwyσxσy ρxy+ 2wxwzσxσz ρxz + 2wywzσyσz ρyz
• Covariances are more influential than with a 2-asset portfolio.
• Three covariances now instead of one.
• As we add more assets, covariances become a more important determinate of
the portfolio’s variance (diversification)
• Covariances: Importance
• If the number of securities is large (and thus, the weights are small), covariances
become the most important determinant of a portfolio’s variance.
• For a n asset portfolio there are n(n − 1)/2 covariance terms, and n variance
terms.
• For example, a portfolio of a 1000 stocks, has 1000 variance terms and 499,950
unique covariance terms.
• Compare that to a portfolio of two assets which has 2 variance terms, and 1
covariance term.
How Much Diversification is Actually Possible?
• We saw that having risky assets that are not perfectly positively correlated helps
us reduce or diversify risk.
• Does that mean that we can endlessly reduce risk by simply adding more risky
assets to our portfolio.
Will the efficient frontier
eventually touch the vertical
axis as we keep adding additional
risky assets to our portfolio. That
is can we completely diversify
away our risk? In other words
can we make it zero?
How Much Diversification is Actually Possible?
• In general, the answer is no.

• Even after adding a large number of assets to portfolio, As long as covariance (co-
movement between the returns) is not zero, the σp2 will remain.
How Much Diversification is Actually Possible?
Total Risk (Standard Deviation) = Unsystematic Risk + Systematic Risk
Systematic Risk
risk that is common to all investing in general and
that cannot be reduced – i.e. the risk that the entire
market will crash.
For example, An increase in inflation will probably
have market-wide impact, affecting the systematic
risk component.
Non- Diversifiable Risk
market “pays” you for bearing non-diversifiable risk
only – In general the more non-diversifiable risk
that you bear, the greater the expected return to
your investment.
Eg. Emerging Market vs Developed Markets
Unsystematic Risk
Fundamental Risk: risk that is specific to a specific
investment – i.e. the risk that a single company’s
stock may go down.
For example, a sudden strike by the employees of a
company you have shares in
Diversifiable Risk
Investor is herself responsible for reducing
diversifiable risk. Many investors fail to properly
diversify, and as a result bear more risk than they
have to in order to earn a given level of expected
return.
Eg. Mapro vs Nestlé