Portfolio Theory

Richard O’Callaghan
Modern Portfolio Theory
• Mathematical system for putting together a
portfolio of securities such that the expected
return is maximised for a given level of risk
• Makes assumptions about the attitude of the
investor and the nature of the market
• Pioneered by Harry Markowitz in 1952
• Received the Nobel Memorial Prize in Economic
Sciences in 1990 for Portfolio Theory
Background
Richard O’Callaghan
Portfolio Theory
• Not sufficient to look at the expected risk and return of one particular
stock
• Investing in a “basket” of stocks provides the benefits of
diversification
• Key gain of diversification is the reduction in the riskiness of the
portfolio
• Portfolio Theory quantifies the benefits of diversification
The Investors Perception of Risk
• Risk for an investor is that the return will be lower than expected
• It is the deviation from the average return
• Each stock has a standard deviation from the mean, and Portfolio
Theory considers this to be the measure of risk
Risk Aversion of the Investor
• Given a choice between two assets with the same rates of return,
most investors will select the asset with the lower level of risk
• Not all investors are risk averse
• Risk preference may have to do with amount of money involved - risking small
amounts, means that you cannot loose a lot in total, so you may be willing to
take on a higher amount of risk
Effect of Diversification
• It is expected that the risk of a diverse portfolio is lower than the risk
in holding an individual share
• A portfolio of stocks that are not directly related (don’t move in
perfect correlation) will “smooth-out” the risk of the portfolio as a
whole
• The key – investment is not just about picking stocks, it is about
picking the appropriate portfolio of stocks to match risk / reward
profile of the individual investor
Markowitz Portfolio Theory
• Quantifies risk
• Derives the expected rate of return for a portfolio of assets and an
expected risk measure
• Shows that the variance of the rate of return is a meaningful measure
of portfolio risk
Assumptions of Portfolio
Theory
Richard O’Callaghan
Assumptions of Markowitz Portfolio Theory
• Investors consider each investment alternative as being presented by
a probability distribution of expected returns over some holding
period
• Investors maximise one-period expected utility, and their utility
curves demonstrate diminishing marginal utility of wealth
• Investors estimate the risk of the portfolio on the basis of the
variability of expected returns
• Investors base decisions solely on expected return and risk, so their
utility curves are a function of expected return and the expected
variance (or standard deviation) of returns only
Assumptions of Markowitz Portfolio Theory
• For a given risk level, investors
prefer higher returns to lower
returns
• For a given level of expected
returns, investors prefer less
risk to more risk
Markowitz Portfolio Theory
• Using these assumptions, a single asset or portfolio of assets is
considered to be efficient if no other asset or portfolio of assets offers
higher expected return with the same (or lower) risk, or lower risk
with the same (or higher) expected return
Expected Return and Risk
Richard O’Callaghan
Expected Return of a Single Asset Portfolio
E(r) = p1r1 + p2r2 + p3r3 + ……. + pnrn
• p = probability of the return (r)
Example
• You have been assessing the probability of the return of an asset
under the best case, worst case and most likely case scenario
• Best case return – 15%; probability of outcome is assessed as .2
• Worst case return - 6%; probability of this outcome is assessed as .
15
• Most likely outcome – 11%; probability of this outcome is assessed
as .65
Expected Return
• For an individual asset, the sum of the potential returns multiplied
with the corresponding probability of the returns
• For a portfolio of assets, the weighted average of the expected rates
of return for the individual investments in the portfolio
• Rational investor will seek to minimise their risk for the given level of
return
Expected Return of a Single Asset

E(r) = p1r1 + p2r2 + p3r3 + ……. + pnrn

E(r) = (.2 x 15%) + (.15 x 6%) + (.65 x 11%)

= 3% + 0.9% + 7.15%

= 11.05%
Expected Return of a Multi-Asset Portfolio
E(r) = w1r1 + w2r2 + w3r3 + ……. + wnrn
• r = expected return of the asset
• w = weighted average of the of the stocks of return (r)
Example
• A portfolio consisting 3 assets has the following weighting
• Asset 1 - 25% of the portfolio
• Asset 2 - 45% of the portfolio
• Asset 3 – 30% of the portfolio
• The expected return of each asset is
• Asset 1 – 15% return
• Asset 2 – 12% return
• Asset 3 – 8% return
Expected Return of a Multi-Asset Portfolio

E(r) = w1r1 + w2r2 + w3r3 + ……. + wnrn

E(r) = (25% x 15%) + (45% x 12%) + (30% x 11%)

= 3.75% + 5.4% + 3.3%

= 12.45%
Risk of a Portfolio
•  Risk of a portfolio is measured by the variance and the standard
deviation of the investment
• Variance of a portfolio:

• Where
• Pn is the probably of occurrence
• Rn is the return in n occurrences
• E(R) is the expected return
Standard Deviation
•  Standard Deviation is the square root of the Variance
Example
Scenario Probability Return Expected Return
Best case .2 18% 0.036 𝟐
𝝈 = ∑ 𝑷𝒏 ¿ ¿
 
Worst case .13 7% 0.0091
Most likely .67 13% 0.0871

  = [.2(0.18 - 0.036)2] + [.13(0.07– 0.0091)2] + [.67(0.13 – 0.0871)2]

= 0.0041472 + 0.0004821453 + 0.00123883
= 0.0058681753

=
= 0.0766
= 7.66%
Standard Deviation of a Two Asset Portfolio
•  The measure of the variability / risk of a portfolio is given by the
standard deviation of the portfolio
• The aim of diversification is the reduction of risk, so the standard
deviation of a portfolio should be lower than the weighted average of
the standard deviations of the individual assets contained within that
portfolio
Formula =
• = Weighting of Asset A
• = Standard Deviation of Asset A …. etc
Example
Stock A Stock B
• 
Weighting 70% 30%
Standard Deviation 12% 25%

• 0.2196
• 21.96%
Covariance and Correlation
Richard O’Callaghan
Covariance of Returns
• A measure of the degree to which two variables “move together”
relative to their individual mean values over time
• In portfolio theory, the measurement of how the movement of two
assets is related
• Two assets with a covariance of 0.7 move in the same direction
however if they have a covariance of -0.7 they move in opposite
directions
• If the covariance is 0 their movements have no relationship
Covariance Calculation
• 
• Where:
• x = the independent variable
• y = the dependent variable
• = the mean of the independent variable x
• = the mean of the dependant variable y
• n = sample size (number of measurements / observations)
Covariance Calculation
Day Carp Ltd
Returns
Newt Ltd
Returns • 
• Carp Ltd = x, Newt Ltd = y
1 2.4% 4%
2 3.2% 4.4%
3 1.5% 2%
4 1.1% 1.6% • 3.84/3
∑ 8.2% 12% • 1.28
n 4 4
Mean 2.05% 3%
Covariance and Correlation
•  Covariance tells us that the stocks move together, but it does not
consider how strong that relationship actually is
• To find out the strength of the relationship we calculate the
correlation between the two stocks
• The correlation coefficient is obtained by standardising (dividing) the
covariance by the product of the individual standard deviations as
follows
•
•=
Correlation Coefficient
• It can vary only in the range +1 to -1
• A value of +1 would indicate perfect positive correlation
• This means that returns for the two assets move together in a
completely linear manner
• A value of –1 would indicate perfect correlation
• This means that the returns for two assets have the same percentage
movement, but in opposite directions
Portfolio Standard Deviation Covariance and
Correlation
• Any asset of a portfolio may be described by two characteristics:
• The expected rate of return
• The expected standard deviations of returns
• The correlation, measured by covariance, affects the portfolio
standard deviation
• Low correlation reduces portfolio risk while not affecting the expected
return
Investors Preferences
Richard O’Callaghan
Indifference Curves
• Indifference curves show the investor’s trade-off between risk and
return. The steeper the slope, the more risk-averse the investor is.
• An investor is indifferent between any two risk-return combinations
on the same indifference curve.
• An investor should attain the highest indifference curve possible.
• The optimum portfolio is determined by the point of tangency
between the investor’s indifference curve and the efficient frontier.
Risk-Return Indifference Curves
Expected return
Higher IB IA

Returns for
the same Risk

X Y

X Y

Portfolio standard deviation (p)

Risk
The Efficient Frontier
• The efficient frontier represents that set of portfolios with the
maximum rate of return for every given level of risk, or the minimum
risk for every level of return
• Frontier will be portfolios of investments rather than individual
securities
• Exceptions being the asset with the highest return and the asset with the
lowest risk
Efficient Frontier for Alternative Portfolios
Efficient B
E(R) Frontier

A C

Standard Deviation of Return

The Efficient Frontier and the Capital Market Line
The Efficient Frontier and Investor Utility
• An individual investor’s utility curve specifies the trade-offs he is
willing to make between expected return and risk
• The slope of the efficient frontier curve decreases steadily as you
move upward
• These two interactions will determine the particular portfolio selected
by an individual investor
• The optimal portfolio has the highest utility for a given investor
• It lies at the point of tangency between the efficient frontier and the
utility curve with the highest possible utility
Selecting an Optimal Risky Portfolio
E(R port )
U3’
U2’
U1’

Y
U3 X
U2
U1

E( port )