Chapter 8 AN INTRODUCTION TO PORTFOLIO MANAGEMENT

Chapter 8 Questions What do we mean be risk aversion, and what evidence indicates that investors are generally risk averse?What do we mean be risk aversion, and what evidence indicates that investors are generally risk averse? What are the basic assumptions behind the Markowitz portfolio theory?What are the basic assumptions behind the Markowitz portfolio theory? What do we mean by risk, and what are some of the measures of risk used in investments?What do we mean by risk, and what are some of the measures of risk used in investments? How do we compute the expected rate of return for an individual risky asset or a portfolio of assets?How do we compute the expected rate of return for an individual risky asset or a portfolio of assets?

Chapter 8 Questions How do we compute the standard deviation of rates of return for an individual risky asset?How do we compute the standard deviation of rates of return for an individual risky asset? What do we mean by the covariance between rates of return, and how is it computed?What do we mean by the covariance between rates of return, and how is it computed? What is the relationship between covariance and correlation?What is the relationship between covariance and correlation?

Chapter 8 Questions 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?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 we diversify a portfolio?Given the formula for the standard deviation of a portfolio, why and how do we diversify a portfolio? What happens to the standard deviation of a portfolio when we change the correlation between the assets in the portfolio?What happens to the standard deviation of a portfolio when we change the correlation between the assets in the portfolio?

Chapter 8 Questions What is the risk-return efficient frontier of risky assets?What is the risk-return efficient frontier of risky assets? Is it reasonable for alternative investors to select different portfolios from the set of portfolios on the efficient frontier?Is it reasonable for alternative investors to select different portfolios from the set of portfolios on the efficient frontier? What determines which portfolio on the efficient frontier is selected by an individual investor?What determines which portfolio on the efficient frontier is selected by an individual investor?

Background Assumptions As an investor you want to maximize the returns for a given level of risk.As an investor you want to maximize the returns for a given level of risk. Your portfolio includes all of your assets, not just financial assetsYour portfolio includes all of your assets, not just financial assets The relationship between the returns for assets in the portfolio is important.The relationship between the returns for assets in the portfolio is important. A good portfolio is not simply a collection of individually good investments.A good portfolio is not simply a collection of individually good investments.

Risk Aversion Portfolio theory assumes that investors are averse to risk Given a choice between two assets with equal expected rates of return, risk averse investors will select the asset with the lower level of riskGiven a choice between two assets with equal expected rates of return, risk averse investors will select the asset with the lower level of risk It also means that a riskier investment has to offer a higher expected return or else nobody will buy itIt also means that a riskier investment has to offer a higher expected return or else nobody will buy it

Are investors risk averse? The popularity of insurance of various types attests to risk aversionThe popularity of insurance of various types attests to risk aversion Yield on bonds increase with risk classifications from AAA to AA to A…., indicating that investors require risk premiums as compensationYield on bonds increase with risk classifications from AAA to AA to A…., indicating that investors require risk premiums as compensation Experimental psychology also confirms that humans tend to be risk averseExperimental psychology also confirms that humans tend to be risk averse

Are investors always risk averse? Risk preference may have to do with amount of money involved - risking only small amounts.Risk preference may have to do with amount of money involved - risking only small amounts. Trips to the casino might seem to refute risk aversion, but realize that gaming is best thought of as entertainment, not investingTrips to the casino might seem to refute risk aversion, but realize that gaming is best thought of as entertainment, not investing

Definition of Risk One definition: Uncertainty of future outcomesOne definition: Uncertainty of future outcomes Alternative definition: The probability of an adverse outcomeAlternative definition: The probability of an adverse outcome We will discuss several measures of risk that are used in developing portfolio theoryWe will discuss several measures of risk that are used in developing portfolio theory

Markowitz Portfolio Theory Derives the expected rate of return for a portfolio of assets and an expected risk measureDerives the expected rate of return for a portfolio of assets and an expected risk measure Markowitz demonstrated that the variance of the rate of return is a meaningful measure of portfolio risk under reasonable assumptionsMarkowitz demonstrated that the variance of the rate of return is a meaningful measure of portfolio risk under reasonable assumptions The portfolio variance formula shows how to effectively diversify a portfolioThe portfolio variance formula shows how to effectively diversify a portfolio

Markowitz Portfolio Theory Assumptions Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period.Investors consider each investment alternative as being presented by a probability distribution of expected returns over some holding period. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth.Investors maximize one-period expected utility, and their utility curves demonstrate diminishing marginal utility of wealth. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.Investors estimate the risk of the portfolio on the basis of the variability of expected returns.

Markowitz Portfolio Theory Assumptions 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.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. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of expected returns, investors prefer less risk to more risk.For a given risk level, 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 Under these five assumptions, a single asset or portfolio of assets is 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.Under these five assumptions, a single asset or portfolio of assets is 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.

Alternative Measures of Risk Variance or standard deviation of expected return (Main focus)Variance or standard deviation of expected return (Main focus) –Based on deviations from the mean return –Larger values indicate greater risk Other measuresOther measures –Range of returns –Returns below expectations Semivariance – measures deviations only below the meanSemivariance – measures deviations only below the mean

Expected Rates of Return Individual risky assetIndividual risky asset –Expected rates of return are calculated by determining the possible returns (R i ) for some investment in the future, and weighting each possible return by its own probability (P i ). E(R) =   P i R i

Expected Return Example Economic ConditionsProbabilityReturn Strong.20 40% Average.50 12% Weak % E(R) =.20(40%) +.50 (12%) +.30 (-20%) E(R) = 8%

Expected Rates of Return PortfolioPortfolio –Weighted average of expected returns (R i ) for the individual investments in the portfolio –Percentages invested in each asset (w i ) serve as the weights E(R port ) =   w i R i

Expected Return Example Weight (%)Expected Return (Ri) 30% 10% 30% 15% 40% 18% E(R) =.30(10%) +.30 (15%) +.40 (18%) E(R) = 14.7%

Variance & Standard Deviation of Returns Individual Investment Standard deviation is the positive square root of the varianceStandard deviation is the positive square root of the variance Both measures are based on deviations of each possible return (R i ) from the expected return (E(R))Both measures are based on deviations of each possible return (R i ) from the expected return (E(R)) Variance:Variance:  2 =  P i (R i -E(R)) 2

Standard Deviation of Expected Returns Economic ConditionsProbabilityReturn Strong.20 40% Average.50 12% Weak % E(R) = 8%  2 =.20 (40-8) (12-8) (-20-8) 2  2 = 448  = 21.2%

Variance & Standard Deviation of Returns Before calculating the portfolio variance and standard deviation, several other measures need to be understood CovarianceCovariance –Measures the extent to which two variables move together –For two assets, i and j, the covariance of rates of return is defined as: Cov ij = E{[R i,t - E(R i )][R j,t - E(R j )]}

Variance & Standard Deviation of Returns Correlation coefficientCorrelation coefficient –Values of the correlation coefficient (r) go from -1 to +1 –Standardized measure of the linear relationship between two variables r ij = Cov ij /(  i  j ) Cov ij = covariance of returns for securities i and j  i = standard deviation of returns for security i  j = standard deviation of returns for security j

Portfolio Standard Deviation Formula

Portfolio Standard Deviation Calculation The portfolio standard deviation is a function of:The portfolio standard deviation is a function of: –The variances of the individual assets that make up the portfolio –The covariances between all of the assets in the portfolio The larger the portfolio, the more the impact of covariance and the lower the impact of the individual security varianceThe larger the portfolio, the more the impact of covariance and the lower the impact of the individual security variance

Implications for Portfolio Formation Assets differ in terms of expected rates of return, standard deviations, and correlations with one anotherAssets differ in terms of expected rates of return, standard deviations, and correlations with one another –While portfolios give average returns, they give lower risk –Diversification works! Even for assets that are positively correlated, the portfolio standard deviation tends to fall as assets are added to the portfolioEven for assets that are positively correlated, the portfolio standard deviation tends to fall as assets are added to the portfolio

Implications for Portfolio Formation Combining assets together with low correlations reduces portfolio risk moreCombining assets together with low correlations reduces portfolio risk more –The lower the correlation, the lower the portfolio standard deviation –Negative correlation reduces portfolio risk greatly –Combining two assets with perfect negative correlation reduces the portfolio standard deviation to nearly zero

Estimation Issues Results of portfolio analysis depend on accurate statistical inputsResults of portfolio analysis depend on accurate statistical inputs Estimates ofEstimates of –Expected returns –Standard deviations –Correlation coefficients With 100 assets, 4,950 correlation estimatesWith 100 assets, 4,950 correlation estimates Estimation risk refers to potential errorsEstimation 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 assetsWith 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:Single index market model: b i = the slope coefficient that relates the returns for security i to the returns for the aggregate stock market R m = 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 returnThe 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 securitiesFrontier will be portfolios of investments rather than individual securities –Exceptions being the asset with the highest return and the asset with the lowest risk

Efficient Frontier and Alternative Portfolios Efficient Frontier A B C E(R) Standard Deviation of Return

The Efficient Frontier and Portfolio Selection Any portfolio that plots “inside” the efficient frontier (such as point C) is dominated by other portfoliosAny portfolio that plots “inside” the efficient frontier (such as point C) is dominated by other portfolios –For example, Portfolio A gives the same expected return with lower risk, and Portfolio B gives greater expected return with the same risk Would we expect all investors to choose the same efficient portfolio?Would we expect all investors to choose the same efficient portfolio? –No, individual choices would depend on relative appetites return as opposed to risk

The Efficient Frontier and Investor Utility An individual investor’s utility curve specifies the trade-offs she is willing to make between expected return and riskAn individual investor’s utility curve specifies the trade-offs she is willing to make between expected return and risk Each utility curve represent equal utility; curves higher and to the left represent greater utility (more return with lower risk)Each utility curve represent equal utility; curves higher and to the left represent greater utility (more return with lower risk) The interaction of the individual’s utility and the efficient frontier should jointly determine portfolio selectionThe interaction of the individual’s utility and the efficient frontier should jointly determine portfolio selection

The Efficient Frontier and Investor Utility The optimal portfolio has the highest utility for a given investorThe 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 utilityIt lies at the point of tangency between the efficient frontier and the utility curve with the highest possible utility

Selecting an Optimal Risky Portfolio X Y U3U3 U2U2 U1U1 U 3’ U 2’ U 1’

Investor Differences and Portfolio Selection A relatively more conservative investor would perhaps choose Portfolio XA relatively more conservative investor would perhaps choose Portfolio X –On the efficient frontier and on the highest attainable utility curve A relatively more aggressive investor would perhaps choose Portfolio YA relatively more aggressive investor would perhaps choose Portfolio Y –On the efficient frontier and on the highest attainable utility curve