CHAPTER 7: EFFICIENT DIVERSIFICATION

CHAPTER OVERVIEW
In this chapter, the concept of portfolio formation moves beyond the risky and risk-free
asset combinations of the previous chapter to include combinations of two or more risky
assets. Risk reduction occurs by combining securities with different return patterns (the
technique known as diversification). By combining securities with differing return
patterns, efficient portfolios (maximum return for a given level of risk) may be created.
Finally, the risky portfolio is expanded to include all risky assets (e.g., the market); the
investor may invest in the market (or in an indexed mutual fund) combined with the
appropriate investment in risk-free instruments to create the portfolio of the desired risk
level.

LEARNING OBJECTIVES
Students should be able to calculate standard deviation and return for two security
portfolios and be able to find the minimum variance combinations of two securities.
Upon completion of this chapter, the student should have a full understanding of
systematic and firm-specific risk. Students will demonstrate how diversification can
reduce the amount of firm-specific risk in the portfolio by combining securities with
differing patterns of returns. The student should be able to quantify this risk-reduction
concept by calculating and interpreting covariance and correlation coefficients. Finally,
the student should be able to conceptualize the importance of diversification.

PRESENTATION OF MATERIAL
7.1 Diversification and Portfolio Risk (PowerPoint Slides 3–5)
The chapter begins with a discussion of market risk (nondiversifiable) and firm-specific
risk (diversifiable). Figure 7.1 shows portfolio risk as a function of the number of stocks
in the portfolio and Figure 7.2 shows portfolio diversification. Discussion of market or
systematic risk and unique or unsystematic risk serves as an introduction for the detailed
discussion of portfolio risk that follows and the power of diversification to reduce that
risk.

7.2 Portfolios of Two Risky Assets (PowerPoint Slides 6–18)

Covariance and correlation are discussed here. Table 7.1 provides a look at descriptive
statistics for two mutual funds. Equations 7.1 and 7.5 calculate the return and risk for a
two-security portfolio. The initial discussion of the concept of covariance can be done on
an intuitive basis. It is useful to get the students to identify securities that will have
returns that vary together and securities whose returns are not highly correlated. The
possible range for correlation coefficients is between positive one and negative one.

Concept Check 1 asks students to consider a three-security portfolio. This will be helpful
for the students to understand how data requirements increase for larger portfolios.

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The effect that varying levels of correlation has on portfolio risk is developed here (see
Table 7.2 and Table 7.3). Lower levels of correlation lead to greater benefits of
diversification. At the extreme, if two assets have a correlation coefficient of −1.0, it is
possible to construct a portfolio with zero risk. Figures 7.3 and 7.4 illustrate portfolio
expected return and portfolio standard deviation as functions of portfolio weights. Figure
7.5 plots expected return as a function of standard deviation.

7.3 Asset Allocation With Stocks, Bonds, and Bills (PowerPoint Slides 19–25)
The development of an optimal investment strategy with a two-security portfolio in
combination with the risk-free rate is presented in this section. It incorporates investor
risk aversion and utility. The investor will maximize utility by forming some combination
of the optimal risky portfolio and the risk-free rate. Figure 7.6 presents the opportunity
set of debt and equity funds and two feasible CALs. Figure 7.7 combines the major
concepts of risk, return, and optimization to form an optimal risky portfolio. Figure 7.8
determines the optimal complete portfolio by combining Figure 7.7 with the ability to
lend at the risk-free rate. An example of the proportion of investment in each of the assets
for one particular investor is shown in Figure 7.9. This is the summation of three steps—
specification of the return characteristics for all securities, establishing optimal risky
portfolio, and allocating funds between the risky portfolio and the risk-free assets (based
on the risk-return profile of each of the investor’s risk aversion).

7.4 Markowitz Portfolio Optimization Model (PowerPoint Slides 26–34)

This section of the text extends the model by including additional risky assets and the
minimum-variance frontier. Applying diversification principles to the universe of risky
securities leads to identification of the efficient frontier of risky assets (Figure 7.10). The
efficient frontier traces the most efficient (i.e., best risk/return trade-off) portfolios,
Figure 7.12.

Regardless of risk aversion, investors will choose the same portfolio of risky assets with
some combination of risk-less borrowing or lending, demonstrated in Figure 7.11. Figure
7.13 shows that the solution strategy is to find the portfolio producing the highest slope of
the CAL. Risk reduction is a function of varying levels of correlation with total risk a
function of the weights and covariances of the assets (Equation 7.16). Equations 7.18–
7.20 demonstrate the power of diversification on overall risk, and Table 7.4 displays the
results.

7.5 Risk Pooling, Risk Sharing, and the Risk of Long-Term Investments
(PowerPoint Slides 35–36)
If an insurance company sells 10,000 uncorrelated policies, one might think it is possible
to diversify away all risk. However, this does not account for the magnitude of risk. Risk
pooling and pooling together many sources of independent risk sources is only part of the
business model. Instead of risk pooling, the industry uses risk sharing, which distributes a
fixed amount of risk among many investors.

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of McGraw Hill LLC.
Excel Models
Two Excel models for diversification concepts are available at www.mhhe.com/bkm. The
first model develops the efficient frontier for two risky assets and allows for
combinations of the tangency portfolio with the risk-free security. The two-security
model is very useful in presenting the material on correlation and its impact on portfolio
risk if display capabilities are available in the classroom. The model demonstrates the risk
reduction with higher levels of correlation.

The second model is the efficient frontier application that is presented in the text. The
model is constructed for eight securities. An assignment requiring students to construct
an efficient portfolio for eight securities is very helpful in reinforcing the principles
related to efficient diversification. If excel can be displayed in the classroom, using the
model to develop a portion of the efficient frontier helps the students’ understanding of
the concepts and provides opportunities to discuss points relevant to the security
weightings.

Excel Applications
Connect Integrated Excel models are available for a variety of learning outcomes in this
chapter. Please utilize the questions developed in Connect!

KEY TERMS
diversification diversifiable risk efficient frontier of risky
insurance principle minimum-variance assets
market risk portfolio input list
systematic risk portfolio opportunity set separation property
nondiversifiable risk optimal risky portfolio risk pooling
unique risk minimum-variance risk sharing
firm-specific risk frontier
nonsystematic risk

KEY EQUATIONS

Expected portfolio return:

The expected rate of return on a two asset portfolio:

Variance of portfolio return:

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw Hill LLC.