REVIEW: DIVERSIFICATION AND THE EFFICIENT FRONTIER: CONCEPTUAL PERSPECTIVE

A. Introduction: We are focusing on the principles of diversification because the

usefulness of a stock for diversification in part determines its price, and thus its
expected return.

Thus far we have considered the issues of portfolio risk and return separately of one
another. In order to understand the above determination, however, we must consider them
jointly and thereby characterize the general risk/return relationship for portfolios.

B. As before, it is sufficient to consider the case of two assets A and B. We will first
examine how the risk return trade-off is affected by different assumptions on AB.



 
~
 ~
 
~
E R p  w A E R A  wB E R B
 p  w A A  wB B  2 w A wB A B
2 2 2 2

 AB  1
 w A A  wB B 
2

  p  w A A  wB


This is a parametric set of equations.

Suppose we have a pair of assets, A and B, with the following characteristics:

𝐸[𝑟̃𝑖 ] 𝜎𝑖

Asset A 10% 10%

Asset B 20% 30%

We can plot 𝐸[𝑟̃𝑝 ] vs. 𝜎𝑝 for all possible combinations of 𝑤𝐴 and 𝑤𝐵 = 1 − 𝑤𝐴 where, for the
moment, we assume 𝑤𝐴 ≥ 0 and 𝑤𝐵 ≥ 0. Since both of the independent expressions for 𝐸[𝑟̃𝑝 ]
and 𝜎𝑝 are linear in 𝑤𝐴 and 𝑤𝐵 , one would expect the "joint relationship" to be linear as well.
That is the case, as we see below:

Prof. Gershun 1
Graphically,
Describes the risk/return
𝑤𝐴 𝐸[𝑟̃𝑝 ] p tradeoffs in the following
0 20 30 sense: it describes (the
.2 18 26 20  slope) how much
addition return an
.4 16 22 investor can expect to
.6 14 18 obtain by increasing his
.8 12 14 10 
1 10 10

10 20 30

2.


~
   
~
E R p  w A E R A  wB E R B
~
 
  w A A  wB B  2 w A wB (0) A B
2 2 2 2
 AB  0 p


 
 p  w A2  A2  wB2  B2 
12

Once again, let us first compute a sample of values:

wA 𝐸[𝑟̃𝑝 ] p
0 20 30
.2 18 26
.4 16 22
notice that for WA = .9, WB = . 1, it
.6 14 18 is possible, in this case, to reduce
.8 12 14 the variance of the portfolio below
that of any constituent asset.
.9 11 9.5
1 10 10
Graphically, we have the following:

Prof. Gershun 2
 efficient
region

Notice the following points:

(i) The fact that AB = 0 (rather than AB = 1) means that the investor can obtain
higher expected returns for the same level of risk or lower risk for the same level
of expected returns.

(ii) The risk/return relationship has changed.

(iii) The hooked portion of the curve - which also characterizes those portfolios that are
inefficient - arises from the fact that for some combinations of A and B, p is less
than either A or B.

(iv) We found the minimum risk portfolio (𝑤𝐴 = 0.9 𝑎𝑛𝑑 𝑤𝐵 = 0.1) by differentiation,

min𝑤𝐴 𝜎𝑝 

min𝑤𝐴 𝜎𝑝2 = min𝑤𝐴 {𝑤𝐴2 𝜎𝐴2 + (1 − 𝑤𝐴 )2 }𝜎𝐵2 + 2𝑤𝐴 (1 − 𝑤𝐴 )𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵

𝜕𝜎𝑝2
= 2𝑤𝐴 𝜎𝐴2 − 2(1 − 𝑤𝐴 )𝜎𝐵2 + 2(1 − 2𝑤𝐴 )𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵
𝜕𝑤𝐴
At the minimum point the value of this derivative should be equal to zero. This is,
so called, the First Order Condition (FOC) for minimum or maximum. Therefore,

𝜎𝐵2 − 2𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵
𝑤𝐴 = 2
𝜎𝐴 + 𝜎𝐵2 − 2𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵

For our example, 𝜎𝐴 = 10%, 𝜎𝐵 = 30% 𝑎𝑛𝑑 𝜌𝐴𝐵 = 0. Therefore,

900
𝑤𝐴 = = 0.9
100 + 900

𝑤𝐵 = 0.1

Prof. Gershun 3
 𝜎𝑀𝑉𝐸 = √0.92 × 100 + 0.12 × 900 ≈ 9.5%

3. 𝜌𝐴𝐵 = −0.5 By now the pattern is clear: Since the return patterns are even more
dissimilar than if 𝜌𝐴𝐵 = 0, we would expect even greater gains to diversification:

𝐸[𝑟̃𝑝 ]

20

11
10

9.5 10 20 30

Clearly, the more dissimilar the return patterns,

i) The greater the 𝐸[𝑟̃𝑝 ] for a given p;

ii) The lower the p for a given 𝐸[𝑟̃𝑝 ];

iii) The lower the risk of the minimum risk portfolio.

4. AB = -1. This is the extreme case; we know that

𝐸[𝑟̃𝑝 ] = 𝑤𝐴 𝐸[𝑟̃𝐴 ] + 𝑤𝐵 𝐸[𝑟̃𝐵 ]

𝜎𝑝 = 𝑤𝐴 𝜎𝐴 − 𝑤𝐵 𝜎𝐵

From earlier work we know that for some 𝑤𝐴 and 𝑤𝐵 , 𝜎𝑝 = 0.

For our example, those weights solve:
𝜎𝑝 = 0 = 𝑤𝐴 × 10% + (1 − 𝑤𝐴 ) × 30%
3 1
𝑤𝐴 = and 𝑤𝐵 =
4 4
3 1 3 1
𝐸[𝑟̃𝑝 ] = 𝐸[𝑟̃𝐴 ] + 𝐸[𝑟̃𝐵 ] = × 10% + × 20% = 12.5%
4 4 4 4

Prof. Gershun 4
 efficient
region

inefficient
region

5. In the discussion thus far, we have required that the investor hold positive amounts of
both assets, i.e., that 𝑤𝐴 > 0 and 𝑤𝐵 > 0. If this assumption is relaxed so that the
investor may sell short either of the assets, how does this additional freedom further
transform the frontier?

In the latter case either 𝑤𝐴 < 0 or 𝑤𝐵 < 0. If 𝑤𝐴 < 0 and 𝑤𝐵 > 0, the story we tell is that
the investors sells asset A short and uses the proceeds of the short sale to buy more of
asset B (vice versa if 𝑤𝐴 > 0 and 𝑤𝐵 < 0).

Generally speaking (and this can be confirmed by plugging some addition values of 𝑤𝐴
and 𝑤𝐵 into the relevant formulae), short selling extends the efficient frontier in both
directions as per below:

Region where
wB >l, wA<0

Region where
wB < 0, wA>1

C. The Empirical Limits of Diversification

We have learned that if investors combine, in a portfolio, stocks for which the return patterns
are not perfectly positively correlated, risk reduction can be achieved, at no loss in expected
return.

The question is: are there any limits to this process? That is, is there a maximum amount

Prof. Gershun 5
 of risk reduction that can be achieved irrespective of the number of assets we acquire?
This is an empirical question.

1. For a portfolio of N assets, recall the expression for the risk of the portfolio:

 
N N N
~ ~
   w    wi w j cov Ri , R j
2
p
2
i i
2

i 1 i 1 j  i 
 ij i j
2. What happens if we add more and more assets to a portfolio, i.e. if we distribute our wealth
over more and more assets? By our assumptions of "competition" and "no transactions costs,"
there is nothing to prevent investors from doing so, at least in our idealized world.

Unless the new assets are perfectly positively correlated with something already in the portfolio,
the addition of assets must reduce risk; conceptually we have:

𝐸[𝑟̃𝑝 ]
Efficient Frontier, A, B, C

Efficient Frontier, B & C Only

Efficient Frontier, A&C Only

Efficient Frontier, A, B Only

σp

3. It is an empirical fact even if we include all the stocks traded on all the stock exchanges in
the world, the efficient frontier would appear as follows:

Prof. Gershun 6
 Efficient Frontier of all stocks

ERp

i.e., it is impossible
to eliminate all
the risk simply by
allocating our wealth over
a very large number of
assets

σp
pminimum

A second way to illustrate this idea is a follows:

min(risk of the
minimum risk
portfolio

N, number of assets
in the portfolio

Diversifiable risk: Risk that can be eliminated via the principles of
diversification; also called idiosyncratic risk, or non-market risk
Sources: Firm Specific Events, Mgmt Decisions,
Lawsuits, Accidents Failure/Success at gaining contracts
Undiversifiable Risk: Risk that cannot be eliminated
irrespective of the number of assets in the portfolio;
also called 'Market Risk" or 'Systematic Risk"
Sources: Business Cycles, Gov't Tax Policy,
Changes in inflation, Energy Costs etc.

So, we cannot even conclude that stock returns are independent since the insurance principle
does not hold (not all risk is eliminated even as the number of individual assets becomes
enormous). On average there must be positive correlation in returns.

D. Gain to International Diversification

1. The same conclusions hold if we examine the possible gains to international diversification:
there is a limit to the amount of risk reduction that can be achieved.

See Figures 1 and 2.

2. Of course, the estimates behind Figures 1 and 2 are based on historical data; that is, we
presume that the historical means, variances, and covariance of returns with one another for
the world's stock markets are good estimates of the ex ante future return possibilities.

Prof. Gershun 7
 3. To complete the characterization of investor's investment possibilities we need only add a
risk free asset.

E. Portfolios of Risky and Risk Free Assets

1. The efficient frontier of risk free and risky assets. Let A be the risky asset; B the risk free
asset:

𝐸[𝑟𝑖 ] 𝜎𝑖

Asset A – risky asset 𝐸[𝑟𝐴 ] 𝜎𝐴 > 0

Asset B – risk-free 𝐸[𝑟𝐵 ] = 𝑟𝑓 𝜎𝐵 = 0

𝐶𝑜𝑣(𝑟𝐴 , 𝑟𝐵 ) = 𝐶𝑜𝑣(𝑟𝐴 , 𝑟𝑓 ) = 0 = 𝜌𝐴𝐵

For these two assets,

i. 𝐸[𝑟̃𝑝 ] = 𝑤𝐴 𝐸[𝑟̃𝐴 ] + 𝑤𝐵 𝐸[𝑟̃𝐵 ] = 𝑤𝐴 𝐸[𝑟̃𝐴 ] + (1 − 𝑤𝐴 )𝑟𝑓

ii. 𝜎𝑝2 = 𝑤𝐴2 𝜎𝐴2 + 𝑤𝐵2 𝜎𝐵2

+ 2𝑤𝜎𝐴𝑝𝑤𝐵 𝜌𝐴𝐵 𝜎𝐴 𝜎𝐵
𝜎𝑝 = 𝑤𝐴 𝜎𝐴  𝑤𝐴 = 𝜎
𝐴
Because 𝜎𝐵 = 0 and AB = 0. Since both equations (i) and (ii) are linear, they suggest that
the relationship between 𝐸[𝑟̃𝑝 ]and p will also be linear. This is, in fact, the case:

𝐸[𝑟̃𝑝 ] = 𝑤𝐴 𝐸[𝑟̃𝐴 ] + (1 − 𝑤𝐴 )𝑟𝑓 = 𝑟𝑓 + 𝑤𝐴 (𝐸[𝑟̃𝐴 ] − 𝑟𝑓 )

𝜎𝑝
= 𝑟𝑓 + (𝐸[𝑟̃𝐴 ] − 𝑟𝑓 )
𝜎𝐴

𝐸[𝑟̃𝐴 ] − 𝑟𝑓
𝐸[𝑟̃𝑝 ] = 𝑟𝑓 + 𝜎𝑝 ( )
𝜎𝐴

2. Graphically, we represent the efficient frontier of risk free and risky assets by the
following:

Prof. Gershun 8
 =
 
~
E RA  rf
A

Lending Region: 0 ≤ 𝑤𝐴 ≤ 1 and 𝑤𝑟𝑓 ≥ 0

Borrowing Region: 𝑤𝐴 > 1 i.e. 𝑤𝑟𝑓 < 0 - borrow at a risk free rate to buy more of A.

3. Example: 𝐸[𝑟𝐴 ] = 10%, A = 15%; 𝑟𝑓 = 5%.

15%
The borrowing region;
In this region 𝑤𝑟𝑓 > 0; 𝑤𝐴 > 1 and 𝑤𝑟𝑓 < 0
i.e., we are holding Suppose 𝑤𝐴 = 1.5 and 𝑤𝑟𝑓 = −0.5
positive amounts of the 𝐸[𝑟̃𝑝 ] = 1.5 × 10% − 0.5 × 5% = 12.5%
risk-free asset; i.e., on
𝜎𝑝 = 𝑤𝐴 𝜎𝐴 = 1.5 × 15% = 22.5%
balance we are lending.

(1) Borrowing thus increases both risk and return, provided the cost of borrowing is less than
the project's expected return, and

(2) Typically, as more is borrowed, the risk of the portfolio will increase proportionately faster
than the expected return. This will exactly be so if

 p /w A =  A > ER A - rf = ER p /w A

(3) Furthermore, it must be the case that borrowing increases the overall portfolio's return in the
best states and reduces it the worst states. If this were not so, we would have an arbitrage

Prof. Gershun 9
 opportunity on our hands (why?).

4. A FINAL EXAMPLE: Buying an apartment,

The current situation:

Amount 𝐸[𝑟𝑖 ] 𝜎𝑖
Your wealth $60,000
Apartment price $150,000 5% (after tax) 5%
Mortgage loan $90,000 4% (after tax benefits) 0% (risk free)

150, 000
wapartment   2 12
60, 000
wloan  1 1 2

𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑜𝑓 1 1
𝐸[𝑟𝑝 ] (1 𝑎𝑝𝑎𝑟𝑡𝑚𝑒𝑛𝑡) = 𝑤𝐴𝑝𝑡. × 5% + 𝑤𝐿𝑜𝑎𝑛 × 4% = 2 × 5% − 1 × 4% = 6.5%
2 2
1 𝑙𝑜𝑎𝑛
1
𝜎𝑝 = 2 × 5% = 12.5%
2

(We have assumed zero risk on the bank loan.)

F. The Efficient Frontier for Portfolios of Risk Free and Risky Assets

1. Risky Assets Only

𝐸[𝑟𝑝 ]

Efficient Frontier, portfolios of risky

assets only

p

Prof. Gershun 10
Risky and Risk Free Asset

𝐸[𝑟𝑝 ]

Efficient Frontier of
risk free and risky
assets

p
.
2. Note that investors will invest all of their wealth in either of two assets: the risk free asset
and the risky tangency portfolio P̂ . This phenomenon is referred to as two fund
separation.

3. Remark (1): clearly, by adding a risk free asset, the efficient frontier is made uniformly
better from the investors’ viewpoint, i.e., for every p, an investor can obtain a higher
𝐸[𝑟𝑝 ] than was possible for risky assets alone.

Remark (2): Note that the tangency portfolio will never be the minimum risk, risky asset
portfolio.

4. We can decompose the investment line into regions of borrowing and lending.

Lending region
𝑤𝑟𝑓 > 0 and
0 < 𝑤𝑃̂ < 1

Borrowing region
𝑤𝑟𝑓 < 0 and 𝑤𝑃̂ > 1

p

Let us characterize the tangency portfolio P̂ a bit more completely. Notice that, of all risky
portfolios P, it is the one for which the ratio

𝐸[𝑟𝑃
̂ ]−𝑟𝑓
is the greatest
𝜎𝑃
̂
This is just the slope of the line joining 𝑟𝑓 and P̂ .

Prof. Gershun 11
 1. This tells us that the constituent assets in portfolio must be combined in such a way that
for any two of them, say assets i and j,

𝐸[𝑟̃ 𝑖 ]−𝑟𝑓 𝐸[𝑟̃ 𝑗 ]−𝑟𝑓 𝐸[𝑟̃ 𝑗 ]−𝑟𝑓

𝜌𝑖,𝑃
= = ()
̂ 𝜎𝑖 𝜌𝑗,𝑃
̂ 𝜎𝑗 𝜎𝑃
̂

2. That is, the expected return above the risk free rate per unit of risk contribution to P̂ ,
(𝜌𝑖,𝑃̂ 𝜎𝑖 ), must be the same for all assets.

Suppose this were not so. Then we would observe two constituent assets, for which
𝐸[𝑟̃𝑖 ] − 𝑟𝑓 𝐸[𝑟̃𝑗 ] − 𝑟𝑓
>
𝜌𝑖,𝑃̂ 𝜎𝑖 𝜌𝑗,𝑃̂ 𝜎𝑗

But this inequality implies that asset 𝑖 is providing more return above 𝑟𝑓 per unit of risk
contribution than asset 𝑗.

3. If this were so, then the portfolio's overall expected return above 𝑟𝑓 per unit of risk could
be increased by increasing the proportion of asset 𝑖 in the portfolio and reducing the
proportion of 𝑗. But then P̂ would not have been the tangency portfolio.

4. As an anticipation to what will follow, notice that equation  implies that for any asset i
in the portfolio P̂ ,

𝜌𝑖,𝑃̂ 𝜎𝑖
𝐸[𝑟̃𝑖 ] = 𝑟𝑓 + (𝐸[𝑟̃𝑝̂ ] − 𝑟𝑓 )
𝜎𝑃̂

This resembles (but is not identical to) the Security Market Line of the CAPM.

H. Summary, Conclusion, and the Next Step

1. We have hypothesized that investors are concerned only with the expected return and risk
of their overall portfolios. A consequence of this assumption is that they will seek to
assemble portfolios that are efficient.

2. The relevant risk of an individual asset to an investor must therefore be the risk the asset
contributes to his overall portfolio; i.e., that portion of its total risk that is not diversified
away when it is included in that portfolio.

3. We have also argued that the expected return to an asset must be a function of its relevant
risk. If we are to achieve an objective measure of an asset's expected return and its
relevant risk, however, all investors must be measuring relevant risk with respect to the
same portfolio. Otherwise, every investor's estimate of the relevant risk of, say EXXON,
would be different since the reference portfolios with respect to which the relevant risk

Prof. Gershun 12
 measurement would be made, would differ.

How can we argue, in effect, that all investors measure relevant risk with respect to the
same benchmark portfolio? The Capital Asset Pricing Model provides the assumption
necessary to guarantee this.

Prof. Gershun 13