Chapter 2 Diversification and Risky Asset Allocation Expected Return and Variances Portfolios Diversification and Portfolio Risk Correlation and Diversification Markowitz Efficient Frontier Asset Allocation and Security Selection Decisions of Portfolio Formation Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Diversification Intuitively, we all know that if you hold many investments Through time, some will increase in value Through time, some will decrease in value It is unlikely that their values will all change in the same way Diversification has a profound effect on portfolio return and portfolio risk. But, exactly how does diversification work?

Diversification and Asset Allocation Our goal in this chapter is to examine the role of diversification and asset allocation in investing. In the early 1950s, professor Harry Markowitz was the first to examine the role and impact of diversification. Based on his work, we will see how diversification works, and we can be sure that we have “efficiently diversified portfolios.” An efficiently diversified portfolio is one that has the highest expected return, given its risk. You must be aware of the difference between historic return and expected return! Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Expected Return Expected return is the “weighted average” return on a risky asset, from today to some future date. The formula is: To calculate an expected return, you must first: Decide on the number of possible economic scenarios that might occur, Estimate how well the security will perform in each scenario, and Assign a probability to each scenario (BTW, finance professors call these economic scenarios, “states.”) The next slide shows how the expected return formula is used when there are two states. Note that the “states” are equally likely to occur in this example. BUT! They do not have to be. They can have different probabilities of occurring.

Expected Return II Suppose there are two stocks: NetCap and JMart We are looking at a period of one year. Investors agree that the expected return: for NetCap is 25 percent and for JMart is 20 percent Why would anyone want to hold JMart shares when NetCap is expected to have a higher return? The answer depends on risk Jmart is expected to return 20 percent But the realized return on Jmart could be significantly higher or lower than 20 percent Similarly, the realized return on NetCap could be significantly higher or lower than 25 percent.

Expected Return

Expected Risk Premium Recall: Suppose riskfree investments have an 8% return. So, in the previous slide, the risk premium expected on Jmart is 12%, and 17% for Netcap. This expected risk premium is the difference between the expected return on the risky asset in question and the certain return on a risk-free investment.

Calculating the Variance of Expected Returns The variance of expected returns is calculated as the sum of the squared deviations of each return from the expected return, multiplied by the probability of the state. Here is the formula: This formula is not as difficult as it appears. It says: add up the squared deviations of each return from its expected return after it has been multiplied by the probability of observing a particular economic state (denoted by “s”).

Standard Deviation The standard deviation is simply the square root of the variance. The following slide contains an example that shows how to use these formulas in a spreadsheet.

Expected Returns and Variances Equal State Probabilities Note that the second spreadsheet is only for Netcap. What would you get for Jmart?

Expected Returns and Variances, Netcap and Jmart

Portfolios Portfolios are groups of assets, such as stocks and bonds, that are held by an investor. One convenient way to describe a portfolio is by listing the proportion of the total value of the portfolio that is invested into each asset. These proportions are called portfolio weights. Portfolio weights are sometimes expressed in percentages. However, in calculations, make sure you use proportions (i.e., decimals).

Portfolios: Expected Returns The expected return on a portfolio is the weighted average, of the expected returns on the assets in that portfolio. The formula, for “n” assets, is: In the formula: E(RP) = expected portfolio return wi = portfolio weight in portfolio asset i E(Ri) = expected return for portfolio asset i

Example: Calculating Portfolio Expected Returns Note that the portfolio weight in Jmart = 1 – portfolio weight in Netcap.

Variance of Portfolio Expected Returns Note: Unlike returns, portfolio variance is generally not a simple weighted average of the variances of the assets in the portfolio. If there are “n” states, the formula is: In the formula, VAR(RP) = variance of portfolio expected return ps = probability of state of economy, s E(Rp,s) = expected portfolio return in state s E(Rp) = portfolio expected return Note that the formula is like the formula for the variance of the expected return of a single asset.

Calculating Variance of Portfolio Returns It is possible to construct a portfolio of risky assets with zero portfolio variance! What? How? (Open the spreadsheet and set the weight in Netcap to 2/11ths.) Note: This is a continuation of the spreadsheet in slide 13. You can set the weights as =2/11 for Netcap, and you will see that the return is the same in both states, i.e., riskless! © 2009 McGraw-Hill Ryerson Limited

Diversification and Risk, I. Table 2.7 Portfolio Standard Deviations Diversification and Risk, I. © 2009 McGraw-Hill Ryerson Limited

Diversification and Risk, II.

Why Diversification Works, I. 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. Negatively correlated assets tend to move in opposite directions. Imperfect correlation, positive or negative, is why diversification reduces portfolio risk.

Why Diversification Works, II. The correlation coefficient is denoted by Corr(RA, RB) or simply, A,B. The correlation coefficient measures correlation and ranges from: From: -1 (perfect negative correlation) Through: (uncorrelated) To: +1 (perfect positive correlation) © 2009 McGraw-Hill Ryerson Limited

Why Diversification Works, III.

Why Diversification Works Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Why Diversification Works Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

Calculating Portfolio Risk For a portfolio of two assets, A and B, the variance of the return on the portfolio is: Where: wA = portfolio weight of asset A wB = portfolio weight of asset B such that wA + wB = 1. (Important: Recall Correlation Definition!)

Correlation and Diversification Suppose that as a very conservative, risk-averse investor, you decide to invest all of your money in a bond mutual fund. Very conservative, indeed? Uh, is this decision a wise one?

Correlation and Diversification Note: A correlation of 0.10 is assumed in calculations

Correlation and Diversification

Correlation and Diversification The various combinations of risk and return available all fall on a smooth curve. This curve is called an investment opportunity set, because it shows the possible combinations of risk and return available from portfolios of these two assets. A portfolio that offers the highest return for its level of risk is said to be an efficient portfolio. The undesirable portfolios are said to be dominated or inefficient.

Correlation and Risk &Return Trade off

Correlation and the Risk-Return Trade-Off If you open this spreadsheet, you can see how the correlation affects the shape of the efficient set. Enter correlations as integers, ranging from -100 to +100.

Risk and Return with Multiple Assets

The Markowitz Efficient Frontier The Markowitz Efficient frontier is the set of portfolios with the maximum return for a given risk AND the minimum risk for a given a return. For the plot, the upper left-hand boundary is the Markowitz efficient frontier. Efficient Frontier All the other possible combinations are inefficient. That is, investors would not hold these portfolios because they could get either more return for a given level of risk, or less risk for a given level of return.

Portfolio Formation Decisions Investors can form their using the following financial assets : 1- Domestic Stocks, 2- Domestic Bonds (government, municipal, provincial bonds, corporate bonds) 3- Derivative Instruments (options, futures, swaps), 4- Money market instruments (T-Bills, certificate of deposits, repurchase agreements, etc), 5- Foreign Stocks and Bonds.

Asset Allocation and Security Selection Investors face with two problems when they form portfolios of multiple securities from different asset classes. 1. Asset Allocation Decision Asset allocation problem involves a decision of what percentage of investor’s portfolio should be allocated among different asset classes (stocks, bonds, derivatives, money market instruments, foreign securities). 2. Security Selection Decision Security selection is deciding which securities to pick in each class and what percentage of funds to allocate to these securities (for example choosing different stocks and their percentages within the asset class).

Portfolio Decisions Suppose you have $100,000 for investment. First you have to decide which assets you want to hold. For example, you may decide to invest $20,000 in money market instruments, $30,000 in bonds and $50,000 in domestic stocks. Then, your portfolio consists of 20% of money market instruments, 30% of bonds and 50% in stocks. This is your asset allocation decision. Then you may decide within the stock part of your portfolio, to allocate $50,000 equally among the following five stocks: Nortel, Research In Motion, Royal Bank, Bombardier, and Molson. That decision, your security selection decision, indicates that you will buy $10,000 worth of stocks of each company.

Useful Internet Sites www.411stocks.com (to find expected returns) www.investopedia.com (for more on risk measures) www.teachmefinance.com (also contains more on risk measure) www.morningstar.com (measure diversification using “instant x-ray”) www.moneychimp.com (review modern portfolio theory) www.efficentfrontier.com (check out the online journal)