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Portfolio Selection
Portfolio Selection
Portfolio Selection
Learning Objectives
• Efficient frontier or
Efficient set (curved
B line from A to B)
x
• Global minimum
E(R) A variance portfolio
(represented by point
y C A)
Risk =
Efficient Portfolios
• The basic Markowitz model is solved by a
complex technique called quadratic
programming model.
• The expected returns, standard deviations,
and correlation coefficients for the securities
being considered are inputs in the Markowitz
analysis.
• The portfolio weights are the only variables
that can be manipulated to solve the portfolio
problem of determining efficient portfolios
1- Selecting an Optimal Portfolio of
Risky Assets
• In finance we assume investors are risk averse (i.e., they
require additional expected return for assuming
additional risk)
• Indifference curves describe investor preferences for risk
and return
• Indifference curves
Cannot intersect since they represent different levels of
desirability
Are upward sloping for risk-averse investors
Greater slope implies greater risk aversion
Investors have an infinite number of indifference curves
Higher indifference curves are more desirable
Selecting an Optimal Portfolio of
Risky Assets
• The optimal portfolio for a risk-averse
investor occurs at the point of tangency
between the investor’s highest indifference
curve and the efficient set of portfolios
• This portfolio maximizes investor utility
because the indifference curves reflect
investor preferences, while the efficient set
represents portfolio possibilities
Selecting an Optimal Portfolio of
Risky Assets
• Markowitz portfolio selection model
Generates a frontier of efficient portfolios which are
equally good
Does not address the issue of riskless borrowing
or lending (investors are not allowed to use leverage)
Different investors will estimate the efficient frontier
differently (this results from estimating the inputs to
the Markowitz model differently)
• Element of uncertainty in application (i.e., uncertainty
is inherent in security analysis)
Selecting Optimal Asset Classes
• Another way to use the Markowitz model is with
asset classes
By allocating portfolio assets to broad asset
categories (i.e., how much of the portfolio’s assets are to
be invested in stocks, bonds, money market securities,
etc.)
• Asset class rather than individual security decisions
are most important for investors.
The rationale behind the asset allocation approach is
that different asset classes offer various returns and
levels of risk
• Correlation coefficients may be quite low
Optimal Risky Portfolios
E (R)
Efficient Frontier
*
2- Borrowing and Lending Possibilities
• Risk-free assets
Certain-to-be-earned expected return (this is
nominal return and not real return which is
uncertain since inflation is uncertain)
Zero variance
No covariance or correlation with risky assets
(ρ_RF = 0 since the risk-free rate is a constant
which by nature has no correlation with the
changing returns on risky securities)
Usually proxied by a Treasury Bill
• Amount to be received at maturity is free of default
risk, known with certainty
Borrowing and Lending Possibilities
p % Total risk
35
Diversifiable Risk
20
Systematic Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio