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