Asset Allocation Decision &

Portfolio Theory

 2013 – Equity Investments & Markets

 Learning Objectives

 Define and present the asset allocation

problem
 Explain the the importance of the
covariance and concept of diversification in
large portfolios
 Study asset allocation frameworks and
optimal portfolios

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 Introduction
 In March 1952, Harry Markowitz, a 25 year old graduate student
from the University of Chicago published “Portfolio Selection” in
the Journal of Finance
 The paper opens with: “The process of selecting a portfolio may be
divided into two stages. The first stage starts with observation and
experience and ends with beliefs about the future performance of
available securities. The second stage starts with the relevant beliefs
about future performances and ends with choice of portfolio”
 38 years later, this paper would earn him a Nobel prize in economics
sciences. His work was the first step in the development of modern
finance
 Bill Sharpe extends the work to develop the CAPM (Nobel Prize,
1990)

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 Asset Allocation
 The portfolio or asset allocation problem is to answer the
question:
How much of your wealth should you invest in each
security?
 We will see that the optimal portfolio of risky assets is
exactly the same for everyone, no matter what their
tolerance for risk
 Investors should control the risk of their portfolio not by
allocating among risky assets, but through the split between risky
and risk-free assets
 The portfolio of risky assets that investors should hold contain
a large number of assets – it should be a well-diversified portfolio

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 Specific Objective
 We will decompose the analysis of this problem into two parts:
 What portfolio of risky assets should we hold?
 How should we distribute our wealth between risky portfolio
and the risk-free asset
 These results are derived under the assumptions that:
 Either, all returns are normally distributed, or
investors care only about mean return and
variance/standard deviation
 All assets are tradable
 There are no transaction costs
 We will discuss the implications of relaxing theses assumptions

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 Diversification with Large Portfolios
 Consider a many stock portfolio:
Var(Rp) =
 There are N variance terms and (N2-N) covariance
terms
 For the variance of a portfolio of 100 stocks, this means
there are 100 variance terms and 9,900 covariance terms!
 Which do you think is more important for determining
the variance of a portfolio? The variance or the
covariance of each individual stock?
 Special case
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 Framework

 We will develop a theoretical framework for

understanding the tradeoff between risk and return
 We will do this by trying to understand the simple problem
of an investor trying to allocate money between a risky
and a risk-free investment
 On April 8, 2012, you are wondering how to split your
money ($100,000) between a riskless security like T-bills
and a risky asset (e.g. TSX index or S&P 500 index)
 Suppose that your horizon is one year and we are going to
work with nominal returns. Although really you should
work with real returns

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 Contd.
 A one year T-bill (risk-free investment) gives you a return
of 4.5% for sure
 The TSX composite index (risky investment), currently at
6495.26
 You think that the TSX could go:
7404.60 with probability 0.7, i.e. a return of 14% and
5975.64 with probability 0.3, i.e a return of -8%.
 This means that the TSX composite index has an expected
return of:
E(rTSX) = 0.7(14%) + 0.3(-8%) = 7.4%

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 Discussion
 How do we decide which of these investments to take?
 First, we calculate the risk premium or Expected
excess return on the risky investment
 Definition: The excess return is defined as the return net
of the risk-free rate, or:
re = r – r F
 The risk premium is the expected excess return or:
E(re) = E(r–rF) = 0.7(9.5%)+0.3(-12.5%) = E(r)–rF = 2.9%

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 Riskiness of the Investments
 We need to calculate the riskiness of the investments
 Then, we need a measure of risk. The measure we will
use for now is the return variance or standard deviation
(the two are equivalent)
 For the risk-free asset, the variance is zero
 For the risky investment, the return variance is
2(rTSX) = 0.7(14%-7.4%)2 + 0.3(-8%-7.4%)2 = 1.0164%
and the return SD is the positive square root of the
variance (rTSX) = 10.1%

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 Discussion
 We need to determine if this a reasonable amount of risk
for the extra expected return we would earn
 We need to quantify our attitudes or preferences towards
this risk
 In the context of this example, let’s assume that we can
only select one of the investments, which should we
choose?
 To answer this question, we introduce preferences over
risk and return
 For a starting point, we assume people like high E(r) and
low (r), that is, that people are risk averse

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 Utility Function
 In economics, people’s preferences are typically
quantified using a Utility Function
 Since people like higher expected return and dislike
variance/standard deviation, then the function U(E,)
represents how good you feel about the investment
(think of this as a “score of happiness”)
 We will use: U(E,) = E – (1/2)2,
a quadratic representation for the utility function
 U(E,) is increasing in E and decreasing in 

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 Risk-Aversion
  is the coefficient of risk aversion (how risk affects you)
 The higher  , the higher an investor’s dislike of risk

 If  > 0, we say an investor is risk-averse

 If  = 0, we say an investor is risk-neutral
 If  < 0, we say an investor is risk-loving
 This description is a considerable simplification of
people’s true preferences
 We use the utility function to make an investment decision

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 Certainty-Equivalent (CE)
 We can introduce the concept of a certainty-equivalent rate
of return rCE for a risky portfolio
 It is the return such that you are indifferent between
earning an expected return E(r) with variance 2(r) or a
risk-free rate of rCE
 Our specification of the utility function gives:
rCE = U(r) = E(r) – (1/2)2(r)
 This is the risk-free rate such that investors would be
indifferent between the pattern of returns r and the risk-
free asset

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  & CE
 For the risky investment in our example:
E(r) = 7.4% and 2(r) = 0.010164, let’s determine the rCE
for different levels of risk aversion
 0.25 0.5 1 2 6
rCE 7.3% 7.1% 6.9% 6.4% 4.4%
 If you have  = 2 would you hold the risky or risk-free
asset?
 What level of risk aversion do you have to have to be
indifferent between the risky and the risk-free asset?
 If you are more risk averse will rCE be larger or smaller?

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 Indifference Curve
 We can plot an indifference curve (IC) for different levels
of 
 Graph
 Note that that there are an infinite number of ICs for a
given 
 There is one curve for each level of utility
 The indifference curves shown here are all for a utility
level of 0.05
 How do we know that?

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 Investment Decision/Optimal Portfolios
 We did develop measure of risk and quantified the tradeoff between
risk and return with a utility function
 We also determined how to choose between the risky and risk-free
asset
 Of course, we don’t usually have binary choice like this. There are, of
course, many more options open to us: We can hold a portfolio of the
risky asset (TSX index) and of the risk-free asset (T-bill)
 We have to determine how to build an optimal portfolio of risky and
risk-free assets (assuming one risky asset)
 What is the optimal portfolio if we have many risky assets and no
risk-free asset?
 What is the best combination of the risk-free asset and this optimal
risky portfolio?

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 One Risky Asset & One Risk-free Asset

 Let rw be the return (uncertain in advance) on a strategy

(portfolio) which puts w% into the TSX index and
(1-w)% into T-bill
 The expected return on this portfolio is:
E(rw) = wE(rTSX) + (1-w)rF
 The risk of the portfolio is:
(rw) = w(rTSX)
 To get a relation between the expected return and the
standard deviation of the portfolio, substitute,
w = (rw)/(rTSX) into the expected return equation
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 The Capital Allocation Line (CAL)
 We obtain the Capital Allocation Line:
E(rw) = rF + [E(rTSX) –rF ][(rw)/(rTSX)]
 Expected return = Risk-free + (Reward/Risk)Risk
 The reward to risk is the risk premium per unit of
portfolio risk (standard deviation)
 The standard term for this ratio is the Sharpe Ratio
 Graph of the CAL
 The CAL shows all risk-return combinations possible from
a portfolio of one-risky asset and the risk-free asset
(feasible investment set or IOS)

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 Interpretation

 The slope of the CAL is the increase in expected return of

the chosen portfolio (or combination of T-bills and the
TSX) per unit of additional risk (standard deviation). It is
the measure of extra return per risk
 Now, we want to answer the question of which risk-return
combination along the CAL we want?
 To answer this we need to bring the utility function back
into the picture
 From all feasible combinations, choose the one that give
you the highest utility
 Graphical solution

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 Optimal Portfolio Solution
 Mathematically, the optimal portfolio is the solution to the
following problem:
U* = Max U(E,) = Max [E(rw) – (1/2)2(rw)]
w w
 Using the portfolio expected return and risk equations, the
maximization problem can be written as:
Max U(E,) = Max [rF + wE(rTSX – rF ) – (1/2)w22(rTSX)]
w w
 This is solved by finding the value of w that makes the first
derivative with respect to w, equal to zero, giving:
w* = E(rTSX – rF )/2(rTSX)
 What is the intuition for the optimal weight equation?

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 Discussion 1.
 Let  = 4, w* = 71%, then 71% in TSX and 29% in T-bills
 If  = 3 (less risk averse), w* = 95% in TSX and 5% in T-
bills
 If  = 6 (more risk averse), w* = 47% in TSX and 53% in
T-bills
 Can you ever get a negative w*
 What about the standard deviations and expected returns
for these optimums?

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 Discussion 2.
 Graph with indifference curves
 The investor is indifferent between the portfolios on any one curve
 The investments that have different expected returns and risk, but
that give the same level of utility to an investor define the
indifference curve
 The level of risk aversion () of an investor determines the
steepness of his/her indifference curve
 ICs for a pension fund manager and for an aggressive
speculator
 Comparing investments
 The optimal portfolio is obtained when the indifference curve
touches the CAL
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 General Framework
 We will use as previously a three step framework:
 Step . For each of the basic securities, estimate
(forecast) the expected returns, standard deviations, and
covariances
 Step . Figure out the full set of investment
opportunities (IOS) attainable by combining the basic
securities
 Step . From among all the possible investment
opportunities, choose the one offering the highest
utility
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 Two Risky Assets & No Risk-Free Asset
 We saw that with one risky asset and one risk-free asset
there is a single optimal risky portfolio
 How to allocate our money between two risky assets in a
portfolio (i.e. two market indexes)?
 The problem gets harder with more than two assets
 We can plot out the possible set of expected returns and
return standard deviations for different combinations of the
assets
 This set is called the Minimum Variance or Portfolio
Frontier, which is defined as the set of portfolios with the
lowest variance for a given expected return

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 Portfolio of Two Risky Assets
 The expected return for the portfolio is:
E(rP) = wE(rA) + (1-w)E(rB)
w is the fraction of the value of portfolio P that is invested
in asset A
 The variance of the portfolio is:
2(rP) =
 The variance of the portfolio depends on the correlation
between the two assets
 The basic parameters we need are the expected returns and
variances for each of the basic securities and the
correlation between the two assets
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 The IOS
 As we vary w, what are the different combinations of expected
return and standard deviation available to the investor?
 Mixing together assets which are not perfectly correlated ( < 1)
reduces the variance of the combination and improves your risk/return
opportunities
 We expect asset to be less than perfectly correlated because things that
affect one asset need not affect other assets
 The lower the correlation between the two assets, the stronger the
effect
 The IOS lies on a curve between the two assets, whose shape depends
on the correlation between the two risky assets (It is the portfolio
frontier)

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 Perfect Positive Correlation (AB = 1)

 They are perfect substitutes. There is no potential

diversification of the risk
 The risk of the portfolio is then simply the weighted
average of the risk of the individual assets:
(rP) = w(rA) + (1-w)(rB)
 The expected return of the portfolio is not affected by the
correlation coefficient
 These two equations give us the minimum variance
frontier
 All combinations of expected return and risk are on a
straight line connecting the two assets
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 Perfect Negative Correlation (AB = –1)
 It is possible to diversify away all of the risk by appropriate weighting
of the two stocks:
(rP) = |w(rA) – (1-w)(rB)|
 It is possible to find a perfect hedge with these two securities. A
perfect hedge is a hedge that gives a portfolio with zero risk ((rP) = 0)
 The weights in a perfect hedge are:
w0 = (rB)/[(rA) + (rB)]
 The minimum variance frontier has two different line segments; the
perfect hedge divides these two segments
 When  = 0, we can simplify the variance equation:
(rP) = [w22(rA) + (1-w)22(rB)]1/2
 There is some hedging effect (not as much as when  = –1)

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 Discussion

 We choose the strategy (or combination) that provides the

maximum utility
 The optimal portfolio is obtained when the indifference
curve of the investor touches the minimum variance frontier
 Graph
 You can get the exact optimal allocation using calculus
(maximize the utility)
 Assets are attractive because:  they have higher expected
returns,  they have low variance, and  they have low
covariance with other things you own (e.g. insurance
policies)

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 Two Risky Assets & One Riskless Asset
 The only new parameter we need is the riskless
interest rate
 The riskless asset has no variance and no
covariance with anything else
 First, we calculate the minimum-variance frontier
(IOS) for the two risky assets as in the previous
section
 If we have only one risky and one risk-free assets,
we will have two possible CALs

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 Contd.

 However, if we don’t want to restrict ourselves to

holding one of the two risky assets alone
 what is the optimal portfolio of risky assets to
combine with the risk-free asset?
 This portfolio is called the tangency portfolio.
Why?

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 Tangency & Optimal Portfolios
 The point where the CAL and the minimum variance
frontier are tangent is the tangency portfolio
 It is sometimes called the Mean-Variance Efficient (MVE)
portfolio
 In combining with the risk-free asset, it provides the
“steepest” CAL (the one with the highest slope, or the
highest risk-excess return tradeoff)
 Therefore, the overall optimal portfolio is a mix of the
riskless asset and the tangency portfolio (depends on your
level of risk aversion)

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 Formal Derivation
 We can find the tangency portfolio or MVE portfolio and the
optimal CAL mathematically
 Solve the problem:
Max [E(rP) – rF]/(rP)
w
where, E(rP) = wE(rA) + (1-w)E(rB) and
2(rP) =
 The solution is quiet complicated
w* =
 We can measure the Sharpe ratio of the MVE portfolio
 Remarks and optimal combination
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 Many Risky Assets & No Riskless Asset
 The analysis above can be extended to the situation where there
are several risky assets available for investment
 We need a general approach to solve the optimal portfolio in a
world with N assets
 First, we need the general formulas for the expected return and the
variance of the portfolio P of N risky assets, and for the
covariance of two portfolios
 With N assets, we need:
 Expected return for each asset (N parameters),
 Variance for each asset (N parameters), and
 Covariance between each pair of assets [N(N-1)/2
parameters]
 General expressions for the portfolio expected return and variance

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 Discussion
 Now we calculate the minimum variance (portfolio) frontier
for the risky assets alone
 If we find the weights of any two portfolios on the
minimum variance frontier, we can find the rest of the
frontier
 Therefore, we just need to calculate the weights for
two portfolios. The two that are easiest for us to
calculate are the global minimum variance portfolio
and the portfolio with the highest [E(rP)/(rP)]
 In general, the more assets we add, the more the efficient
frontier will extend in the north-westerly direction, offering
even more diversification power

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 Two-Fund Separation
 All frontier portfolios are combinations of any two
distinct frontier portfolios
 Once any two frontier portfolios are found, we can
generate the entire portfolio frontier
 If individuals prefer frontier portfolios, they can simply
hold a linear combination of two frontier portfolios or
mutual funds
 In this case, given any feasible portfolio there exists a
portfolio of two mutual funds such that individuals prefer
at least as much as the original portfolio

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 Efficient Frontier Portfolios

 Those frontier portfolios which have expected rates of

return strictly greater than that of the mv portfolio are
called efficient portfolios
 Portfolios that are on the portfolio frontier that are
neither efficient or mv are called inefficient portfolios
 For each inefficient portfolio there exists an efficient
one having the same variance but a higher expected
rate of return
 Other properties

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 Many Risky Assets & One Riskless Asset
 We can see the investment possibilities by continuing
from the previous case
 When adding another asset to the feasible set, the efficient
frontier expands. The riskless asset is no exception
 Since the riskless asset by definition is the minimum
variance asset, it will be on the efficient frontier
 Because of the two fund separation, we now only need to
find another efficient portfolio from the risky assets in
order to generate the entire frontier
 There is one optimal risky portfolio in this case: The
tangency portfolio
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 Optimal Portfolio

 The optimal portfolio is combination of the

riskless asset and the tangency portfolio
 The tangency portfolio is the combination of risky
assets only with the highest Sharpe ratio
 We find the tangency portfolio in a similar way in
which we found the minimum variance portfolio
 Formal derivation using vector calculus

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 Contd.

 We wish to maximize the ratio of expected return to

variance (standard deviation), which is the same thing
as maximizing the Sharpe ratio or the slope of the
CAL
 We have a two step procedure:
 find the tangency portfolio and
 use methods for optimal allocation between the
riskless asset and the tangency portfolio
 Example to determine the tangency portfolio

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 The Separation Principle

 Assume that people use mean-variance analysis

 Suppose we all agree on the same values for the inputs
 Then everyone will hold the same combination of risky
assets, regardless of their level of risk aversion
 This combination is the tangency portfolio
 Of course, more risk-averse people will hold more of
the riskless asset and less of the tangency portfolio
of risky assets
 But they will keep the same relative proportions of
risky assets
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 Discussion

 Example
 An investment advise should recommend the same
portfolio of risky assets to all clients
 This was not the case in the 50’s and 60’s
 Even today, the investment advice often conflicts
with the separation principle

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 Conclusion
 We have developed mean-variance portfolio analysis
 It is called mean-variance analysis because we assume that
all that matters to investors is the average return and the
return variance of their portfolio
 This is appropriate if returns are normally distributed
 You should hold the same portfolio of risky assets no
matters what your tolerance for risk
 If you want less risk, combine this portfolio with
investment in the risk-free asset
 If you want more risk, buy the portfolio on margin
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