Topic 2: Portfolio Theory, selection & investing

Portfolio risk and return Modern portfolio theory Markowitz portfolio selection Efficient portfolio and efficient frontier

Investment Decisions

Involve uncertainty Focus on expected returns

Estimates of future returns needed to consider and manage risk

Goal is to reduce risk without affecting returns

Accomplished by building a portfolio DIVERSIFICATION is the key

Dealing With Uncertainty

Risk that an expected return will not be realized Investors must think about return distributions, not just a single return Probabilities weight outcomes

Should be assigned to each possible outcome to create a distribution Can be discrete or continuous

Expected return & risk of a portfolio

Expected return

Expected risk

E(Rp) = wi E(Ri) 2p wi 2i

* Investors can reduce the risk of a portfolio through diversification, hence, a portfolios risk is not just the sum of weighted average of individual securities risk

Modern Portfolio Theory

Background assumption and definitions

Investors want to maximize the investment returns for a given level of risk A portfolio includes all the assets and liabilities of the investor Investors are risk averse, i.e. given equal rates of return, investor will always select the asset with the lowest risk Risk is defined as the uncertainty associated with the outcome of an event

Markowitz Portfolio Theory

In a simple term: Do not put all eggs in one basket Markowitz was the first to develop the concept of portfolio diversification in a formal way he quantified the concept of DIVERSIFICATION He showed quantitatively why and how portfolio diversification works to reduce the risk of a portfolio to an investor

Markowitz Portfolio Theory

Assumptions:

Investors view the mean of the distribution of a potential outcomes as the expected return of an investment Investors view the variability of a potential outcomes about the mean as the risk of an investment Investors all have the same holding period. This eliminates time horizon risk Investors base all their decisions on expected return and risk For a given risk level, investors prefer higher returns to lower returns, or for a given return level, investors prefer less risk to more risk

Markowitz Portfolio Theory

Expected return (2 stocks portfolio)

Expected risk (or variance for 2 stocks portfolio)

E(Rp) = wi E(Ri) or = w1E(R1) + w2E(R2)

2portfolio

= wi2i2 + ij wi wj covij = w1212 + w2222 +2w1w2121,2

Where, Covij = covariance of the 2 stocks, an absolute measure of the extent to which 2 variables tend to co vary, or move together 1,2 = correlation coefficient, covariance standardized by dividing by the product of 2 standard deviations of returns

Covariance

Covij = ij i,j A +ve covariance means the returns of the 2 securities move in the same direction A ve covariance means the returns of the 2 securities move in the opposite directions A zero covariance means there is no relationship between the behaviors of 2 stocks

Correlation Coefficient

Statistical measure of association i,j = correlation coefficient between securities i and j

i,j = +1.0 = perfect positive correlation i,j = -1.0 = perfect negative (inverse)
correlation i,j = 0.0 = zero correlation

What if a portfolio with 3 securities?

Expected return

E(Rp) = wa E(Ra) + wb E(Rb) + wc E(Rc)

Variance

2portfolio = wa2a2 + wb2b2 + wc2c2 + 2wawbaba,b + 2wawca ca,c + 2wbwc bcb,c

Portfolio Selection

Diversification is key to optimal risk management Analysis required because of the infinite number of portfolios of risky assets How should investors select the best risky portfolio? How could riskless assets be used?

Building a Portfolio

Step 1: Use the Markowitz portfolio selection model to identify optimal combinations

Estimate expected returns, risk, and each covariance between returns

Step 2: Choose the final portfolio based on your preferences for return relative to risk

An Efficient Portfolio

Smallest portfolio risk for a given level of expected return Largest expected return for a given level of portfolio risk From the set of all possible portfolios

Only locate and analyze the subset known as the efficient set

Lowest risk for given level of return

Efficient Portfolios

x E(R) A C Risk =

Efficient frontier or Efficient set (curved line from A to B) Global minimum variance portfolio (represented by point A)

Implications of Portfolio Selection

Investors should focus on risk that cannot be managed by diversification Total risk =systematic (nondiversifiable) risk + nonsystematic (diversifiable) risk

Systematic risk

Variability in a securitys total returns directly associated with economy-wide events Common to virtually all securities Affects number of securities needed to diversify

Both risk components can vary over time