Introduction to

Portfolio Management

Chapter 4
 Chapter 4 - An Introduction to
Portfolio Management
Questions to be answered:
• What do we mean by risk aversion and what evidence
indicates that investors are generally risk averse?
• What are the basic assumptions behind the Markowitz
portfolio theory?
• What is meant by risk and what are some of the
alternative measures of risk used in investments?
• How do you compute the expected rate of return for
an individual risky asset or a portfolio of assets?
• How do you compute the standard deviation of rates of
return for an individual risky asset?
• What is meant by the covariance between rates of
return and how do you compute covariance?
 Chapter 4 - An Introduction to
Portfolio Management
• What is the relationship between covariance and correlation?
• What is the formula for the standard deviation for a portfolio of
risky assets and how does it differ from the standard deviation of
an individual risky asset?
• Given the formula for the standard deviation of a portfolio, why
and how do you diversify a portfolio?
• What happens to the standard deviation of a portfolio when you
change the correlation between the assets in the portfolio?
• What is the risk-return efficient frontier?
• Is it reasonable for alternative investors to select different
portfolios from the portfolios on the efficient frontier?
• What determines which portfolio on the efficient frontier is
selected by an individual investor?
 Background Assumptions
• As an investor, you want to maximize return
for a given level of risk.
• Your portfolio includes all of your assets and
liabilities, not just your traded securities.
• The relationship between the returns of the
assets in the portfolio is important.
• A good portfolio is not simply a collection of
individually good investments.
 The three basic questions to investor in
decision making!
1. How to compare different assets in inv’t selection
process?
• What are the quantitative characteristic of
the assets and how to measure them?
2. How does one asset in the same portfolio influence
the other one in the same portfolio?
• What could be the influence of this r/ship to
the investor’s portfolio?
3. What is the relationship between the returns on an
asset and returns in the whole market (market
portfolio)?
 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:
– Life
Insurance is one of the few
– Automobile things we buy which we know
– Health has a negative NPV
– Disability
• The insured trades a known cost (the
premium) for an unknown risk of loss
• The required yield on bonds increases with
risk classifications from AAA to AA to A….
 But Not Totally Risk Averse . . .
• Risk preferences may have to do with
the amount of money involved – we are
willing to risk small amounts, but we
insure against large losses
– People buy lottery tickets (negative
expected value but the potential loss is
small)
– But also buy insurance (negative expected
value but the potential loss is large)
 Which Definition of Risk?
• Uncertainty of future outcomes
– Risk involves both positive & negative
outcomes
– What we measure with standard deviation

• Probability of an adverse outcome

– Ignore outcomes that are better than
expected
– Investors only really care about negative
surprises. They like positive surprises.
 Markowitz Portfolio Theory
• Derives the expected rate of return and
expected risk for a portfolio of assets.
• Shows that the variance & standard
deviation of the rate of return is a
meaningful measure of portfolio risk.
• Derives the formula for computing the
variance & standard deviation of a
portfolio, showing how to effectively
diversify a portfolio.
 Harry Markowitz
• Nobel Laureate (1990)
• In 1952, while still a graduate
student at Chicago, Markowitz
took just one afternoon to convert
the notions of risk & return into a
set of written rules involving the
use of diversification &
optimization. These became the
building blocks for all future
advances in investment theory.
 Assumptions of Markowitz Portfolio
Theory
1. Investors consider each investment alternative as
defined by a probability distribution of expected returns
over a 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 (assumes that
returns are normally distributed).
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 level of risk, investors prefer higher returns
to lower returns. Similarly, for a given level of expected
returns, investors prefer less risk to more risk.
 Markowitz Portfolio Theory
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 a
higher expected return with the same
(or lower) risk, or lower risk with the
same (or higher) expected return.
 Concept of Dominance
Return A dominates B & C
B dominates C
D does not dominate
D
A
B

Standard Deviation
 Expected Rates of Return: Single
Asset

• For an individual asset - sum of the

possible returns multiplied by the
corresponding probability of the
return occurring
 Expected Rate of Return:
Single Risky Asset
Probability Possible Rate Expected
of Return Return
35% 8% 2.8%
30% 10% 3.0%
20% 12% 2.4%
15% 14% 2.1%
E(R) 10.30%
N
E ( RSecurity )   PR
i i
i 1

 .35  8   .30 10   .20 12   .15 14 

 10.30%
Variance (Standard Deviation) of Returns
for an Individual Asset

• Variance is a measure of the dispersion

of returns around the mean
• If returns are tightly clustered around
the mean, variance is low
• If returns are widely dispersed around
the mean, variance is high
• Standard deviation is the square root of
the variance
 Variance (Standard Deviation) of
Returns for an Individual Investment

n
Variance ( )   Pi R i - E(R i ) 
2 2

i 1
Where:
Pi is the probability of Ri occurring
Ri is the ith rate of return

n
Standard deviation ( )   Pi  R i - E(R i ) 
2

i 1
 Variance & Standard Deviation:
Example
Calculate the variance & Probability Return
standard deviation for 35% 8%
an asset with the
following returns & 30% 10%
associated probabilities. 20% 12%
15% 14%
 Variance & Standard Deviation:
Example
n
Variance ( )   Pi  R i -E(R i ) 
2 2

i 1

 0.35  8  10.3 +0.30 10  10.3  0.20 12  10.3   0.15 14 10.3 
2 2 2 2

 4.51

n
Standard deviation ( )   Pi  R i -E(R i ) 
2

i 1

 0.35  8  10.3 +0.30 10  10.3  0.20 12  10.3  0.15 14  10.3
2 2 2 2

 4.51
 2.12%
 Variance & Standard Deviation of
Historical Rates of Return
• The variance & standard deviation we just calculated
assumes that we have a distribution of expected
returns
• When we are calculating the variance and standard
deviation of historical returns, the probability for
each return occurring is the same.

 
n

 R - R
2 n 2
Ri - R i
Variance (  2
Sample )= i 1
Std Dev (  Sample )= i 1
n -1 n-1
Moving From One Risky Asset to
Several Risky Assets
• The return on the risky asset portfolio
is calculated as a weighted average of
the return of the assets in the
portfolio
– Weights are the market values of each
asset divided by the total market value of
the portfolio. N
E ( RPortfolio )   Wi Ri
i 1
 Expected Rate of Return:
Portfolio of Risky Assets
Weight Expected Expected
(% of Portfolio) Return (Asset i) Portfolio Return
20% 10% 2.0%
30% 11% 3.3%
30% 12% 3.6%
20% 13% 2.6%
E(R) 11.50%

N
E ( RPortfolio )  Wi Ri
i 1

 .20 10%   .30 11%   .30 12%   .20 13% 

 11.50%
 Calculating Risk: Two Risky
Assets
• The risk of a single risky asset is
calculated as its standard deviation
• When there are two or more risky
assets in a portfolio, we must also
incorporate how the individual assets
move in relation to each other
• Thus we need to understand
covariance & correlation
 Covariance of Returns
• A measure of the degree to which two
variables “move together” relative to their
individual mean values over time
– If both returns are typically above their respective
means at the same time, the covariance will be
positive
– If one return is typically above its mean when the
other return is below its mean, covariance will be
negative
– For two assets, i and j, the covariance of their
returns is defined as:

Covij = E{[Ri - E(Ri )] [R j - E(R j )]}

 Covariance of Returns: Example
Covij = E{[R i - E(R i )] [R j - E(R j )]}
 {[2.23 - 1.02] [1.77 - 0.67]  [1.46 - 1.02] [2.00 - 0.67]  [1.07 - 1.02] [1.50 - 0.67] 
[2.13 - 1.02] [5.59 - 0.67]  [1.38 - 1.02] [0.54 - 0.67]  [2.08 - 1.02] [0.95 - 0.67] 
[3.82 - 1.02] [1.73 - 0.67]  [0.33 - 1.02] [3.74 - 0.67]  [1.78 - 1.02] [0.84 - 0.67] 
[1.71 - 1.02] [1.51 - 0.67]  [4.68 - 1.02] [2.19 - 0.67]  [3.63 - 1.02] [2.31 - 0.67]}/11
7.00

11
 0.637

Note that we divided by N -1 rather than N,

since we are dealing with a sample of the data
rather than a population.
 Covariance and Correlation
• The correlation coefficient is obtained by dividing the
covariance by the product of the individual standard
deviations
Cov ij
ij 
 i j
where:
ij  the correlation coefficient (small Greek letter rho)
 i  the standard deviation of R it
 j  the standard deviation of R jt

ij 
Covij
The correlation between the

Wilshire 5000 and the Lehman
i j

0.637
 2.38  2.46  Treasury Bond Index is 0.109


 0.109
 Correlation Coefficient
• 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
Measuring Portfolio Return &
Risk: 2 Risky Assets
RPortfolio = x A RA + xB RB
Where : xi = proportion in the i th asset
Ri = return on the i th asset

 Portfolio
2
 x A2 A2  xB2 B2  2 x A xB  AB A B
Where : xi = proportion of the i th asset
 i2 = variance of the i th asset
 i = standard deviation of the i th asset
 AB = correlation coefficient
 Variance-Covariance Matrix
The variance of a two stock portfolio is
the sum of these four boxes
Stock A Stock B
X A X B AB 

Stock A xAσA
2 2
X A X B  AB  A B

X A X B  AB  A B x Bσ B
2 2
Stock B
 Example
• You are holding the following portfolio of
two risky assets:
Calculate:
Asset A Asset B
1. Return on
Return 14% 8% the portfolio
2. Risk of the
Standard 22% 14% portfolio
Deviation
Proportion of 40% 60%
portfolio
Correlation 0.20
 Example: Solution
RPortfolio = x1 R1 + x2 R2
  0.40 14%    0.60  8% 
 10.0%

 Portfolio
2
 x A2 A2  xB2 B2  2 x A xB  AB A B
  0.4   484    0.6  196   2  0.4  0.6  0.20  22 14 
2 2

 177.6

 Portfolio  Variance

 177.6
 13.3%
 Many Risky Assets Portfolio
• Return on the portfolio is simply
a weighted average of the
returns of the assets within the
portfolio.
RPortfolio  X1R1  X 2 R2  ...  X N RN

Xi = Proportion in asset i
Ri = Return on asset i
 Risk: Many Risky Assets
• To calculate the variance of the portfolio, use a
variance-covariance matrix
Asset 1 Asset 2 Asset 3 Asset 4

Asset 1 Variance of Covariance of Covariance of Covariance of

Asset 1 Asset 1 & 2 Asset 1 & 3 Asset 1 & 4

Asset 2 Covariance of Variance of Covariance of Covariance of

Asset 1 & 2 Asset 2 Asset 2 & 3 Asset 2 & 4

Asset 3 Covariance of Covariance of Variance of Covariance of

Asset 1 & 3 Asset 2 & 3 Asset 3 Asset 3 & 4

Asset 4 Covariance of Covariance of Covariance of Variance of

Asset 1 & 4 Asset 2 & 4 Asset 3 & 4 Asset 4
 Variance-Covariance Matrix
• The variance-covariance matrix shows
that the influence of individual asset
risk quickly diminishes as the size of the
portfolio grows, whereas the influence
of covariance grows quickly.
• For a portfolio of N assets, there are N
variance terms and N2 – N covariance
terms
 Contribution to Portfolio Risk
1  1
 Portfolio
2
=  Average variance   1-   Average Covariance 
+
N  N

As N, the number of securities in the portfolio,

increases, portfolio variance approaches the average
covariance
Thus, the risk of a well-diversified portfolio depends on
the market risk of the securities in the portfolio.
Market risk is measured by Beta.
 Measuring Risk
Portfolio risk falls rapidly as the number of
Portfolio standard deviation

securities in the portfolio rises. A 1970 study

by Fama & Lorie found that 80% of the
unique risk is diversified away with 8 stocks;
95% with 32 stocks & 99% with 128 stocks
Unique
risk

Market risk
0
5 10 15
Number of Securities

Canadian studies have found that substantially more

stocks are required in Canada to achieve good
diversification, due to the heavy concentration of
resource stocks on the Toronto Stock Exchange (TSX).
 Estimation Issues
• Results of portfolio allocation depend on
accurate statistical inputs
• Estimates of
– Expected returns
– Standard deviation
– Correlation coefficient
• Among entire set of assets
• With 100 assets, 4,950 correlation estimates
• Estimation risk refers to potential errors
 Estimation Issues
• With assumption that stock returns can be described
by a single market model, the number of correlations
required reduces to the number of assets.
• Single index market model:

R i  a i  bi R m   i
bi = the slope coefficient that relates the returns for
security i to the returns for the aggregate stock market
Rm = the returns for the aggregate stock market
έi = error term (lower case Greek letter epsilon)
 Estimation Issues
If all the securities are similarly related to the
market and a bi derived for each one, it can be shown
that the correlation coefficient between two
securities i and j is given as:

 m2
 ij  bi bj
 i j
Where :
 ij  the correlatio n between asset i and asset j
 m2  the variance of returns for the aggregate stock market
b i  the slope coefficien t that relates the returns
for security i to the returns for the aggregate stock market
 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.
– An exception is the asset with the highest
return.
 Efficient Frontier
for Alternative Portfolios

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 more risk averse the individual, the steeper the slope of
his/her utility curve
• The slope of the efficient frontier decreases steadily
as you move upward
• These two interactions will determine the particular
portfolio selected by an individual investor
• 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

E(R port ) U3’ Less Risk

More Risk
Averse
Averse U2’
Investor U1’ Investor

Y
U3 X

U2
U1

E( port )
 The Internet Investments
Online
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http://www.styleadvisor.com
http://www.wagner.com
http://www.effisols.com
http://www.efficientfrontier.com
 The end of Chapter 4

Next Chapter 5:
Modern Portfolio Theories