Risk versus Diversification for randomly selected portfolios

No. of Average σ Systematic Unsystematic r R2

security in a Return risk risk (correlation)
portfolio (N)
1 0.68 7 3.8 3.2 0.54 0.29
2 0.69 5.0 3.8 1.2 0.63 0.40
3 0.74 4.8 3.8 1.0 0.75 0.56
4 0.65 4.6 3.8 0.8 0.77 0.59
5 0.71 4.6 3.8 0.8 0.79 0.62
10 0.68 4.2 3.8 0.4 0.85 0.72
15 0.69 4.0 3.8 0.2 0.88 0.77
20 0.67 3.9 3.8 0.1 0.89 0.80
25 0.67 3.8 3.8 0.0 1.00 1.00
30 0.67 3.8 3.8 0.0 1.00 1.00

• As N increases from 1 to 30, the unsystematic risk of portfolio reduces to zero.

• Systematic risk is unaltered. Hence, total risk decreases.
• As N increases, our portfolio mimics entire market. i.e. it starts behaving like market. Hence, r (column
6) increases and gets close to 1.
• However, stocks inside the portfolio will have r between -1<r<1.
Modern Portfolio Theory (MPT)

■ Modern portfolio theory (MPT) is a theory on how risk-averse investors can construct
portfolios to maximize expected return based on a given level of market risk.
■ Video : https://www.investopedia.com/terms/m/modernportfoliotheory.asp

■ Let construct portfolios using two assets and then three assets.
 TWO Asset portfolios of stock X and Y
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B
• All possible portfolios lie on different points on the blue line
• Each portfolio has different weights of X and Y
• Each portfolio on line has relation between risk and return as shown in this graph
• Point A is portfolio containing only stock X i.e. X has 100% weight
• Point B is portfolio containing only stock Y i.e. Y has 100% weight
• Moving from A towards B on blue line, different portfolios are possible.
• Weight of stock X decreases and Y increases as we move from A to B on blue line
Risk /σ (Standard Deviation)
 Three Asset portfolio

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X
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• The colored area shows different portfolios that are possible using stock X, Y and Z
• Each portfolio will have different weights of X,Y, and Z
• All possible portfolios lie on different points inside the colored region
• No portfolio is possible outside the colored region

Risk /σ (Standard Deviation)

Efficient frontier
■ The efficient frontier is the set of optimal portfolios that offer the highest expected
return for a defined level of risk or the lowest risk for a given level of expected
return.
■ The red dotted line is efficient frontier.

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Risk /σ (Standard Deviation)

 R A B
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Risk /σ (Standard Deviation)

■ Portfolio A and B offer same level of returns to investors

■ But, Portfolio A has less risk, as it is on the efficient frontier (red dotted line)
■ Therefore, for a rational investor portfolio A is a better choice than portfolio B.
 R A
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Risk /σ (Standard Deviation)

■ Which is the efficient portfolio between A and B?
■ Portfolio A is efficient as it gives high return for same risk portfolio B
■ Hence, lower portion of red dotted line is not efficient.
■ Hence, Only the upper part of red dotted line is efficient.
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Risk /σ (Standard Deviation)

■ Therefore, efficient portfolios will lie only on the Green part (as shown in the above figure)
■ This is the efficient frontier now.
■ Minimum variance portfolio is a portfolio that can provide minimum risk to the investor.
 Why efficient frontier is a curve? And
not a straight line
■ Because of Diversification i.e. included assets that are negatively/un correlated in portfolio
■ Let us see how risk-return for a two asset portfolio will change for different correlations
between assets.
Correlation (r)= -1 -1 < r < 1, Curve is because of diversification.
Practically also, r lies in this range only when we
diversify portfolio. Hence, efficient frontier is a curve.
■ E(RP)

Correlation (r)=1, Risk-return relation is a direct

relation
■ correlation= -1

■ Risk (σ)
Mean – Variance analysis
I.e. Return – Risk Analysis
■ Modern portfolio theory identifies two aspects of the investment problem.
– First, an investor will want to maximize the expected rate of return on the portfolio.
– Second, an investor will want to minimize the risk of the portfolio.

■ The two aspects amount to the objective of maximizing the expected rate of return for any given, acceptable,
level of risk.

■ Portfolios on efficient frontier help to achieve this objective as they provide highest return for a given risk level.

■ Mean-variance analysis gives investors a framework to assess the tradeoff between risk and return

■ A Rational risk averse investor would to achieve the best risk-return trade off.
■ Rational investor will try to maximize the risk-reward ratio.
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Risk /σ (Standard Deviation)

■ We have seen that an investor can achieve any portfolio (as presented by dots) inside the feasible
portfolio region using her/his own wealth.
■ For achieving any portfolio, investor will divide the wealth into different securities/stocks.
■ Is it possible to achieve a portfolio outside this feasible region (i.e. area outside the coloured
portion)? i.e. She/he wants to achieve a risk/return combination outside this area.
Lending and Borrowing
■ Suppose that you can also lend or borrow money at some risk-free rate of interest Rf

All risky assets

and portfolios Capital Market line
Expected
return (Ei) Market
Portfolio
M

Riskless Efficient
asset Minimum frontier
Variance
Portfolio
Std dev (i)

■ Portfolio M is market portfolio. This means that investor has divided her/his wealth into all the
securities available in market. It simply represents the market.
Capital Market Line (lending)

■ Suppose you are a risk averse investor, Then you may divide your money in following way :
– Partially invest in market portfolio of risky stocks (i.e. M) and lend remainder money at
rate Rf (E.g. invest in treasury bonds)
– By doing so investor may achieve any risk return combination on the lending part of the
capital market line.
 Capital Market Line (Lending)
Rf = 5%, Return of portfolio M= 15%,
M M σ (M) =16%, σ (risk free asset) =0%
15

=5

16
■ Suppose you are a risk averse investor, and your wealth is divided 50:50 between M and risk free
asset.
■ Let Rf = 5%, Return of portfolio M= 15%, σ (M) =16%
■ Then, Return on total investment= .5* 5% + .5* 15% = 10%
■ Risk on total investment = .5*0% + .5*16%= 8%
■ Hence, risk and return both are reduced with respect to M
 Capital Market Line (Lending)
Rf = 5%, Return of portfolio M= 15%,
M M σ (M) =16%, σ (risk free asset) =0%
15

10 New Return/Risk level

=5

8 16

 p  [ X 12 12  X 22 22  2 X 1 X 2 12 ]1/ 2

• Risk may also be calculated using above expression (Assume correlation/covariance is zero):
• σ = √ (.5^2 * .16^2 + .5^2* 0 + 0) = √(.0064)=.08=8%
• Hence, New Return/Risk level is 10%/8%.
• Therefore, by lending some portion of money at risk free rate investor may end up in lending
part of capital market line.
Capital Market Line (Borrowing)
Rf = 5%, Return of portfolio M= 15%,
σ (M) =16%, σ (risk free asset) =0%
M M

■ Suppose you are a risk prone investor, Then you may divide your money in following way :
– Invest all your wealth in portfolio M and borrow same amount at rate Rf and invest that
also in M.
– By doing so investor may achieve any risk return combination on the borrowing part of
the capital market line.
Capital Market Line (Borrowing)

MM
Rf = 5%, Return of portfolio M= 15%,
σ (M) =16%, σ (risk free asset) =0%

■ Risk prone investor:

– Return=2 * (Return on M) - 1* (Interest paid at Rf ) =2 * 15 – 1* 5% =25%
– Risk (σ)= 2 * (Risk on M) - 1* (risk on risk free asset ) = 2*16% - 1 (0%)=32%

■ Video- https://www.investopedia.com/terms/c/cml.asp
 Capital Market Line (Borrowing)
25 New Return/Risk level

MM

15

Rf = 5%, Return of portfolio M= 15%,

σ (M) =16%, σ (risk free asset) =0%

16 32
 p  [ X 12 12  X 22 22  2 X 1 X 2 12 ]1/ 2
• Risk may also be calculated using above expression (Assume correlation/covariance is zero):
• σ = √ (2^2 * .16^2 + 0^2* 0 + 0) = √(.1024)=.32=32%
• Hence, New Return/Risk level is 25%/32%.
• Therefore, by borrowing some portion of money at risk free rate investor may end up in borrowing part of
capital market line.
 M

Risk Premium

■ Slope of CML indicates how much the expected rate of return must increase if the standard
deviation increases by one unit.
Using CML to find expected return for
given risk.
■ Consider an oil drilling company; current share price = $875, expected share price to be
$1, 000 in one year. The standard deviation of stock returns, σ = 40%; and rf = 10%. Also,
rM = 17% and σM = 12% for the market portfolio.

■ Risk here is 40%. As per CML, for a risk of 40%, return should be:
– r= .10 + (.17-.10)/ .12 * .40= 33%
■ But, Actual Return on this stock = (1000-875)/875 * 100 = 14.28%

■ For a risk as high as 40%. Investor could have achieved a return of 33% by obtaining a
portfolio on CML (either on lending or borrowing part of CML).
■ But, this stock has a return of only 14.28% with a 40% risk.
■ Hence, it is not wise to purchase this stock.
Why CML is better?

■ In last example, we saw that CML gives a idea of risk-return trade off. I.e. How much
should be the return for given level of risk.

■ But, Why CML should be the benchmark for comparison?

 M

Slope of CML is highest as compared to other lines

in graph

■ Slope of CML is nothing but return to risk ratio. It is highest as compared to other lines on graph as
shown above. Rational Investors would prefer CML as they get maximum return for given risk level.
■ CML Provides the highest risk-return trade off possible because the slope is highest as compared
to any other portfolio in the feasible portfolio region (Green area above).
– This means that increase in returns is highest for a portfolio on CML as risk increases.
■ Hence. It is logical to make portfolios on CML ,
■ and M (on CML) is the best portfolio of risky assets /stocks.