Financial Management 3A

COFIA3-22

Eduvos (Pty) Ltd (formerly Pearson Institute of Higher Education) is registered with the Department of Higher Education and Training as a private higher education institution under the
Higher Education Act, 101, of 1997. Registration Certificate number: 2001/HE07/008
Week 2: Lesson 3 – Portfolio management
Learning outcomes and Assessment criteria
Learning Outcome 3:
Explain the impact of diversification on risk and return of a portfolio
Assessment Criteria 3.1 :
Explain the impact of diversification on the expected return and risk of a portfolio of shares.
Assessment Criteria 3.2:
Calculate and explain the following indicators of risk and expected return on a portfolio of shares: expected return on a
two-asset portfolio, risk of a two-asset portfolio using co-variance, expected return on a multi-share portfolio, beta of a
portfolio, expected return on a leveraged portfolio, and standard deviation of a leveraged portfolio.
Assessment Criteria 3.3:
Evaluate the concept of market efficiency, i.e., weak form, semi-strong, and strong-form efficiency.
 What will be covered in
today’s lesson?

Week 2: Lesson 3 (1) Explain impact of diversification on

risk and return of a portfolio of shares
Portfolio
Management (2) Calculate indicators of risk on a
portfolio of shares

(3) Evaluate the concept of market

efficiency
Prescribed reading

Financial Management – Carlos Correia 9th Ed

Chapter 4 – Portfolio Management
Introduction
• Remember the saying: Don’t put all your
eggs in one basket – meaning have a number
of investments because if one fails the other
one will thrive.
• This brought about the concept of
diversification
Diversification
• As future returns are uncertain, investors
place all their funds in more than one
investment (portfolio of investments).
• Profitable investments compensate for
investments that fail.
• Diversification has therefore effect on
returns and risk through portfolio
management
Two asset portfolio risk and return
• The holding of more than one asset is often
referred to the holding a portfolio of
assets/investments.
Measuring two asset portfolio returns
• Expected return on a portfolio = the
weighted average of the expected returns of
the individual shares

• Rp = expected return on the portfolio

• Wi = the proportion of funds invested in
share I
• Ri = expected return on share i
The principal of two asset portfolio risk
• The risk of a portfolio depends not only on
the riskiness of the individual shares, which
comprise the portfolio, but also on the
relationship between their returns.
• Portfolio risk is NOT a weighted average of
the risk of the individual shares in a
portfolio.
Activity 1
• An investor decides to invest R10 000 in a portfolio
which may consist of any combination of shares in
Plasco Ltd and Quinco Ltd.

• The following summary statistics are available for the

two companies:
Plasco Re = 30%; σ = 12.6%
Quinco Re = 20%; σ = 10.3%
Expected returns for various portfolio holdings of P and Q at different
weightings of P and Q

The greater the proportion of funds invested in PLtd, the

higher the expected return
Table 4.2 Past performance of shares P and Q and an equally
weighted portfolio PQ

In years when P
performs well, so
does Q
In years when P
performs poorly,
so does Q
Discussion
P has a higher variability in returns than Q and this is indicated by the
individual standard deviations.
P and Q are highly correlated as their returns move in similar
directions from one year to the next.
The covariance and correlation coefficient measures the extent to
which the shares move together. A correlation coefficient of 1, means
that the share movements will be perfectly related to each other.
The correlation coefficient of P and Q is 0.978 which reflects a very
high level of correlation
As the shares are highly correlated, the risk of the portfolio in this
case will be close to the weighted average of the individual shares.
Although company invested in more than one share and the risk of
losing money may have been reduced, the variability of portfolio
returns is similar to the individual shares. The construction of the
portfolio has not resulted in a reduction of risk (as measured by
variability of returns) as compared to the individual shares.
Cont.

THE PRINCIPLE
These two shares have a high positive correlation-near
perfect unison.
There will NOT BE much risk reducing benefit
Activity 2 Table 4.3 Past performance of shares P and Q and an equally
weighted portfolio PQ

The portfolio
PQ’s combined
return is
relatively stable

• Equally weighted P & Q portfolio but we have moved Q’s returns one period
forward and we begin with 12% in Year 1.
• In the years that P performs well, Q performs poorly
• In the years that P performs poorly, then Q performs well
Discussion
P has a higher variability in returns than Q and this is indicated by the
individual standard deviations.
P and Q are highly negatively correlated as their returns move in
opposite directions from one year to the next.
The covariance and correlation coefficient measures the extent to
which the shares move together. A correlation coefficient of 1, means
that the share movements will be perfectly related to each other.
The correlation coefficient of P and Q is -0.9667 which reflects a very
high level of correlation
As the shares are highly negatively correlated, the risk of the portfolio
in this case will be far from the weighted average of the individual
shares.
The construction of the portfolio has resulted in a reduction of risk (as
measured by variability of returns) as compared to the individual
shares.
Cont.
The returns for Q are the same but occur in
different years.
The Standard deviations for P and Q remain the
same, yet the portfolio risk has been
significantly reduced.
Cont.

THE PRINCIPLE
These two shares have a near perfect negative correlation.
There will be much risk reducing benefit
 What is required to reduce portfolio risk?

• Perfectly negatively correlated firms are hard

to find.
• Yet, if shares are less than perfectly
correlated, then the portfolio risk will be
LESS than the weighted average of the
individual shares.
Discussion

The dispersion around the mean of Q Ltd is tighter than

that of P Ltd. P Ltd is more riskier than Q Ltd but offers
a high expected return. The dispersion around the mean
of portfolio is tighter than that of P Ltd and Q Ltd. The
risk of holding a portfolio is lower than that of individual
shares
Analysis of the risk of two shares, B&G
Returns:
• Portfolio weightings: 50% of B and 50% of G

• Compare portfolio standard deviation of 3.18% to

weighted average of 4.56% [(3.16%+5.97%)/2]. This means
we can increase our return with hardly any increase in risk.
Analysis of the risk of two shares, B&G
Correlation Coefficient

• Slightly negative correlation

Analysis of the risk of two shares, B&G –using
excel • Returns:
• Portfolio weightings: 25% of B and % 75of G

• The weighted average return per portfolio of 25% B & 75% G

• Ex. Year 1 = 25% x 26% + 75% x 24% = 24.5%
• Then we can compute the average return for the portfolio and the
standard deviation of the portfolio’s returns
• No complex formulae required
Variance of the portfolio
• The variance of a portfolio may be determined by
applying the following formula:
Variance of the portfolio
• Assume a portfolio of 25% B and 75% G

Note: Formula for the portfolio variance can also be

stated as follows;
Question 1

3.3. Practice Activities [ ± 120 min ]: Activity 1 (vossie.net)

 Multiple share portfolio risk and return

• The principle of calculating returns and risk

of a portfolio with more than two shares are
identical to those of a two – share portfolio.
• The expected return is the weighted average
of the expected returns of all shares in the
portfolio.
• The risk of multiple share portfolio is
determined using the variance matrix
Multiple share portfolio risk and return
Opportunity set of
share portfolios
• A,C,D,E are individual
shares
• AEDC is a result of a
two share portfolio
• AB is the efficient
frontier, any portfolio
along that line offer
higher returns e.g X
better than Y
Benefits of diversification
• Reduce variability of portfolio returns.
• Risk is less than weighted averages of the
variances.
Figure 4.9
• Risk reduce with smaller shares and
stabilises later
• Total risk of 8shares held is 30% but
35shares is 20%, no more benefits of
diversification after
• At 20%, company can hold all shares
 Introducing a risk - free asset
Modern Portfolio Theory assumptions
• All investors are rational and prefer less risk
rather than more for a given rate of return.
• All investors have full and equal access to all
available information which results in similar
expectations.
• There are no transaction costs such as
brokerage; the markets are perfectly
competitive; and all financial assets are
divisible.
• There is no taxation.
• All investors can lend and borrow at the risk-
free rate
 Introducing a risk - free asset

• What is the effect of being able to invest and

borrow at a risk-free rate, such as a Treasury
Bill rate?
• This results in a capital market line which is
tangent to the efficient frontier and begins
at the risk-free rate.
Introducing a risk - free asset
Introducing a risk - free asset

The expected return for the leveraged/new portfolio is calculated using

the following formula:
Introducing a risk - free asset
• Where the standard deviation of the risk-free investment is zero and so
Formula 4.5 loses two of its terms.
Activity 3
An investor has a portfolio with Rp =25% and σm 17%
before a risk - free rate was available on the market.

Assume that an investor borrows at a risk-free rate of

12% = Rf , the return on the market is expected to be
22% = Rm, and standard deviation of market is σm = 12%

Calculate:
2.1 The expected return on a leveraged portfolio.
2.2 Return on investment.
2.3 Risk of the portfolio.
Assume the investor invests R10000 and borrows R5000
Solution

2.1 Rpl = (-0.5 x 0.12) + (1.5 x 0.22) = 27%

2.2 Received: 22% × R15 000 = 3 300
Paid: 12% × R5 000 = –600
Return on investment of R10 000 = 2 700

2.3
The investor by using borrowing facility, has leveraged herself from Rp
=25% and σm 17% to Rp =27% and σm 18% which offers higher utility
to her
Beta and Capital Asset Pricing Model (CAPM)
• Beta measures sensitivity of a shares to fluctuations in the market.
• Total Risk = Systematic (market) Risk + Unsystematic (specific) Risk
• Beta measures non-diversifiable risk
• Beta measures volatility of a share relative to volatility of the whole share market
• Beta of a Portfolio = weighted average of betas of shares in the portfolio
• The required return on a share is as follows:
Question 2

3.3. Practice Activities [ ± 120 min ]: Activity 3 (vossie.net)

Work through the questions from Page 4 – 49
to 4 – 58 in the prescribed textbook
Market Efficiency
• The Efficient Market Hypothesis (EMH)
• Weak form-shares follow a random walk
• Semi-strong form-all publicly available information is
impounded and without bias
• Strong form- all privately and publicly available
information is impounded and without bias
• Market efficiency: the evidence
• Share prices react quickly to information about
mergers, increases/decreases in earnings
• Fund managers do not on average beat the market
• But…there are ”anomalies” or unrecognised risk
factors
• Momentum
• Mean reversion over longer periods
• Low P/E firms / neglected firms / high book-to-
market / small firms
• Inside information
What Happens Next?
To be completed before the next lecturer-led session (self-directed learning and assessments):
• Lesson 4-Time value of money
• 4.1 Notes
• 4.2 Practice Quiz
• 4.3 Practice Activities
• Learning outcomes post assessment

What will be covered in the next lecturer-led session:

• Time value money
NB: Self-assessment Quiz 3