Chapter six

Portfolio theory
6.1. Diversification and portfolio risk
Portfolio:
 Portfolio - an appropriate mix of or collection of investments held by an institution or a
private individual
 Group of assets such as stocks and bonds held by an investor.
 One convenient way of describing a portfolio is to list the percentages of the portfolio’s
total value that are invested in each portfolio asset
 We call these percentages the portfolio weights.
 means a collections or combinations and in the context of investment management
 A collection or combination of financial assets or security such as shares ,debentures
and government security
 Collect of asset which can even include physical asset (gold silver, real estate etc.)
 A asset are held for investment purposes and not for consumption purpose
 collection of assets ( financial or physical or both)
 Portfolio should include all of your assets and liabilities, not only your stocks or even
your marketable securities but also such items as your car, house, and less-marketable
investments, such as coins, stamps, art, antiques, and furniture.
 Portfolio theory also assumes that investors are basically risk averse, meaning that,
given a choice between two assets with equal rates of return, they will select the asset
with the lower level of risk.
 Evidence that most investors are risk averse is that they purchase various types of
insurance, including life insurance, car insurance, and health insurance
Diversification:
 The spreading of investments over more than one asset with a view to reduce the
portfolio’s risk ( the variability of expected portfolio returns)
 Efforts to spread and minimize portfolio risk take the form of diversification
 Most asset prefer to hold several assets rather than putting all their eggs into one basket
with the hope that if the goes bad the others will provide some protection from extreme
loss
 Risk associated with investments can be reduced through diversification and such
diversification helps the investors to reduce the risk of the portfolio
 Investment in individual security risk (variance) associated with individual security and
the relationship (covariance) between the securities.
 Diversification reduce the unsystematic risk of portfolio
 In a large portfolio, some stocks will go up in value because of positive company-
specific events, while others will go down in value because of negative company-
specific events.
 Unsystematic risk is essentially eliminated by diversification, so a portfolio with many
assets has almost no unsystematic risk.
 Unsystematic risk is also called diversifiable risk, while systematic risk is also called no
diversifiable risk.
 The systematic risk principle states that the reward for bearing risk depends only on the
systematic risk of an investment.
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  So, no matter how much total risk an asset has, only the systematic portion is relevant
in determining the expected return (and the risk premium) on that asset.
 Measuring Systematic Risk: Beta coefficient (b):
 Measure of the relative systematic risk of an asset. Assets with betas larger
than 1.0 have more systematic risk than average, and vice versa.
 Because assets with larger betas have greater systematic risks, they will have
greater expected returns.
6.2. Portfolio risk and return
 Risk is the uncertainty of future outcomes
 The probability of an adverse outcome.
 The basic portfolio model was developed by Harry Markowitz, who derived the
expected rate of return for a portfolio of assets and an expected risk measure
 Markowitz showed that the variance of the rate of return was a meaningful measure
of portfolio risk under a reasonable set of assumptions, and he derived the formula
for computing the variance of a portfolio
 This portfolio variance formula indicated the importance of diversifying your
investments to reduce the total risk of a portfolio but also showed how to effectively
diversify.
 The risk of portfolio of stock is lower than the sum of the risk of individuals stock
 The Markowitz model is based on several assumptions regarding investor behavior:
a) Investors consider each investment alternative as being represented by a
probability distribution of expected returns over some holding period.
b) Investors maximize one-period expected utility, and their utility curves
demonstrate diminishing marginal utility of wealth.
c) Investors estimate the risk of the portfolio on the basis of the variability of
expected returns.
d) 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.
e) For a given risk level, investors prefer higher returns to lower returns.
Similarly, for a given level of expected return, investors prefer less risk to more
risk.
 Under these 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
return.
 One of the best-known measures of risk is the variance, or standard deviation
of expected returns
 Expected return and risk of a portfolio:
 The return on a portfolio of asset is simply a weight average of the return
on the individual assets
 The expected return on a portfolio is a linear combination of the expected
returns on the assets in that portfolio
 The weight applied to each return is the fraction of the portfolio invested in
that asset

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  R(p) = ∑ nXiRi
 Where :
R(p) = the expected return of the portfolio
Xi = the proportion of the portfolio’s initial fund invested in asset i
Ri = the expected return of asset i
n= number of asset in portfolio
 Assume portfolio of two equity share A and B . The expected return on A
is 15% and on B is 20%. Assume the investors invest his resources 40%
fund in share A and the remaining in B. What is the expected portfolio
return?
 R(p) = ∑ nXiRi = 0.40 X.15 + 0.60 X0.20 = 18%
 Portfolio Betas:
The riskiness of a portfolio has no simple relation to the risks of the
assets in the portfolio.
In contrast, a portfolio beta can be calculated just like the expected
return of a portfolio.
In general, you can multiply each asset’s beta by its portfolio weight
and then add the results to get the portfolio’s beta.
Beta =the covariance between asset i and the M portfolio
the variance of the M portfolio.
Covim= rimσiσm
Where :
 Covim=the covariance between asset i and the M portfolio
 rim= correlation coefficient between returns for asset i and the
M portfolio
 σiσm = Standard Deviation asset i and the M portfolio
Covariance is equal to the summation of product of the result of the
difference of return and is arthematic mean of two or more asset.
We can calculate some different possible portfolio expected returns
and betas by varying the percentages invested in these two assets.
 Covariance is a measure of the degree to which two variables “move together” relative to
their individual mean values over time.
 A positive covariance means that the rates of return for two investments tend to move in
the same direction relative to their individual means during the same time period.
 a negative covariance indicates that the rates of return for two investments tend to move
in different directions relative to their means during specified time intervals over time
 The magnitude of the covariance depends on the variances of the individual return series,
as well as on the relationship between the series.
 The covariance statistic provides an absolute measure of how they moved together over
time.
 Variance is calculated as the sum of the squared deviations from the expected return
multiplied by their probabilities.
 The standard deviation is the square root of the variance. Standard deviation = s variance

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  Where:
VAR(RP)=variance of portfolio return
ps =probability of state of economy s
E(Rs) = expected portfolio return given state s
E(Rp) = Expected value of return of portfolio
 Correlation:
The tendency of the returns on two assets to move together.
Imperfect correlation is the key reason why diversification reduces portfolio
risk as measured by the portfolio standard deviation.
Positively correlated assets tend to move up and down together,
while negatively correlated assets tend to move in opposite directions
The correlation coefficient is denoted by Corr(RA, RB) or r.
It measures correlation and ranges from -1 (perfect negative correlation) to
0 (uncorrelated) to +1 (perfect positive correlation).

6.3. Capital allocation between risky and risk free assets

 Investors want to earn the highest return possible for a level of risk that they are willing to
take.
 An investor allocate her capital to maximize her investment utility the risk-return profile
that yields the greatest satisfaction
 A risk-free asset that has a low rate of return but no risk,
 A risky asset that has a higher expected return for a higher risk.
 Investment risk is measured by the standard deviation of investment returns
 The greater the standard deviation, the greater the risk.
 An investor can earn a risk-free return by investing all of her/his money in the risk-free
asset, or she can potentially earn the maximum return by investing entirely in the risky
asset, or she/h can select a risk-return trade-off.
 Asset allocation is the apportionment of funds among different types of assets with
different ranges of expected returns and risk.
 Capital allocation, on the other hand, is the apportionment of funds between risk-free
investments, such as T-bills, and risky assets, such as stocks.
 The simplest case of capital allocation is the allocation of funds between a risky asset and
a risk-free asset.
 If this portfolio consists of a risky asset with a proportion of y, then the proportion of the
risk-free asset must be 1 – y.
 Portfolio Return = y × Risky Asset Return + (1 – y) × Risk-free Return
 One way to adjust the riskiness of a portfolio is by varying the proportion of the risk-free
asset and the risky asset.
 The investment opportunity set is the set of all combinations of the risky and risk-free
assets and measured by the standard deviation.

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  Capital allocation line (CAL) is the graph of all possible combinations of the risk-free
asset and the risky asset.
 The slope of the capital allocation line is equal to the incremental return of the portfolio to
the incremental increase in risk.
 The slope of the capital allocation line is called the reward-to-variability ratio because
the expected return increases continually with the increase in risk as measured by the
standard deviation.
Reward-to-Variability Ratio=Portfolio Return – Risk-Free Return
Standard Deviation of Portfolio
 The risk-free return is subtracted from the portfolio return to yield the proportion of the
return due to the risky asset.
 The increased return for the increased risk is the reward for accepting the increased risk—
the risk premium.
 The capital market line (CML) is the capital allocation line formed when the risky asset is
a market return rather than a single-asset return.
 For the risky asset, many investors choose a mutual fund or an exchange-traded fund based
on a market index, which provides some diversification in the risky asset without the need
for security analysis.
 This passive strategy of selecting a market index security or investment for the risky asset is
sometimes called the mutual fund theorem.
6.4. Optimum risky portfolio
 Optimal portfolio the feasible portfolio that offers an investor the maximum level
satisfaction given his or her own preference for return and risk
 The expected return of a portfolio is the weighted average of the component security
expected returns with the investment proportions as weights.
 The variance of a portfolio is the weighted sum of the elements of the covariance
matrix with the product of the investment proportions as weights. Thus the variance of
each asset is weighted by the square of its investment proportion. The covariance of
each pair of assets appears twice in the covariance matrix; thus the portfolio variance
includes twice each covariance weighted by the product of the investment proportions
in each of the two assets.
 Even if the covariance is positive, the portfolio standard deviation is less than the
weighted average of the component standard deviations, as long as the assets are not
perfectly positively correlated. Thus portfolio diversification is of value as long as
assets are less than perfectly correlated.
 The greater an asset's covariance with the other assets in the portfolio, the more it
contributes to portfolio variance.
 An asset that is perfectly negatively correlated with a portfolio can serve as a perfect
hedge.
 The perfect hedge asset can reduce the portfolio variance to zero.
 The efficient frontier is the graphical representation of a set of portfolios that maximize
expected return for each level of portfolio risk.
 Rational investors will choose a portfolio on the efficient frontier.

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  A portfolio manager identifies the efficient frontier by first establishing estimates for
asset expected returns and the covariance matrix.
 In general, portfolio managers will arrive at different efficient portfolios because of
differences in methods and quality of security analysis.
 Managers compete on the quality of their security analysis relative to their management
fees.
 If a risk-free asset is available and input lists are identical, all investors will choose the
same portfolio on the efficient frontier of risky assets:
The portfolio tangent to the CAL.
All investors with identical input lists will hold an identical risky portfolio,
differing only in how much each allocates to this optimal portfolio and to the
risk-free asset.
This result is characterized as the separation principle of portfolio construction.
 An individual investor can determine how much volatility he or she is willing to maintain
in his other portfolio by picking another point which lies along the so-called efficient
frontier.
 Doing so will provide maximum return for the amount of risk that the investor has decided
to accept.

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