PORTFOLIO THEORY AND ASSET ALLOCATION

Session 4
PROPOSED ACTIVITIES
▷Group Projects:

▷Individual assignments

▷Markowitz Portfolio Optimisation Model

▷Investment Game with Rs. 10 million

▷A group Exercise with Mutual Funds for submission

▷A group presentation of investment analysis at the

end of the course.
SESSION PLAN
▷INTRODUCTION TO PORTFOLIO THEORY

▷CONCEPTS RELATED TO PORTFOLIO THEORY

RISK AND RISK FREE ASSET
CAPITAL ALLOCATION
MEAN VARIANCE CRITERION
EFFICIENT FRONTIER

▷PORTFOLIO RISK AND RETURN

▷PORTFOLIO DIVERSIFICATION
SESSION PLAN
▷PORTFOLIO OF ONE RISKY AND A RISK FREE ASSET

▷RISK TOLERANCE AND CAPITAL ALLOCATION

CONCEPTS OF PORTFOLIO
THEORY
RISK
▷HARRY MARKOWITZ (1952)

THAT THE INVESTOR DOES (OR SHOULD) CONSIDER

EXPECTED RETURN A DESIRABLE THING AND VARIANCE OF
RETURN AN UNDERSIRABLE THING. FURTHER…..USUALLY IF
THE TERM YIELD WERE REPLACED BY EXPECTED YIELD OR
EXPECTED RETURN AND RISK BY VARIANCE OF RETURN, LITTLE
CHANGE OF MEANING WOULD RESULT.

Measurement is SD of returns : σ
RISK FREE ASSET
▷ Money supply and cost of money (Monetary Policy)
and Taxes and spending on Infra (Fiscal Policy) are
within the control of the Government and hence
any paper issued by the sovereign government is
RISK FREE ASSET (e.g., T-Bills, G-Sec, SDL etc.) and
the rates offered on these assets is RISK FREE RATE
PORTFOIO: CAPITAL ALLOCATION
▷Portfolio Value = Rs. 10 lakhs

▷Money Market Fund = Rs. 3 Lakhs (Risk Free

Asset)

▷Risky securities = Rs. 7 lakhs

Of this Rs. 3,78,000 in equities
remaining 3,22,000 in long term bonds

E = 378000/700000 = 0.54
B = 322000/700000 = 0.46

Risky Portfolio weight is 700000/1000000 = 70%

y = 70% 1-y = 30%
PORTFOLIO WEIGHTS
Weight of Each asset class in the portfolio

Equity = 378000/1000000 = 0.378

Bonds = 322000/1000000 = 0.322

Risky Portfolio = E+B = 0.700

Risk reduction is done by spreading across many

independent risk sources and is called the
INSURANCE PRINCIPLE
PORTFOLIO RISK REDUCTION
Assume we want to reduce weightage to risky assets
from 70% to 50%
Risky Portfolio would be 10 * .5 = Rs. 5 lakh

Hence sell risky asset of Rs. 7 lakh -5 lakh = 2 lakhs and invest that money in
risk free asset

For portfolio proportion to remain constant sell equivalently from risky portfolio

E= 378000 – 108000 (0.54*2 lakhs)

B = 322000 – 92000 (0.46*2 lakhs)

E = 270000 /500000 = 0.54

B = 230000/500000 = 0.46
PORTFOLIO RISK AND RETURN
PORTFOLIO RISK & RETURN
1. Single Asset Portfolio

Rp = R1

σ2 P = σ2 1

2. Two Asset Portfolio

Rp = w1R1 +w2R2

σ2P = w21σ21 + w22σ22 + 2w1w2Cov(r1, r2)

ONE ASSETS PORTFOLIO
Consider the following:

1. Cash
2. The Indian Lottery
3. Game of tossing the coin
4. G-Sec or T-Bills
5. Venture Capital
6. Equity
7. Commodities
8. Real estate
9. Stocks
10.ETFs
DIVERSIFICATION AND PORTFOLIO RISK
SOURCE OF RISK
▷Assume a single stock INFOSYS in the portfolio.

What is the source of risk in this portfolio?

INFOSYS
2. Firm Specific
TYPE OF RISKS
1. Market Risk or Systematic Risk or Non-
Diversifiable risk

2. Firm Specific Risk, Unique risk or Unsystematic

Risk or Diversifiable risk
DIVERSIFICATION
▷Add another popular stock say HDFC Bank in equal
proportion (50:50), vis-à-vis say TCS or HCL or
WIPRO

▷What Happens to Portfolio Risk?

▷REDUCED RISK DUE TO OFFSETTING EFFECTS

▷Let us see HDFC and Reliance worksheet (Var Cov)

DIVERSIFICATION REDUCES RISK
DIVERSIFICATION
ESTIMATING RISK AVERSION

▷How much investment risk can you afford to take.

▷Decide how much risk you can tolerate.

PORTFOLIO OF ONE RISKY ASSET
AND A RISK FREE ASSET
MODEL WITH ONE RISKY ASSET
Portfolio = P

Investment in Risky Asset = y

Risk free asset = 1-y in risk free asset F

Denote risky asset return rP and E (rP), σP

Risk free asset return = rf
Assume E(rP) = 15%, σP = 22% and rf = 7%

Risk premium is 8%

RC = y* rP +(1-y)* rf or RC = 7 + (15-7) y

σC = y* σP = 22y
PORTFOLIO OF TWO RISKY ASSETS
TWO RISKY ASSETS PORTFOLIO

Consider 2 Mutual Funds:

1. A Bond Portfolio of long term debt denoted by D

2. A stock fund that specializes in equities E

A proportion wD in Bonds and wE in equities

TWO RISKY ASSETS PORTFOLIO
RETURN AND VARIANCE
Returns on this portfolio is given by

rP = wD* rD + wE * rE

Variance of the portfolio is

σ2P = w2Dσ2D + w2Eσ2E + 2wDwECov(rD, rE)

Covariances are symmetric, hence we can also write it

σ2P = wDwD σD σD+ wEwEσE σE + 2wDwECov(rD, rE)

σ2P = wDwD Cov(rD, rD)+ wEwE Cov(rE, rE) + 2 wDwE

Cov(rD, rE)
PORTFOLIO VARIANCE
Adding another asset has changed the variance

Variance of the portfolio is

σ2P = w2Dσ2D + w2Eσ2E + 2wDwECov(rD, rE)-----------(7.3)

If covariance negative then portfolio variance is lower

Even if it is positive, portfolio SD is less than the

weighted average of individual SDs
LOWER PORTFOLIO VARIANCE
To understand let us use the concept of Correlation

Cov (rD, rE) = PDEσDσE

Therefore,
σ2P = w2Dσ2D+w2Eσ2E+2wDwEσDσEPDE

1. Portfolio variance is higher when correlation is

higher.
2. In case of perfect correlation =1, SD of the portfolio
is weighted average of components SD
3. When correlation less than 1, portfolio SD < WA
component SD
4. Hedge asset with <0 correlation, reduces risk
BENEFIT OF DIVERSIFICATION
Portfolio return is weighted average of its component
expected returns.

Whereas SD of the portfolio is less than the weighted

average of the component SDs.

Portfolios of less than perfectly correlated assets

always offer some degree of diversification benefit in
terms of lower SD.
HOW LOW SD BE
Lowest possible value of correlation is -1, representing
perfectly negative correlation.

σ2P = (wDσD – wEσE)2

Portfolio SD is σP = (Abs) (wDσD – wEσE)

For corr = -1, Proportions can be obtained by choosing

weights

wDσD – wEσE = 0

wD = σE / (σD +σE) and wE = σD/ (σD +σE)

Or wE = 1 - wD
PORTFOLIO PROPORTION AND RISK RETURN
Experiment with different proportions to observe the
effect on portfolio expected return and variance
WEIGHTS AND PORTFOLIO SD
Relationship between different portfolio weights and
portfolio standard deviations for different correlations
LOWEST SD
Minimisation problem:

σ2P = w2Dσ2D + w2Eσ2E + 2wDwECov(rD, rE)-----------(7.3)

Subject to wD+wE = 1

if we substitute 1-wD for wE

And differentiate w.r.t. wD,
We get the following:

wMIN(D) = σ2E – Cov(rD, rE) / (σ2D+σ2E- 2 Cov(rD, rE))

DIVERSIFICATION AND VARIANCE

Minimum Variance portfolio has SD of 11.45% that is

less than 12% of debt and 20% of equity

THIS IS THE EFFECT OF DIVERSIFICATION

PORTFOLIO OPPORTUNITY SET

Combine relationship between portfolio risk and

expected return given the parameters of available
assets.

Using Risk Returns data we can create the PORTFOLIO

OPPORTUNITY SET
 “
▷ASSET ALLOCATION IS THE KEY TO
PORTFOLIO PERFORMANCE
CONCEPT FOR THE DAY
CAPITAL ALLOCATION LINE