PROFESSOR: We will now talk about risk and return

in portfolio investments.
In particular, we will introduce the core concept
of this lecture, diversification.
When forming your portfolio, why not
pick the best asset among many possible investments?
There are many problems with this idea.
One is, of course, it's hard to tell which stock is the best.
It is also the case that by forming
a portfolio of multiple investments,
one can achieve a better risk return trade off
than by picking one asset over another.
That is the benefit of diversification,
something we are going to discuss
in detail in this segment.
One can use a portfolio to enhance performance
by focusing one's bets.
This could be achieved by hedging.
For example, suppose that you have
a view on a particular company.
Your view is on the quality of firms management
or on its opportunities in the marketplace.
If you want to place a bet on a company,
you are, in fact, betting on much more
than your initial view.
You are betting on broad market moves
to which the stock is exposed.
By taking additional positions, for example,
by taking a short position in the market,
you will be able to isolate your bet.
So that you are betting on stock specific performance
rather than on that plus additional movements
in the market.
So forming portfolios could be very useful
in order to isolate views on particular elements
of the trade.
Portfolios can be used to customize and manage risks.
This is an important part of the risk management process.
They could be used to tailor a risk return trade off
to the needs of the particular investor.
How do we go about choosing the best portfolio?
Now, first of all, we have to say, what is the best mean?
This is subjective.
What we want to do is to find the portfolio that
is the best for a particular investor given
his or her preferences.
This process is an optimization process
among all possible portfolios.
We are going to look at the one that
maximizes the investor's objective,
such as expected utility.
This means that before we form a portfolio,
we need to agree on what the objective is.
What are we trying to optimize?
Which properties of the portfolio are important?
Now, in the mean variance framework,
there are two aspects of the portfolio that matter.
One is the expected return.
Investors prefer higher expected returns.
The other important dimension is risk.
Investors prefer lower risk, and in particular, risk
is measured by variance of portfolio returns.
Expected return on the portfolio, as well as
the variance of returns, are determined
by the composition of the portfolio, which
is the collection of weights on individual investments
and by the properties of the individual investments
themselves.
In particular, when we think about the portfolio average
return, portfolio mean return, it
is based on the average returns of individual assets
and portfolio weights.
If we have put together expected returns
on individual investments into a vector from one to N,
call each of the elements R bar, which
represents the expected return on each
of the stocks in the portfolio.
Then the expected return on the portfolio
is a sum over all of the positions of the expected
return on an individual asset times the portfolio
weight of that asset.
In other words, the expected return on the portfolio
is a weighted average of the individual expected returns.
For portfolio variance, it's a bit more involved.
First, let's summarize the information
about the properties of the individual investments.
This is no longer a vector, but a matrix.
It's the co-variance matrix.
The diagonal elements of this matrix
summarize riskiness of individual securities.
They are given by the variance of security returns.
The off diagonal elements, which will turn out
to be very important when we talk about diversification
capture co-movements of investments with each other.
They capture co-variance, pair-wise co-variance
of assets in the portfolio.
As an example, let's consider a portfolio of two assets.
One is a ETF SPY.
It's an equity ETF.
The other is a bond ETF.
We have seen these two securities before.
In the following two tables, you could see historical estimates
of average returns on the two securities,
as well as their variance co-variance matrix.
The variance co-variance matrix is not easy to read.
It is more intuitive to present information
as volatilities of individual investments,
as well as their relations with each other.
As we have seen before, investment in SPY
has much higher volatility than the bond ETF investment,
and correlation between these two securities
is very close to zero.
Now, let's take a close look at the expected return
on the portfolio.
As we said before, they expected return on the portfolio
is a weighted average of expected
returns on the securities in the portfolio.
Let's see why that is the case.
We will do that by following a simple example.
Again, two securities, SPY and AGG.
Suppose that we invest $600 into the equity ETF and $400
into the bond ETF.
It's $1,000 investment in total, and the portfolio weights
are 0.6 on SPY and 0.4 on AGG respectively.
Suppose that over the next month, the return on SPY
happens to be 2% and a return on the bond ETF AGG is minus 1%.
Keep in mind that these are realized returns
over a particular month.
These are not expected values.
What is the total return on the portfolio?
We can see that the portfolio value is going to change,
and the change is going to be equal to the sum of changes
in the values of the individual positions.
The investment in SPY is going to increase by 2%, which
is going to be equal to $12.
The investment in AGG is going to decline
by 1%, which is a $4 decline.
The total increase is $8 over 1,000,
which gives us 0.8% return on the entire portfolio.
What this illustrates is that the return on the portfolio
is equal to the weighted average of returns
on the individual positions.
Once we know how the return on the portfolio
is related to the returns on the individual investments,
we can compute the expected portfolio return
and the variance of the return.
The expected portfolio return is an expected value
of the weighted average of individual asset returns, which
ends up being the weighted average of expected returns
on the investments in the portfolio.
The unexpected component of the return
can be computed by subtracting the portfolio return mean
from the realized return.
Portfolio return variance is the variance
of the weighted average of the individual security returns.
Using the formula for the variance,
we see that this amounts to summing up
elements of the matrix that you see presented here,
where the diagonal elements of the matrix
are individual variances multiplied
by the squares of security weights in the portfolio.
And the off diagonal elements are co-variances
of asset returns multiplied by the product
of the corresponding weights.
In case of two assets in the portfolio,
we end up with three terms, two diagonal terms, which
capture the contribution of individual return variances,
and the off diagonal terms, which
are identical to each other and capture the contribution
of the co-movement between the two assets in the portfolio.
Going back to our original example of a two asset
portfolio of SPY and AGG, let's assume
that the weights on the two securities
are equal to each other, W1 equal to W2 equal to 1/2.
In this case, the expected portfolio return
is an arithmetic average of the expected returns on the two
securities.
A portfolio mean is always a weighted average
of individual return means.
Next, we compute the volatility of portfolio returns.
For our portfolio of SPY and AGG,
we find that the portfolio volatility is, in fact, less
than the weighted average of the individual volatilities
of returns.
This is an example of portfolio diversification.
Volatility of the portfolio is not a simple weighted average
of individual volatilities, and by combining securities
together, one can achieve a significant reduction in risk.
What enables us to do that is the imperfect
correlation between returns and the individual positions
in the portfolio.
We now extend our results to the general case,
a portfolio of M assets.
This is analogous to the two assets portfolio.
Except now, we have a longer sum of terms,
and the expressions are general.
The portfolio return as before is a weighted average
of individual asset returns.
The portfolio mean is a weighted average
of mean returns on individual assets in the portfolio,
and the variance of the portfolio return is a sum.
It's a double sum over all assets in the portfolio,
and each element of the sum is given
by the product of security weights, WI and WJ for assets I
and J, times the co-variance between their returns.
If you look closely at the portfolio variance,
we see that it can be decomposed into two types of terms.
The diagonal terms capture the contribution
of their own variance of each of the positions,
and the off diagonal terms that are driven by co-variances.