Portfolio Theory

Sriram
Rangarajan
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 RISK AND RETURNS - DIVERSIFICATION
DIVERSIFICATION AND PORTFOLIO RISK
• Let us understand how diversification influences risk. Suppose you have ₹100,000 to invest and
you want to invest it equally in two stocks, A and B. The return on these stocks depends on the
state of the economy. Your assessment suggests that the probability distributions of the returns
on stocks A and B are as shown in Exhibit 1. For the sake of simplicity, all the five states of the
economy are assumed to be equiprobable. The last column of Exhibit 1 shows the return on a
portfolio consisting of stocks A and B in equal proportions. Graphically, the returns are shown in
Exhibit 2. The expected return and standard deviation of return on stocks A and B and the
portfolio consisting of A and B in equal proportions are calculated in Exhibit 3.

• Probability Distribution of Returns Exhibit 1

PC

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 RISK AND RETURNS - DIVERSIFICATION
Returns on Individual Stocks and the Portfolio
Exhibit 2

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RISK AND RETURNS - DIVERSIFICATION
Expected Return and Standard Deviation Exhibit 3

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 RISK AND RETURNS - DIVERSIFICATION
EXPECTED RETURNS OF INDIVIDUAL STOCK/S, PORTFOLIO AND STD DEVIATION OF STOCK/S, PORTFOLIO
Exhibit 3A

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 RISK AND RETURNS - DIVERSIFICATION
• Exhibit 3/ 3A shows that if you invest only in stock A, the expected return is 15% and the
standard deviation is 14.14%. Likewise, if you invest only in stock B, the expected return is 15%
and the standard deviation is 14.14%. What happens if you invest in a portfolio consisting of
stocks A and B in equal proportions? While the expected return remains at 15%, the same as
that of either stock individually, the standard deviation of the portfolio return, 9.49%, is lower
than that of each stock individually. Thus, in this case, diversification reduces risk.

• In general, if returns on securities do not move in perfect lockstep, diversification reduces risk.
In technical terms, diversification reduces risk if returns are not perfectly positively correlated.
The relationship between diversification and risk is shown graphically in Exhibit 4. When the
portfolio has just one security, say stock 1, the risk of the portfolio, p , is equal to the risk of the
single stock included in it, 1. As a second security-say stock 2 is added, the portfolio risk
decreases. As more and more securities are added, the portfolio risk decreases, but at a
decreasing rate, and reaches a limit.

• Empirical studies suggest that the bulk of the benefit of diversification, in the form of risk
reduction, is achieved by forming a portfolio of about twenty securities. Thereafter, the gain
from diversification tends to be negligible.

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 RISK AND RETURNS - DIVERSIFICATION
Relationship Between Diversification and Risk
Exhibit 4
• Market Risk Versus Unique Risk Notice that the
portfolio risk does not fall below a certain level,
irrespective of how wide the diversification is.
Why? The answer lies in the following
relationship which represents a basic insight of
modern portfolio theory.
TOTAL RISK = UNIQUE RISK + MARKET RISK
The UNIQUE RISK of a stock represents that
portion of its total risk which stems from firm-
specific factors like the development of a new
product, a labour strike, or the emergence of a new
competitor. Events of this nature primarily affect
the specific firm and not all firms in general. Hence,
the unique risk of a stock can be washed away by
combining it with other stocks. In a diversified
portfolio, unique risks of different stocks tend to
cancel each other–a favourable development in
one firm may offset an adverse happening in
another and vice versa. Hence, unique risk is also
referred to as diversifiable risk or unsystematic risk.
The MARKET RISK of a stock represents that
portion of its risk which is attributable to economy-
wide factors like the growth rate of GNP, the level
of government spending, money supply, interest
rate structure, and inflation rate. Since these
factors affect all firms to a greater or lesser degree,
investors cannot avoid the risk arising from them,
however diversified their portfolios may be. Hence,
it is also referred to as systematic risk (as it affects
all securities) or non-diversifiable risk.
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 RISK AND RETURNS - DIVERSIFICATION

• Risk reduction by spreading exposure across many independent risk sources is sometimes
called the insurance principle because of the notion that an insurance company depends on
such diversification when it writes many policies insuring against many independent sources of
risk, each policy being a small part of the company’s overall portfolio. When common sources
of risk affect all firms, however, even extensive diversification cannot eliminate risk. The risk
that remains even after extensive diversification is called market risk, risk that is attributable to
market wide risk sources. Such risk is also called systematic risk, or non diversifiable risk. In
contrast, the risk that can be eliminated by diversification is called unique risk, firm-specific
risk, nonsystematic risk, or diversifiable risk.

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 RISK AND RETURNS - UTILITY
RISK AVERSION AND UTILITY VALUES
• Historical returns on various asset classes, analyzed in empirical studies, leave no doubt that
risky assets command a risk premium. This implies that most investors are risk averse.
• Investors who are risk averse reject investment portfolios that are fair games or worse. Risk-
averse investors consider only risk-free or speculative prospects with positive risk premiums.
Loosely speaking, a risk-averse investor “penalises” the expected rate of return of a risky
portfolio by a certain percentage (or penalizes the expected profit by a dollar amount) to
account for the risk involved. The greater the risk, the larger the penalty.
• If we were to choose amongst portfolios with varying degrees of risk, suppose the risk-free rate
is 5% and that an investor is comparing the three alternative risky portfolios shown in Table
(next slide). The risk premiums and degrees of risk (standard deviation, SD) represent the
properties of low-risk short-term bonds (L), medium-risk long-term bonds (M), and higher-risk
large stocks (H). Accordingly, these portfolios offer progressively higher risk premiums to
compensate for greater risk.
• How might investors choose among them? Intuitively, a portfolio is more attractive when its
expected return is higher and its risk is lower. But when risk increases along with return, the
most attractive portfolio is not obvious.
• How can investors quantify the rate at which they are willing to trade off return against risk?
We will assume that each investor can assign a welfare, or utility, score to competing portfolios
on the basis of the expected return and risk of those portfolios.

BKMM

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 RISK AND RETURNS - UTILITY
• Higher utility values are assigned to portfolios with more attractive risk–return profiles.
Portfolios receive higher utility scores for higher expected returns and lower scores for higher
volatility. One function that has been employed by financial theorists assigns a portfolio with
expected return E(r) and variance of returns σ2 the following utility score:

• U is the utility value and A is an index of the investor’s risk aversion. The factor of ½ is just a
scaling convention. To use above equation, rates of return must be expressed as decimals
rather than percentages. Standard deviation is the appropriate measure of risk. The risk-free
portfolios (with variance = 0) receive a utility score equal to their (known) rate of return,
because they receive no penalty for risk. The extent to which the variance of risky portfolios
lowers utility depends on A, the investor’s degree of risk aversion. More risk-averse investors
(who have larger values of A) penalize risky investments more severely. Investors choosing
among competing investment portfolios will select the one providing the highest utility level.

• We can interpret the utility score of risky portfolios as a certainty equivalent rate of return. The
certainty equivalent is the rate that a risk-free investment would need to offer to provide the
same utility score as the risky portfolio. In other words, it is the rate that, if earned with
certainty, would provide a utility score equal to that of the portfolio in question. The certainty
equivalent rate of return is a natural way to compare the utility values of competing portfolios.

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 RISK AND RETURNS - UTILITY

• A portfolio can be desirable only if its certainty equivalent return exceeds that of the risk-free
alternative. If an investor is sufficiently risk averse, he will assign any risky portfolio, even one
with a positive risk premium, a certainty equivalent rate of return below the risk-free rate and
will reject the portfolio. At the same time, a less risk-averse investor may assign the same
portfolio a certainty equivalent rate greater than the risk free rate and thus will prefer it to the
risk-free alternative.

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 RISK AND RETURNS - UTILITY
• A portfolio has an expected rate of return of 20% and standard deviation of 30%. T-bills offer a safe
rate of return of 7%. Would an investor with risk-aversion parameter A = 4 prefer to invest in T-bills or
the risky portfolio? What if A = 2?

• For A=4, the utility of T-Bills is U= 0.07 – ( x 4 x 0) = 0.07. The investor would prefer the T-Bills,
however, if A= 2, Utility is 0.11, higher than 0.07 of T-Bills . The less risk-averse investor would
prefer the risky portfolio over T-Bills.

• In contrast to risk-averse investors, risk-neutral investors (with A = 0) judge risky prospects

solely by their expected rates of return. The level of risk is irrelevant to the risk neutral investor,
meaning that there is no penalty for risk. For this investor, a portfolio’s certainty equivalent rate
is simply its expected rate of return.

• A risk lover (for whom A < 0) is happy to engage in fair games and gambles; this investor adjusts
the expected return upward to take into account the “fun” of confronting the prospect’s risk.
Risk lovers will always take a fair game because their upward adjustment of utility for risk gives
the fair game a certainty equivalent that exceeds the alternative of the risk-free investment.

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 RISK AND RETURNS - UTILITY
• We can depict the individual’s trade-off between risk and return by plotting the characteristics of
portfolios that would be equally attractive on a graph with axes measuring the expected value and
standard deviation of portfolio returns. The Chart below plots the characteristics of one portfolio, denoted
P. Portfolio P, which has expected return E(rp) and standard deviation σP, is preferred by risk-averse
investors to any portfolio in quadrant IV because its expected return is equal to or greater than any
portfolio in that quadrant and its standard deviation is equal to or smaller than any portfolio in that
quadrant.
• Conversely, any portfolio in quadrant I dominates portfolio P because its expected return is equal to or
greater than P’s and its standard deviation is equal to or less than P’s.

Exhibit 5

The trade-off between risk and return of a potential investment portfolio, P

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 RISK AND RETURNS - UTILITY

Exhibit 6
The mean-standard deviation or the mean-
variance (M-V) criterion can be stated as
follows: portfolio A dominates B if

E (rA) ≥ E (rB) and σA ≤ σB

and at least one inequality is strict (to rule out

indifference between the two portfolios). In the
expected return–standard deviation plane in
Exhibit 5 (previous slide) the preferred direction
is northwest, because in this direction we Indifference Curve
simultaneously increase the expected return
and decrease the volatility of the rate of return.
Any portfolio that lies northwest of P is superior to it. What can be said about portfolios in quadrants II
and III? Their desirability, compared with P, depends on the degree of the investor’s risk aversion.
Suppose an investor identifies all portfolios that are equally attractive as portfolio P. Starting at P, an
increase in standard deviation lowers utility; it must be compensated for by an increase in expected
return. Thus, point Q in Exhibit 6 is equally desirable to this investor as P. Investors will be equally
attracted to portfolios with high risk and high expected returns as to portfolios with lower risk but
lower expected returns. These equally preferred portfolios will lie in the mean–standard deviation
plane on a curve called the indifference curve, which connects all portfolio points with the same
utility value in Exhibit 6.
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 RISK AND RETURNS - CAPITAL ALLOCATION
Exhibit 6A

The less risk-averse investor has a shallower indifference curve. An increase in risk requires less
increase in expected return to restore utility to the original level
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 RISK AND RETURNS
• How will the indifference curve of a less risk-averse investor compare to the indifference curve drawn
in Exhibit 6?

• Estimating Risk Aversion

• How can we estimate the levels of risk aversion of individual investors? A number of methods may be
used. Questionnaires of the simplest variety and, indeed, can distinguish between high
(conservative), medium (moderate), or low (aggressive) levels of the coefficient of risk aversion. More
complex questionnaires, allowing subjects to pinpoint specific levels of risk aversion coefficients, ask
would-be investors to choose from various sets of hypothetical lotteries.

• Access to the investment accounts of active investors would provide observations of how portfolio
composition changes over time. Coupling this information with estimates of the risk and return of
these positions would in principle allow us to infer investors’ risk aversion coefficients.

• Finally, researchers track the behavior of groups of individuals to obtain average degrees of risk
aversion. These studies range from observed purchase of insurance policies to labor supply and
aggregate consumption behavior.

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 RISK AND RETURNS - CAPITAL ALLOCATION

• CAPITAL ALLOCATION ACROSS RISKY AND RISK-FREE PORTFOLIOS

• History shows us that long-term bonds have been riskier investments than Treasury bills and
that stocks have been riskier still. On the other hand, the riskier investments have offered
higher average returns. Investors, of course, do not make all-or-nothing choices from these
investment classes. They can and do construct their portfolios using securities from all asset
classes. Some of the portfolio may be in risk-free Treasury bills, some in high-risk stocks.

• The most straightforward way to control the risk of the portfolio is through the fraction of the
portfolio invested in Treasury bills or other safe money market securities versus what is invested
in risky assets. Most investment professionals consider such broad asset allocation decisions
the most important part of portfolio construction.

• Lets look into the risk–return trade-off available to investors by examining the most basic asset
allocation choice: how much of the portfolio should be placed in risk-free money market
securities versus other risky asset classes.

• Let the investor’s portfolio of risky assets be represented as P and the risk-free asset as F. We
assume for the sake of illustration that the risky component of the investor’s overall long-term
bonds. For now, we take the composition of the risky portfolio as given and focus only on the
allocation between it and risk-free securities.

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 RISK AND RETURNS - CAPITAL ALLOCATION
• When we shift wealth from the risky portfolio to the risk-free asset, we do not change the
relative proportions of the various risky assets within the risky portfolio. Rather, we reduce the
relative weight of the risky portfolio as a whole in favor of risk-free assets.

• For example, assume that the total market value of an initial portfolio is ₹300,000, of which
₹90,000 is invested in the Ready Asset money market fund, a risk-free asset for practical
purposes. The remaining ₹210,000 is invested in risky securities, ₹113,400 in equities ( E) and
₹96,600 in long-term bonds (B). The equities and bond holdings comprise “the” risky portfolio,
54% in E and 46% in B:
E: WE = =0.54
B: WB = =0.46
• The weight of the risky portfolio, P, in the complete portfolio, including risk-free and risky
investments, is denoted by y:
y= = 0.70 (risky portfolio)
1-y = = 0.30 (risky portfolio)

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 RISK AND RETURNS - CAPITAL ALLOCATION
• The weights of each asset class in the complete portfolio are, therefore, as follows:
E: = 0.378
B: = 0.322
• Risky portfolio = E + B = 0.700
• The risky portfolio makes up 70% of the complete portfolio.

• THE RISKY PORTFOLIO

• Suppose the owner of this portfolio wishes to decrease risk by reducing the allocation to the risky portfolio
from y = 0.70 to y = 0.56. The risky portfolio would then total only 0.56 × ₹300,000 = ₹168,000, requiring
the sale of ₹42,000 of the original ₹210,000 of risky holdings, with the proceeds used to purchase more
shares in Ready Asset (the money market fund). Total holdings in the risk-free asset will increase to
₹300,000 × (1 − 0.56) = ₹1,32,000, the original holdings plus the new contribution to the money market
fund:
₹90,000 + ₹42,000 = ₹132,000
• The key point, however, is that the proportions of each asset in the risky portfolio remain unchanged.
Because the weights of E and B in the risky portfolio are 0.54 and 0.46, respectively, we sell 0.54 × ₹42,000 =
₹22,680 of E and 0.46 × ₹42,000 = ₹19,320 of B. After the sale, the proportions of each asset in the risky
portfolio are in fact unchanged:
E: WE = = 0.54

B: WB = = 0.46

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 RISK AND RETURNS - CAPITAL ALLOCATION
• Therefore, rather than thinking of our risky holdings as E and B separately, it is better to view our holdings
as if they were in a single fund that holds equities and bonds in fixed proportions. In this sense, we may
treat the risky fund as a single risky asset, that asset being a particular bundle of securities. As we shift in
and out of safe assets, we simply alter our holdings of that bundle of securities commensurately.

• With this simplification, we turn to the desirability of reducing risk by changing the risky/risk-free asset mix,
that is, reducing risk by decreasing the proportion y. As long as we do not alter the weights of each security
within the risky portfolio, the probability distribution of the rate of return on the risky portfolio remains
unchanged by the asset reallocation. What will change is the probability distribution of the rate of return
on the complete portfolio that consists of the risky asset and the risk-free asset.

• What will be the rupee value of your position in equities (E), and its proportion in your overall portfolio, if
you decide to hold 50% of your investment budget in Ready Asset (money market fund, a risk-free asset) ?
Total Portfolio size ₹3,00,000.
y = = 0.5 (risky assets) and 1 − y = = 0.5 (risk free assets)

Risky portfolio – We have 54% in Equity (E) and 46% in Bonds (B)

E = 0.54*1,50,000= ₹81,000 and B= 0.46*1,50,000 = ₹69,000

• Risky portfolio = E + B = 0.500
• The risky portfolio makes up 50% of the complete portfolio.
• The rupee value of position in equities (E) = ₹81,000

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 RISK AND RETURNS
• THE RISK-FREE ASSET
• By virtue of its power to tax and control the money supply, only the government can issue
default-free bonds. Even the default-free guarantee by itself is not sufficient to make the bonds
risk-free in real terms. The only risk-free asset in real terms would be a perfectly price-indexed
bond. Moreover, even a default-free perfectly indexed bond would offer a guaranteed real
return to an investor only if the maturity of the bond is identical to the investor’s desired holding
period. Even indexed bonds are subject to interest rate risk, because real interest rates change
unpredictably through time. When future real rates are uncertain, so is the future price of
indexed bonds.

• It is common practice to view Treasury bills as the “risk-free asset”. Their short-term nature
makes their prices insensitive to interest rate fluctuations. Indeed, an investor can lock in a
short-term nominal return by buying a bill and holding it to maturity. Moreover, inflation
uncertainty over the course of a few weeks, or even months, is negligible compared with the
uncertainty of stock market returns. In practice, most investors use a broad range of money
market instruments as a risk-free asset. All the money market instruments are virtually free of
interest rate risk because of their short maturities and are fairly safe in terms of default or credit
risk.

• Money market funds hold, for the most part hold Treasury bills and repurchase agreements. The
yields to maturity on nongovernment money market securities are always somewhat higher
than those of T-bills with comparable maturity.

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 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• PORTFOLIOS OF ONE RISKY ASSET AND A RISK-FREE ASSET
• We examine the risk–return combinations available to investors once the properties of the risky
portfolio have been determined.
• Suppose the investor has already decided on the composition of the risky portfolio, P. Now the
concern is with capital allocation, that is, the proportion of the investment budget, y, to be
allocated to P. The remaining proportion, 1 − y, is to be invested in the risk-free asset, F.
• We denote the risky rate of return of P by rp, its expected rate of return by E(rp), and its standard
deviation by σP. The rate of return on the risk-free asset is denoted as rf. In the example, we will
assume that E(rp) = 15%, σP = 22%, and the risk-free rate is rf = 7%. Thus the risk premium on the
risky asset is E(rp) − rf = 8%.
• With a proportion, y, in the risky portfolio, and 1 − y in the risk-free asset, the rate of return on the
complete portfolio, denoted C, is rc where
rc = y rp + ( 1 − y ) rf (1)
Expressing this in terms of expected returns, E(rc ) = yE(rp) + (1 − y) rf
Lets manipulate this equation a little E(rc ) = yE(rp) + r f - yrf
Lets collect y terms together E(rc ) = y[E(rp)-rf] + rf

We rewrite this as = rf + y[E(rp) − rf ] (2)

= 7 + y(15 − 7)
• This result has a nice interpretation: The base rate of return for any portfolio is the risk free rate. In
addition, the portfolio is expected to earn a proportion, y, of the risk premium of the risky
portfolio, E(rp) − rf . 22
 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• With a proportion y in a risky asset, the standard deviation of the complete portfolio is the standard
deviation of the risky asset multiplied by the weight, y, of the risky asset in that portfolio. Because the
standard deviation of the risky portfolio is σ P = 22%,
σc = y σP = 22y (3)
• which makes sense because the standard deviation of the complete portfolio is proportional to both
the standard deviation of the risky asset and the proportion invested in it. In sum, the expected
return of the complete portfolio is
• E(rc) = rf + y[E(rp) − rf] = 7 + 8y; and the
Exhibit 7
standard deviation is; σc = 22y.

• The next step is to plot the portfolio

characteristics (with various choices for y) in
the expected return–standard deviation
plane in Exhibit 7. The risk-free asset, F,
appears on the vertical axis because its
standard deviation is zero. The risky asset, P,
is plotted with a standard deviation of 22%,
and expected return of 15%. If an investor
chooses to invest solely in the risky asset,
then y = 1.0, and the complete portfolio is P.
If the chosen position is y = 0, then 1 − y =
1.0, and the complete portfolio is the risk-
free portfolio, F The investment opportunity set with a risky asset and a risk-
free asset in the expected return–standard deviation plane

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 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• What about the more interesting midrange portfolios where y lies between 0 and 1? These
portfolios will graph on the straight line connecting points F and P. The slope of that line is
rise/run = [E(rp) − rf ]/ σP, which in this case equals 8/22.

• Increasing the fraction of the overall portfolio invested in the risky asset increases expected
return at a rate of 15% − 7% = 8%, according to Equation 2. It also increases portfolio standard
deviation at the rate of 22%, according to Equation 3. The extra return per extra risk is thus
8/22 = 0.36.

• To derive the exact equation for the straight line between F and P, we rearrange Equation 3 to
find that y = σC /σP, and we substitute for y in Equation 2 to describe the expected return–
standard deviation trade-off:
E (rC ) = r f + y [ E (rp ) − ​r f ]
= r f + [ E (rp ) − r f ] (4)

• Thus, the expected return of the complete portfolio as a function of its standard deviation is a
straight line, with intercept rf and slope
S= = (5)

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 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• Exhibit 7 graphs the investment opportunity set, which is the set of feasible expected return and
standard deviation pairs of all portfolios resulting from different values of y. The graph is a straight
line originating at rf and going through the point labeled P.

• This straight line is called the capital allocation line (CAL). It depicts all the risk– return combinations
available to investors. The slope of the CAL, denoted S, equals the increase in the expected return of
the complete portfolio per unit of additional standard deviation—in other words, incremental return
per incremental risk. The slope, the reward to volatility ratio, is usually called the Sharpe ratio, after
William Sharpe, who first used it extensively.

• A portfolio equally divided between the risky asset and the risk-free asset, that is, where y =0.5, will
have an expected rate of return of E(rC) = 7 + .5 × 8 = 11%, implying a risk premium of 4%, and a
standard deviation of = .5 × 22 = 11%. It will plot on the line FP midway between F and P. The Sharpe
ratio is S = 4/11 = .36, precisely the same as that of portfolio P.

• What about points on the CAL to the right of portfolio P? If investors can borrow at the (risk-free) rate
of rf = 7%, they can construct portfolios that may be plotted on the CAL to the right of P.

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 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• Can the Sharpe (reward-to-volatility) ratio, S = , of any combination of the risky asset and the
risk-free asset be different from the ratio for the risky asset taken alone, [E()−rf]/σP, which, in
this case, is .36?

• In the expected return–standard deviation plane all portfolios that are constructed from the
same risky and risk-free funds (with various proportions) lie on a line from the risk-free rate
through the risky fund. The slope of the CAL (capital allocation line) is the same everywhere;
hence the reward-to-volatility (Sharpe) ratio is the same for all of these portfolios. Formally, if
you invest a proportion, y, in a risky fund with expected return E(rp) and standard deviation ,
and the remainder, 1 − y, in a risk-free asset with a sure rate rf, then the portfolio’s expected
return and standard deviation are
E(rC ) = r f + y [ E(rp) − r f ]
=y
and therefore the Sharpe ratio of this portfolio is

which is independent of the proportion y.

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 RISK AND RETURNS - ONE RISKY ASSET AND A RISK-FREE ASSET
• Suppose the investment budget is ₹300,000 and the investor borrows an additional ₹120,000,
investing the total available funds in the risky asset. This is a levered position in the risky asset,
financed in part by borrowing. In that case
y = = 1.40

and 1 − y = 1 − 1.4 = −0.4, reflecting a short (borrowing) position in the risk-free asset. Rather
than lending at a 7% interest rate, the investor borrows at 7%. The distribution of the portfolio
rate of return still exhibits the same reward-to-volatility ratio:

• As one might expect, the levered portfolio has a higher standard deviation than does an
unlevered position in the risky asset.

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 RISK TOLERANCE AND ASSET ALLOCATION

• Investor confronting the CAL now must choose one optimal complete portfolio, C, from the set
of feasible choices. This choice entails a tradeoff between risk and return. Individual differences
in risk aversion lead to different capital allocation choices even when facing an identical
opportunity set (i.e., a risk-free rate and Sharpe ratio). In particular, more risk-averse investors
will choose to hold less of the risky asset and more of the risk-free asset.

Particulars Equations
Expected return on the complete portfolio E(rc) = rf + y[E(rP) − rf ]
Its variance is equation is σ 2c = y 2 σ 2P
Allocation to Risky assets that maximise Utility function U = E(r) - A σ2

• As the allocation to the risky asset increases (higher y), expected return increases, but so does
volatility, so utility can increase or decrease.

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 RISK TOLERANCE AND ASSET ALLOCATION
Utility levels for various positions in risky assets ( y ) for an investor with risk
aversion A = 4

• Table above shows utility levels corresponding to different values of y. Initially, utility increases
as y increases, but eventually it declines. Exhibit 8 is a plot of the utility function from above
Table. The graph shows that utility is highest at y = 0.41. When y is less than 0.41, investors are
willing to assume more risk to increase expected return. But at higher levels of y, risk is higher,
and additional allocations to the risky asset are undesirable beyond this point, further increases
in risk dominate the increase in expected return and reduce utility. To solve the utility
maximization problem more generally, we write the problem as follows: 29
 RISK TOLERANCE AND ASSET ALLOCATION

Utility as a function of allocation to the risky asset, y

Students of calculus will recognize that Exhibit 8
the maximization problem is solved by
setting the derivative of this expression
to zero. Doing so and solving for y gives
us the optimal position for risk-averse
investors in the risky asset, y*, as
follows:

E(rp) − rf - *2Ayσ2P
= E(rp) − rf - Ayσ2P = 0.
We can now write this as;
E(rp) − rf = Ayσ2P ;

• This solution shows that the optimal position in the risky asset is inversely proportional to the
level of risk aversion and the level of risk (as measured by the variance) and directly
proportional to the risk premium offered by the risky asset.

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 RISK TOLERANCE AND ASSET ALLOCATION
• Capital Allocation Example

• Using our numerical example [rf = 7%, E(rp) = 15%, and σP = 22%], and expressing all returns as
decimals, the optimal solution for an investor with a coefficient of risk aversion A = 4 is
y * = .15 − .07 = 0.41
4 × 0.222
• In other words, this particular investor will invest 41% of the investment budget in the risky
asset and 59% in the risk-free asset. As we saw in Exhibit 8, this is the value of y at which utility
is maximized. With 41% invested in the risky portfolio, the expected return and standard
deviation of the complete portfolio are

E (rc) = 7 + [ .41 × ( 15 − 7 ) ] = 10.28%

σC = .41 × 22 = 9.02%

• The risk premium of the complete portfolio is E(rc) − rf = 3.28%, which is obtained by taking on a
portfolio with a standard deviation of 9.02%.
• Examine here that 3.28/9.02 = 0.36, which is the reward to volatility (Sharpe) ratio of any
complete portfolio given the parameters of this example

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 RISK AND RETURNS - THE CAPITAL MARKET LINE
THE CAPITAL MARKET LINE
• The CAL is derived with the risk-free and “the” risky portfolio, P. Determination of the assets to
include in P may result from a passive or an active strategy. A passive strategy describes a
portfolio decision that avoids any direct or indirect security analysis. At first blush, a passive
strategy would appear to be naïve. As will become apparent, however, forces of supply and
demand in large capital markets may make such a strategy the reasonable choice for many
investors.

• A natural candidate for a passively held risky asset would be a well-diversified portfolio of
common stocks such as the “U.S. Market” or “Indian Market”. Because a passive strategy
requires that we devote no resources to acquiring information on any individual stock or group
of stocks, we must follow a “neutral” diversification strategy. One way is to select a diversified
portfolio of stocks that mirrors the value of the corporate sector of that country’s economy. This
results in a portfolio in which, for example, the proportion invested in Microsoft stock will be
the ratio of Microsoft’s total market value to the market value of all listed stocks.

• Exhibit 9 summarizes the performance of the U.S. Market portfolio over the 90-year period
1926–2015, as well as for four sub periods. The table shows the average return for the portfolio,
the annual return realized by rolling over 1-month T-bills for the same period, as well as the
resultant average excess return (risk premium) and its standard deviation. The Sharpe ratio was
0.40 for the overall period, 1926–2015. In other words, stock market investors enjoyed a 0.40%
average excess return over the T-bill rate for every 1% of standard deviation.

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 RISK AND RETURNS - THE CAPITAL MARKET LINE
• But the risk–reward trade-off we infer from the historical data is far from precise. This is
because the excess return on the market portfolio is so variable, with an annual standard
deviation of 20.59%. With such high year-by-year volatility, it is no surprise that the reward-to-
risk trade-off was also highly variable.

• We call the capital allocation line provided by 1-month T-bills and a broad index of common
stocks the capital market line (CML). A passive strategy generates an investment opportunity
set that is represented by the CML. How reasonable is it for an investor to pursue a passive
strategy? We cannot answer such a question without comparing the strategy to the costs and
benefits accruing to an active portfolio strategy. Some thoughts are relevant even at this point,

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However,
• First, the alternative active strategy is not free. Whether you choose to invest the time and cost
to acquire the information needed to generate an optimal active portfolio of risky assets, or
whether you delegate the task to a professional who will charge a fee, constitution of an active
portfolio is more expensive than a passive one. Passive management entails only negligible
costs to purchase T-bills and very modest management fees to either an exchange-traded fund
or a mutual fund company that operates a market index fund.
• A second reason to pursue a passive strategy is the free-rider benefit. If there are many active,
knowledgeable investors who quickly bid up prices of undervalued assets and force down prices
of overvalued assets (by selling), we have to conclude that at any time most assets will be fairly
priced. Therefore, a well-diversified portfolio of common stock will be a reasonably fair buy, and
the passive strategy may not be inferior to that of the average active investor. Passive index
funds have actually outperformed most actively managed funds in the past decades and
investors are increasingly responding to the lower costs and better performance of index funds
by directing their investments into these products.
• To summarize, a passive strategy involves investment in two passive portfolios: virtually risk-
free short-term T-bills (or, alternatively, a money market fund) and a fund of common stocks
that mimics a broad market index. The capital allocation line representing such a strategy is
called the capital market line. Historically, based on 1926 to 2015 data, the passive risky
portfolio offered an average risk premium of 8.3% and a standard deviation of 20.59%, resulting
in a reward-to-volatility ratio of 0.40.

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 RISK AND RETURNS - THE CAPITAL MARKET LINE
investors are increasingly responding to the lower costs and better performance of index funds
by directing their investments into these products.
• To summarize, a passive strategy involves investment in two passive portfolios: virtually risk-
free short-term T-bills (or, alternatively, a money market fund) and a fund of common stocks
that mimics a broad market index. The capital allocation line representing such a strategy is
called the capital market line. Historically, based on 1926 to 2015 data, the passive risky
portfolio offered an average risk premium of 8.3% and a standard deviation of 20.59%, resulting
in a reward-to-volatility ratio of 0.40.

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Thanks

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