UNCERTAINTY
AND
PORTFOLIO
THEORY
CHAPTER 7
BY DR LOGANANTHINY KUMARAGURU
2
LEARNING OUTCOMES
• Probailities definition
• Probability distributions
• Calculating expected return for a security
• Calculating risk for a security
• Introduction to modern portfolio theory
• Portfolio return and risk
• Analysing portfolio risk
• The components of portfolio risk
• Calculating portfolio risk
DEALING WITH 3
UNCERTAINTY
Realized Returns
• Investors need to assess past portfolio performance.
• Provides a basis for forming expectations about future
returns.
• Helps estimate expected returns using historical data, e.g.,
Treasury bills’ average returns.
Estimating Returns
• Use return and risk measures (variance, standard
deviation) developed in Chapter 6.
• Future returns are estimated based on expected cash flows.
• Variability in returns leads to uncertainty.
4
PROBABILITIES
Probabilities in Investing
•Future returns are uncertain, requiring estimates of
possible outcomes.
•Probability distributions describe all possible
outcomes for a security.
•For common stocks, multiple outcomes have
probabilities that sum to 1.0 or 100%.
Discrete vs. Continuous Probability
Distributions
•Discrete: Limited outcomes (e.g., General Foods
with 5 return possibilities).
•Continuous: Infinite outcomes, often shown with a
bell-shaped curve (normal distribution).
5
A) CALCULATING EXPECTED B) CALCULATING RISK FOR A
RETURN FOR A SECURITY SECURITY
• Expected Return : The ex ante
return expected by investors over
some future holding period
6
MODERN PORTFOLIO THEORY
(MPT)
• Developed by Harry Markowitz in 1952.
• MPT revolutionized the approach to portfolio management by
providing a quantitative framework for diversification.
• MPT has been widely adopted by portfolio managers, financial
advisors, mutual fund families, and commentators.
Contributions of Markowitz
• Quantifying Diversification: Demonstrated how diversification
reduces risk.
• Portfolio Risk: Markowitz showed that portfolio risk is not just the
sum of individual security risks.
• Interrelationship of Returns: To calculate portfolio risk, it's crucial
to account for how security returns interact with each other.
PORTFOLIO RETURN AND RISK
7
• Portfolio Return: Investors should analyze total portfolio returns
and risks. Optimal portfolios can be constructed through proper
diversification.
• Portfolio Weights: The percentage of total portfolio value
invested in each security. Portfolio weights sum up to 100% (1.0),
indicating total investable funds are allocated.
Calculating the Expected Return on a
Portfolio
ANALYZING PORTFOLIO RISK
8
• Risk Measurement: Portfolio risk is measured by variance or standard deviation.
• Portfolio Risk ≠ Weighted Average of Individual Risks: Unlike expected returns,
portfolio risk isn't simply the weighted average of individual security risks.
Risk Reduction
• Diversification reduces portfolio risk below the weighted average of individual risks.
• Two General Sources of Risk:
• Firm-Specific Risk: Can be reduced with diversification.
• Market Risk: Cannot be diversified away.
• Exception: If securities have perfectly correlated returns (extremely rare), risk won't reduce.
THE COMPONENTS OF PORTFOLIO RISK 9
Portfolio risk is determined by two primary factors:
1. Weighted Individual Security Risks: The risk of each security, usually measured
by variance, weighted by the proportion of funds invested in that security.
2. Weighted Comovements Between Securities: The extent to which securities'
returns move together, measured by the covariance or correlation between each
security and all other securities in the portfolio.
3. Covariance measures how two securities' returns move together over time.
• Positive: The returns on two securities tend to move in the same direction.
• Negative: The returns tend to move in opposite directions.
• Zero: The returns are independent, with no relationship.
10
THE CORRELATION COEFFICIENT
• While covariance shows the direction of the relationship, it is not
easy to interpret the strength of this relationship. The correlation
coefficient provides a standardized measure between -1 and +1:
• +1: Perfect positive correlation, where securities move together in
the same direction.
• -1: Perfect negative correlation, where securities move in opposite
directions.
• 0: No relationship between the securities' returns.
CALCULATING PORTFOLIO RISK 11
• When analyzing portfolio risk, particularly with two securities, understanding how their
returns move together is essential. Here’s a breakdown of the concepts discussed,
focusing on the two-security case and the extension to multiple securities.
12
Impact
•
of the Correlation Coefficient
The portfolio risk is sensitive to the correlation coefficient. As the correlation
decreases, the portfolio risk can significantly decline, highlighting the benefits
of diversification.
For instance:
• When the correlation is +1.0: Portfolio risk might be around 22.2%
• When the correlation is 0: Portfolio risk might drop to 16.1%
• When the correlation is -1.0: Portfolio risk could be minimized further,
potentially down to 5.4% (given optimal weights).
THANK
YOU