Ch 7Portfolio Management
• Journal of Finance (1952) “Portfolio Selection”
by Hanry Markowitz
• In portfolio theory bench mark was 1952 before 1952
there were different criteria to evaluate investment….
Tools….. HPR, HPY, IRR, NPV, PI etc. all these measures tell
us the mean return and for risk we have a different
measure which was standard deviation or variance. In
1952 Markowitz introduced a concept that by combining
different securities individuals may become better off. He
introduced a concept that by combining different
securities individuals will be better off.
• He introduced the concept of variance which can be
obtained by incorporation of covariance in the formula of
variance. This was the start of modern portfolio theory.
Background Assumptions
• As an investor you want to maximize the
returns for a given level of risk.
• Your portfolio includes all of your assets and
liabilities
• The relationship between the returns for assets
in the portfolio is important.
• A good portfolio is not simply a collection of
individually good investments.
• Risk Aversion: Given a choice between two
assets with equal rates of return, most
investors will select the asset with the lower
level of risk.
Evidence That
Investors are Risk Averse
• Many investors purchase insurance for
example: Life, Automobile, Health, Home/Rental,
Liability and Disability insurance. The
purchaser trades known costs for unknown risk
of loss
• Yield on bonds increases with risk
classifications from AAA to AA to A….
Note: Not All Investors are Risk Averse
Risk preference may have to do with amount of
money involved - risking small amounts, but
insuring large losses.
Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
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
• Derives the formula for computing the
variance of a portfolio, showing how to
Assumptions of Markowitz
Portfolio Theory
1. Investors consider each investment
alternative as being presented by a
probability distribution of expected returns
over some holding period.
2. Investors maximize one-period expected
utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio
on the basis of the variability of expected
returns.
Assumptions of Markowitz Portfolio
Theory
4. 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.
5. For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a given level
of expected returns, investors prefer less risk to
more risk.
Using these five 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
Alternative Measures of Risk
• Variance or standard deviation of
expected return
• Range of returns
• Returns below expectations
– Semivariance – a measure that only
considers deviations below the mean
– These measures of risk implicitly assume
that investors want to minimize the
damage from returns less than some target
rate
Expected Rates of Return
• For an individual asset - sum of the
potential returns multiplied with the
corresponding probability of the returns
• For a portfolio of assets - weighted
average of the expected rates of return
for the individual investments in the
portfolio
Computation of Expected Return for
an Individual Risky Investment
Exhibit 7.1
Computation of the Expected
Return for a Portfolio of Risky
Assets
Exhibit 7.2
Variance (Standard Deviation) of
Returns for an Individual Investment
Standard deviation is the square root of the
variance
Variance is a measure of the variation of
possible rates of return Ri, from the expected
rate of return [E(Ri)] (or in case of statistics 1
Arithmetic Mean rate or Return)
Where Pi is the probability of the possible rate of
return, Ri
Variance (Standard Deviation) of
Returns for an Individual Investment
Exhibit 7.3
Variance ( 2) = .00050
Standard Deviation ( ) = .02236
Covariance of Returns
• A measure of the degree to which two
variables “move together” relative to
their individual mean values over time
For two assets, i and j, the covariance of
rates of return is defined as:
Covij = E{[Ri - E(Ri)][Rj - E(Rj)]}/n
Covariance and Correlation
The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Correlation coefficient varies from -1 to +1
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
NEGATIVE correlation. This means that
the returns for two assets have the
same percentage movement, but in
opposite directions
Portfolio Standard Deviation
Formula
• Markowitz changed the formula of portfolio risk.
He said if different assets whose correlation
coefficient is less than one are combined to
form a portfolio the portfolio risk will always be
less than the weighted average of the risks of
individual securities.
• Expected return of the portfolio is same i.e.
weighted average but the standard deviation
becomes less than the weighted average.
Portfolio Standard Deviation
Formula
Portfolio Standard Deviation
Calculation
• 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
Combining Stocks with Different
Returns and Risk
1 .10 .50 .0049 .07
2 .20 .50 .0100 .10
Case Correlation Coefficient Covariance
a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070
Combining Stocks with
Different Returns and Risk
• Assets may differ in expected rates of return
and individual standard deviations
• Negative correlation reduces portfolio risk
• Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to
zero only when individual standard deviations
are equal (we can also mathematically prove
that if the individual standard deviations are
not equal even than we can reduce the
portfolio SD to zero (when the correlation
coefficients of assets is -1.0 )
Constant Correlation
with Changing Weights
1 .10 rij = 0.00
2 .20 2
C a se W 1 W E (R i )
f 0 .0 0 1 .0 0 0 .2 0
g 0 .2 0 0 .8 0 0 .1 8
h 0 .4 0 0 .6 0 0 .1 6
i 0 .5 0 0 .5 0 0 .1 5
j 0 .6 0 0 .4 0 0 .1 4
k 0 .8 0 0 .2 0 0 .1 2
l 1 .0 0 0 .0 0 0 .1 0
Constant Correlation
with Changing Weights
C a se W 1 W 2 E (R i ) E (F p o r t )
f 0 .0 0 1 .0 0 0 .2 0 0 .1 0 0 0
g 0 .2 0 0 .8 0 0 .1 8 0 .0 8 1 2
h 0 .4 0 0 .6 0 0 .1 6 0 .0 6 6 2
i 0 .5 0 0 .5 0 0 .1 5 0 .0 6 1 0
j 0 .6 0 0 .4 0 0 .1 4 0 .0 5 8 0
k 0 .8 0 0 .2 0 0 .1 2 0 .0 5 9 5
l 1 .0 0 0 .0 0 0 .1 0 0 .0 7 0 0
Portfolio Risk-Return Plots for
Different Weights
E(R)
2
With two perfectly
correlated assets, it
is only possible to Rij = +1.00
create a two asset
portfolio with risk- 1
return along a line
between either
single asset
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) f
g 2
With uncorrelated h
assets it is possible i
to create a two j
Rij = +1.00
asset portfolio with
lower risk than k
1
either single asset Rij = 0.00
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) f
g 2
With correlated h
assets it is possible i
to create a two j
Rij = +1.00
asset portfolio
between the first k Rij = +0.50
1
two curves Rij = 0.00
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) With Rij = -0.50 f
negatively 2
g
correlated h
assets it is i
possible to j
Rij = +1.00
create a two
k Rij = +0.50
asset portfolio 1
with much Rij = 0.00
lower risk than
either single
asset
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights Exhibit 7.13
E(R) Rij = -0.50 f
Rij = -1.00 g 2
h
i
j
Rij = +1.00
k Rij = +0.50
1
Rij = 0.00
With perfectly negatively correlated
assets it is possible to create a two
asset portfolio with almost no risk
Standard Deviation of Return
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 Exhibit 7.15
Efficient
E(R) B
Frontier
A C
Standard Deviation of Return
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 Efficient Frontier
and Investor Utility
• 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 Exhibit 7.16
U3’
U2’
U1’
U3 X
U2
U1