Chapter 7

Why Diversification Is a Good Idea

1
The most important lesson learned
is an old truth ratified.

- General Maxwell R. Thurman

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 Outline
Introduction
Carrying your eggs in more than one basket
Role of uncorrelated securities
Lessons from Evans and Archer
Diversification and beta
Capital asset pricing model
Equity risk premium
Using a scatter diagram to measure beta
Arbitrage pricing theory
3
 Introduction
Diversification of a portfolio is logically a
good idea

Virtually all stock portfolios seek to

diversify in one respect or another

4
 Carrying Your Eggs in More
Than One Basket
Investments in your own ego
The concept of risk aversion revisited
Multiple investment objectives

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 Investments in Your Own Ego
Never put a large percentage of investment
funds into a single security
If the security appreciates, the ego is stroked
and this may plant a speculative seed
If the security never moves, the ego views this
as neutral rather than an opportunity cost
If the security declines, your ego has a very
difficult time letting go
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 The Concept of
Risk Aversion Revisited
Diversification is logical
If you drop the basket, all eggs break

Diversification is mathematically sound

Most people are risk averse
People take risks only if they believe they will
be rewarded for taking them

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 The Concept of Risk
Aversion Revisited (contd)
Diversification is more important now
Journal of Finance article shows that volatility
of individual firms has increased

Investors need more stocks to adequately diversify

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Multiple Investment Objectives
Multipleobjectives justify carrying your
eggs in more than one basket
Some people find mutual funds unexciting
Many investors hold their investment funds in
more than one account so that they can play
with part of the total
E.g., a retirement account and a separate brokerage
account for trading individual securities

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Role of Uncorrelated Securities
Variance of a linear combination: the
practical meaning
Portfolio programming in a nutshell
Concept of dominance
Harry Markowitz: the founder of portfolio
theory

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 Variance of A Linear
Combination
One measure of risk is the variance of
return
The variance of an n-security portfolio is:
n n
xi x j ij i j
2
p
i 1 j 1

where xi proportion of total investment in Security i

ij correlation coefficient between
Security i and Security j
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 Variance of A Linear
Combination (contd)
The variance of a two-security portfolio is:

x x 2 xA xB AB A B
2
p
2
A
2
A
2
B
2
B

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 Variance of A Linear
Combination (contd)
Return variance is a securitys total risk

2p xA2 A2 xB2 B2 2xA xB AB A B

Total Risk Risk from A Risk from B Interactive Risk

Most investors want portfolio variance to be

as low as possible without having to give up
any return
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 Variance of A Linear
Combination (contd)
If two securities have low correlation, the
interactive risk will be small
If two securities are uncorrelated, the
interactive risk drops out
If two securities are negatively correlated,
interactive risk would be negative and
would reduce total risk

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 Portfolio Programming
in A Nutshell
Various portfolio combinations may result
in a given return

Theinvestor wants to choose the portfolio

combination that provides the least amount
of variance

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 Portfolio Programming
in A Nutshell (contd)
Example

Assume the following statistics for Stocks A, B, and C:

Stock A Stock B Stock C

Expected return .20 .14 .10
Standard deviation .232 .136 .195

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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

The correlation coefficients between the three stocks are:

Stock A Stock B Stock C

Stock A 1.000
Stock B 0.286 1.000
Stock C 0.132 -0.605 1.000
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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

An investor seeks a portfolio return of 12%.

Which combinations of the three stocks accomplish this

objective? Which of those combinations achieves the least
amount of risk?

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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

Solution: Two combinations achieve a 12% return:

1) 50% in B, 50% in C: (.5)(14%) + (.5)(10%) = 12%

2) 20% in A, 80% in C: (.2)(20%) + (.8)(10%) = 12%

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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

Solution (contd): Calculate the variance of the B/C

combination:
2p x A2 A2 xB2 B2 2 x A xB AB A B
(.50) 2 (.0185) (.50) 2 (.0380)
2(.50)(.50)(.605)(.136)(.195)
.0046 .0095 .0080
.0061
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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

Solution (contd): Calculate the variance of the A/C

combination:
2p xA2 A2 xB2 B2 2 xA xB AB A B
(.20) 2 (.0538) (.80) 2 (.0380)
2(.20)(.80)(.132)(.232)(.195)
.0022 .0243 .0019
.0284
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 Portfolio Programming
in A Nutshell (contd)
Example (contd)

Solution (contd): Investing 50% in Stock B and 50% in

Stock C achieves an expected return of 12% with the
lower portfolio variance. Thus, the investor will likely
prefer this combination to the alternative of investing
20% in Stock A and 80% in Stock C.

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 Concept of Dominance
Dominance is a situation in which investors
universally prefer one alternative over
another
All rational investors will clearly prefer one
alternative

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Concept of Dominance (contd)
A portfolio dominates all others if:
For its level of expected return, there is no
other portfolio with less risk

For its level of risk, there is no other portfolio

with a higher expected return

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Concept of Dominance (contd)
Example (contd)
In the previous example, the B/C combination dominates the A/C
combination:
0.14
0.12
Expected Return

0.1
0.08 B/C combination
dominates A/C
0.06
0.04
0.02
0
0 0.005 0.01 0.015 0.02 0.025 0.03
Risk 25
 Harry Markowitz: Founder of
Portfolio Theory
Introduction
Terminology
Quadratic programming

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 Introduction
Harry Markowitzs Portfolio Selection Journal
of Finance article (1952) set the stage for modern
portfolio theory
The first major publication indicating the important of
security return correlation in the construction of stock
portfolios

Markowitz showed that for a given level of expected

return and for a given security universe, knowledge of
the covariance and correlation matrices are required

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 Terminology
Security Universe
Efficient frontier
Capital market line and the market portfolio
Security market line
Expansion of the SML to four quadrants
Corner portfolio

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 Security Universe
Thesecurity universe is the collection of all
possible investments
For some institutions, only certain investments
may be eligible

E.g., the manager of a small cap stock mutual fund

would not include large cap stocks

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 Efficient Frontier
Construct a risk/return plot of all possible
portfolios
Those portfolios that are not dominated
constitute the efficient frontier

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 Efficient Frontier (contd)
Expected Return
100% investment in security
No points plot above with highest E(R)
the line

Points below the efficient

All portfolios frontier are dominated
on the line
are efficient
100% investment in minimum
variance portfolio

Standard Deviation

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 Efficient Frontier (contd)
The farther you move to the left on the
efficient frontier, the greater the number of
securities in the portfolio

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 Efficient Frontier (contd)
When a risk-free investment is available,
the shape of the efficient frontier changes
The expected return and variance of a risk-free
rate/stock return combination are simply a
weighted average of the two expected returns
and variance
The risk-free rate has a variance of zero

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 Efficient Frontier (contd)
Expected Return
C

Rf
A

Standard Deviation
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 Efficient Frontier (contd)
The efficient frontier with a risk-free rate:
Extends from the risk-free rate to point B
The line is tangent to the risky securities efficient
frontier

Follows the curve from point B to point C

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 Capital Market Line and the
Market Portfolio
The tangent line passing from the risk-free
rate through point B is the capital market
line (CML)
When the security universe includes all possible
investments, point B is the market portfolio
It contains every risky assets in the proportion of its
market value to the aggregate market value of all
assets
It is the only risky assets risk-averse investors will
hold
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 Capital Market Line and the
Market Portfolio (contd)
Implication for investors:
Regardless of the level of risk-aversion, all
investors should hold only two securities:
The market portfolio
The risk-free rate
Conservative investors will choose a point near
the lower left of the CML
Growth-oriented investors will stay near the
market portfolio
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 Capital Market Line and the
Market Portfolio (contd)
Any risky portfolio that is partially invested
in the risk-free asset is a lending portfolio

Investors can achieve portfolio returns

greater than the market portfolio by
constructing a borrowing portfolio

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 Capital Market Line and the
Market Portfolio (contd)
Expected Return
C

Rf
A

Standard Deviation
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 Security Market Line
Thegraphical relationship between
expected return and beta is the security
market line (SML)
The slope of the SML is the market price of risk

The slope of the SML changes periodically as

the risk-free rate and the markets expected
return change

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 Security Market Line (contd)
Expected Return

E(R)
Market Portfolio

Rf

1.0 Beta

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 Expansion of the SML to
Four Quadrants
Thereare securities with negative betas and
negative expected returns
A reason for purchasing these securities is their
risk-reduction potential
E.g., buy car insurance without expecting an
accident

E.g., buy fire insurance without expecting a fire

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Security Market Line (contd)
Expected Return

Securities with Negative

Expected Returns

Beta

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 Corner Portfolio
A corner portfolio occurs every time a new
security enters an efficient portfolio or an
old security leaves
Moving along the risky efficient frontier from
right to left, securities are added and deleted
until you arrive at the minimum variance
portfolio

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 Quadratic Programming
TheMarkowitz algorithm is an application
of quadratic programming
The objective function involves portfolio
variance

Quadratic programming is very similar to linear

programming

45
Markowitz Quadratic
Programming Problem

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 Lessons from
Evans and Archer
Introduction
Methodology
Results
Implications
Words of caution

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 Introduction
Evansand Archers 1968 Journal of
Finance article
Very consequential research regarding portfolio
construction

Shows how nave diversification reduces the

dispersion of returns in a stock portfolio
Nave diversification refers to the selection of
portfolio components randomly

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 Methodology
Used computer simulations:
Measured the average variance of portfolios of
different sizes, up to portfolios with dozens of
components

Purpose was to investigate the effects of

portfolio size on portfolio risk when securities
are randomly selected

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 Results
Definitions
General results
Strength in numbers
Biggest benefits come first
Superfluous diversification

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 Definitions
Systematic risk is the risk that remains after
no further diversification benefits can be
achieved
Unsystematic risk is the part of total risk
that is unrelated to overall market
movements and can be diversified
Research indicates up to 75 percent of total risk
is diversifiable
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 Definitions (contd)
Investors are rewarded only for systematic
risk
Rational investors should always diversify

Explains why beta (a measure of systematic

risk) is important
Securities are priced on the basis of their beta
coefficients

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 General Results
Portfolio Variance

Number of Securities

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 Strength in Numbers
Portfolio variance (total risk) declines as the
number of securities included in the
portfolio increases
On average, a randomly selected ten-security
portfolio will have less risk than a randomly
selected three-security portfolio

Risk-averse investors should always diversify

to eliminate as much risk as possible
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 Biggest Benefits Come First
Increasingthe number of portfolio
components provides diminishing benefits
as the number of components increases
Adding a security to a one-security portfolio
provides substantial risk reduction

Adding a security to a twenty-security portfolio

provides only modest additional benefits
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 Superfluous Diversification
Superfluous diversification refers to the
addition of unnecessary components to an
already well-diversified portfolio
Deals with the diminishing marginal benefits of
additional portfolio components

The benefits of additional diversification in

large portfolio may be outweighed by the
transaction costs
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 Implications
Very effective diversification occurs when
the investor owns only a small fraction of
the total number of available securities
Institutional investors may not be able to avoid
superfluous diversification due to the dollar size
of their portfolios
Mutual funds are prohibited from holding more than
5 percent of a firms equity shares

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 Implications (contd)
Owning all possible securities would
require high commission costs

It is difficult to follow every stock

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 Words of Caution
Selecting securities at random usually gives
good diversification, but not always
Industry effects may prevent proper
diversification
Although nave diversification reduces risk,
it can also reduce return
Unlike Markowitzs efficient diversification

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 Diversification and Beta
Beta measures systematic risk
Diversification does not mean to reduce beta
Investors differ in the extent to which they will
take risk, so they choose securities with
different betas
E.g., an aggressive investor could choose a portfolio
with a beta of 2.0
E.g., a conservative investor could choose a
portfolio with a beta of 0.5
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 Capital Asset Pricing Model
Introduction
Systematicand unsystematic risk
Fundamental risk/return relationship
revisited

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 Introduction
The Capital Asset Pricing Model (CAPM)
is a theoretical description of the way in
which the market prices investment assets
The CAPM is a positive theory

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 Systematic and
Unsystematic Risk
Unsystematic risk can be diversified and is
irrelevant

Systematic risk cannot be diversified and is

relevant
Measured by beta
Beta determines the level of expected return on a
security or portfolio (SML)
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 Fundamental Risk/Return
Relationship Revisited
CAPM
SML and CAPM
Market model versus CAPM
Note on the CAPM assumptions
Stationarity of beta

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 CAPM
Themore risk you carry, the greater the
expected return:
E ( Ri ) R f i E ( Rm ) R f
where E ( Ri ) expected return on security i
R f risk-free rate of interest
i beta of Security i
E ( Rm ) expected return on the market
65
 CAPM (contd)
The CAPM deals with expectations about
the future

Excess returns on a particular stock are

directly related to:
The beta of the stock
The expected excess return on the market

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 CAPM (contd)
CAPM assumptions:
Variance of return and mean return are all
investors care about
Investors are price takers
They cannot influence the market individually
All investors have equal and costless access to
information
There are no taxes or commission costs
67
 CAPM (contd)
CAPM assumptions (contd):
Investors look only one period ahead

Everyone is equally adept at analyzing

securities and interpreting the news

68
 SML and CAPM
Ifyou show the security market line with
excess returns on the vertical axis, the
equation of the SML is the CAPM
The intercept is zero

The slope of the line is beta

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 Market Model Versus CAPM
The market model is an ex post model
It describes past price behavior

The CAPM is an ex ante model

It predicts what a value should be

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 Market Model
Versus CAPM (contd)
The market model is:
Rit i i ( Rmt ) eit
where Rit return on Security i in period t
i intercept
i beta for Security i
Rmt return on the market in period t
eit error term on Security i in period t
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 Note on the
CAPM Assumptions
Several assumptions are unrealistic:
People pay taxes and commissions
Many people look ahead more than one period
Not all investors forecast the same distribution

Theory is useful to the extent that it helps us learn

more about the way the world acts
Empirical testing shows that the CAPM works
reasonably well
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 Stationarity of Beta
Beta is not stationary
Evidence that weekly betas are less than
monthly betas, especially for high-beta stocks
Evidence that the stationarity of beta increases
as the estimation period increases

The informed investment manager knows

that betas change
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 Equity Risk Premium
Equity risk premium refers to the difference
in the average return between stocks and
some measure of the risk-free rate
The equity risk premium in the CAPM is the
excess expected return on the market

Some researchers are proposing that the size of

the equity risk premium is shrinking

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 Using A Scatter Diagram to
Measure Beta
Correlation of returns
Linear regression and beta
Importance of logarithms
Statistical significance

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 Correlation of Returns
Muchof the daily news is of a general
economic nature and affects all securities
Stock prices often move as a group

Some stock routinely move more than the

others regardless of whether the market
advances or declines
Some stocks are more sensitive to changes in
economic conditions

76
 Linear Regression and Beta
To obtain beta with a linear regression:
Plot a stocks return against the market return

Use Excel to run a linear regression and obtain

the coefficients
The coefficient for the market return is the beta
statistic
The intercept is the trend in the security price
returns that is inexplicable by finance theory

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 Importance of Logarithms
Takingthe logarithm of returns reduces the
impact of outliers
Outliers distort the general relationship

Using logarithms will have more effect the

more outliers there are

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 Statistical Significance
Published betas are not always useful
numbers
Individual securities have substantial
unsystematic risk and will behave differently
than beta predicts

Portfolio betas are more useful since some

unsystematic risk is diversified away
79
 Arbitrage Pricing Theory
APT background
The APT model
Comparison of the CAPM and the APT

80
 APT Background
Arbitragepricing theory (APT) states that a
number of distinct factors determine the
market return
Roll and Ross state that a securitys long-run
return is a function of changes in:
Inflation
Industrial production
Risk premiums
The slope of the term structure of interest rates

81
 APT Background (contd)
Not
all analysts are concerned with the
same set of economic information
A single market measure such as beta does not
capture all the information relevant to the price
of a stock

82
 The APT Model
General representation of the APT model:

RA E ( RA ) b1 A F1 b2 A F2 b3 A F3 b4 A F4
where RA actual return on Security A
E ( RA ) expected return on Security A
biA sensitivity of Security A to factor i
Fi unanticipated change in factor i
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 Comparison of the
CAPM and the APT
The CAPMs market portfolio is difficult to
construct:
Theoretically all assets should be included (real estate,
gold, etc.)
Practically, a proxy like the S&P 500 index is used

APT requires specification of the relevant

macroeconomic factors

84
 Comparison of the
CAPM and the APT (contd)
TheCAPM and APT complement each
other rather than compete
Both models predict that positive returns will
result from factor sensitivities that move with
the market and vice versa

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