1. Modern Portfolio Concepts
Chapter 5
Modern Portfolio Concepts

2. Modern Portfolio Concepts
Learning Goals
Understand portfolio management objectives and calculate the return and standard deviation of a portfolio.
Discuss the concepts of correlation and diversification, and the effectiveness, methods, and benefits of international diversification.
Describe the two components of risk, beta, and the capital asset pricing model (CAPM).
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3. Modern Portfolio Concepts
Learning Goals (cont’d)
Review traditional and modern approaches to portfolio management and reconcile them.
Describe the role of investor characteristics and objectives and of portfolio objectives and policies in constructing an investment portfolio.
Summarize why and how investors use an asset allocation scheme to construct an investment portfolio.
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4. What is a Portfolio?
Portfolio is a collection of investment vehicles assembled to meet one or more investment goals.
Growth-Oriented Portfolio: primary objective is long-term price appreciation
Income-Oriented Portfolio: primary objective is current dividend and interest income
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5. The Ultimate Goal: An Efficient Portfolio
A portfolio that provides the highest return for a given level of risk
Given the choice between two equally risky investments, an investor will chose the one with the highest potential return.
Given the choice between two investments offering the same return, an investor will choice the one that has the least risk.
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6. Portfolio Return and Risk Measures
Return on a Portfolio is the weighted average of returns on the individual assets in the portfolio.
Standard Deviation of a portfolio’s returns is calculated using all of the individual assets in the portfolio.
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7. Return on Portfolio
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8. Correlation: Why Diversification Works!
Correlation is a statistical measure of the relationship between two series of numbers representing data.
Positively Correlated items move in the same direction.
Negatively Correlated items move in opposite directions.
Correlation Coefficient is a measure of the degree of correlation between two series of numbers representing data.
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9. Correlation Coefficients
Perfectly Positively Correlated describes two positively correlated series having a correlation coefficient of +1
Perfectly Negatively Correlated describes two negatively correlated series having a correlation coefficient of -1
Uncorrelated describes two series that lack any relationship and have a correlation coefficient of nearly zero
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10. Figure 5.1 The Correlation Between Series M, N, and P
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11. Correlation: Why Diversification Works!
To reduce overall risk in a portfolio, it is best to combine assets that have a negative (or low-positive) correlation.
Uncorrelated assets reduce risk somewhat, but not as effectively as combining negatively correlated assets.
Investing in different investments with high positive correlation will not provide sufficient diversification.
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12. Figure 5.2 Combining Negatively Correlated Assets to Diversify Risk
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13. Table 5.3 Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations
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14. Figure 5.3 Range of Portfolio Return and Risk for Combinations of Assets A and B for Various Correlation Coefficients
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15. Why Use International Diversification?
Offers more diverse investment alternatives than U.S.-only based investing
Foreign economic cycles may move independently from U.S. economic cycle
Foreign markets may not be as “efficient” as U.S. markets, allowing true gains from superior research
Study done between 1984 and 1994 suggests that portfolio 70% S&P 500 and 30% EAFE would reduce risk 5% and increase return 7% over a 100% S&P 500 portfolio
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16. International Diversification
Advantages of International Diversification
Broader investment choices
Potentially greater returns than in U.S.
Reduction of overall portfolio risk
Disadvantages of International Diversification
Currency exchange risk
Less convenient to invest than U.S. stocks
More expensive to invest
Riskier than investing in U.S.
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17. Methods of International Diversification
Foreign company stocks listed on U.S. stock exchanges
Yankee Bonds
American Depository Receipts (ADRs)
Mutual funds investing in foreign stocks
U.S. multinational companies (typically not considered a true international investment for diversification purposes)
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18. Components of Risk Diversifiable (Unsystematic) Risk
Results from uncontrollable or random events that are firm-specific
Can be eliminated through diversification
Examples: labor strikes, lawsuits
Nondiversifiable (Systematic) Risk
Attributable to forces that affect all similar investments
Cannot be eliminated through diversification
Examples: war, inflation, political events
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19. Components of Risk
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20. Beta: A Popular Measure of Risk
A measure of nondiversifiable risk
Indicates how the price of a security responds to market forces
Compares historical return of an investment to the market return (the S&P 500 Index)
The beta for the market is 1.00
Stocks may have positive or negative betas. Nearly all are positive.
Stocks with betas greater than 1.00 are more risky than the overall market.
Stocks with betas less than 1.00 are less risky than the overall market.
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21. Figure 5.5 Graphical Derivation of Beta for Securities C and D
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22. Beta: A Popular Measure of Risk
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23. Interpreting Beta
Higher stock betas should result in higher expected returns due to greater risk
If the market is expected to increase 10%, a stock with a beta of 1.50 is expected to increase 15%
If the market went down 8%, then a stock with a beta of 0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained from Value Line reports or online websites such as yahoo.com
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24. Interpreting Beta
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25. Capital Asset Pricing Model (CAPM)
Model that links the notions of risk and return
Helps investors define the required return on an investment
As beta increases, the required return for a given investment increases
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26. Capital Asset Pricing Model (CAPM) (cont’d)
Uses beta, the risk-free rate and the market return to define the required return on an investment
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27. Capital Asset Pricing Model (CAPM) (cont’d)
CAPM can also be shown as a graph
Security Market Line (SML) is the “picture” of the CAPM
Find the SML by calculating the required return for a number of betas, then plotting them on a graph
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28. Figure 5.5 The Security Market Line (SML)
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29. Two Approaches to Constructing Portfolios
Traditional Approach
versus
Modern Portfolio Theory
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30. Traditional Approach
Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds
Uses a broad range of industries to diversify the portfolio
Tends to focus on well-known companies
Perceived as less risky
Stocks are more more liquid and available
Familiarity provides higher “comfort” levels for investors
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31. Modern Portfolio Theory (MPT)
Emphasizes statistical measures to develop a portfolio plan
Focus is on:
Expected returns
Standard deviation of returns
Correlation between returns
Combines securities that have negative (or low- positive) correlations between each other’s rates of return
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32. Key Aspects of MPT: Efficient Frontier
The leftmost boundary of the feasible set of portfolios that include all efficient portfolios: those providing the best attainable tradeoff between risk and return
Portfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferior
Portfolios that fall to the left of the efficient frontier are not available for investments
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33. Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier
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34. Key Aspects of MPT: Portfolio Betas
The beta of a portfolio; calculated as the weighted average of the betas of the individual assets the portfolio includes
To earn more return, one must bear more risk
Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship
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35. Key Aspects of MPT: Portfolio Betas
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36. Figure 5.8 Portfolio Risk and Diversification
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37. Interpreting Portfolio Betas
Portfolio betas are interpreted exactly same way as individual stock betas.
Portfolio beta of 1.00 will experience a 10% increase when the market increase is 10%
Portfolio beta of 0.75 will experience a 7.5% increase when the market increase is 10%
Portfolio beta of 1.25 will experience a 12.5% increase when the market increase is 10%
Low-beta portfolios are less responsive and less risky than high-beta portfolios.
A portfolio containing low-beta assets will have a low beta, and vice versa.
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38. Interpreting Portfolio Betas
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39. Reconciling the Traditional Approach and MPT
Recommended portfolio management policy uses aspects of both approaches:
Determine how much risk you are willing to bear
Seek diversification between different types of securities and industry lines
Pay attention to correlation of return between securities
Use beta to keep portfolio at acceptable level of risk
Evaluate alternative portfolios to select highest return for the given level of acceptable risk
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40. Figure 5.9 The Portfolio Risk-Return Tradeoff
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41. Constructing a Portfolio Using Asset Allocation
Asset Allocation is the process of dividing an investment portfolio into various asset classes to preserve capital by protecting against negative developments while taking advantage of positive ones.
In other words, don’t put all of your eggs in one basket, and choose your baskets carefully.
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42. Constructing a Portfolio Using Asset Allocation (cont’d)
Individual investor characteristics and objectives determine relative income needs and ability to bear risk
Investor characteristics to consider:
Level and stability of income, net worth
Age and family factors
Investment experience and ability to handle risk
Tax considerations
Investor objectives to consider:
High level of current income
Significant capital appreciation
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43. Portfolio Objectives and Policies
Capital Preservation Objective
Low-risk, conservative investment strategy
Emphasis on current income and capital preservation
Normally contains low-beta securities
Capital Growth Objective
Higher-risk investment strategy
Emphasis on more speculative investments
Normally contains higher-beta securities
Tax Efficient Objective
Emphasis on capital gains and longer holding periods to defer income taxes
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44. Approaches to Asset Allocation
Fixed-Weightings Approach: asset allocation plan in which a fixed percentage of the portfolio is allocated to each asset category
Flexible-Weightings Approach: asset allocation plan in which weights for each asset category are adjusted periodically based on market analysis
Tactical Approach: asset allocation plan that uses stock-index futures and bond futures to change a portfolio’s asset allocation based on market behavior
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45. Alternative Asset Allocation
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46. Applying Asset Allocation
Consider impact of economic and other factors on your investment objective.
Design your asset allocation plan for the long haul (at least 7 to 10 years).
Stress capital preservation.
Provide for periodic reviews to maintain consistency with changing investments goals.
Consider using mutual funds, especially for portfolios under $100,000.
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47. Chapter 5 Review Learning Goals
Understand portfolio management objectives and calculate the return and standard deviation of a portfolio.
Discuss the concepts of correlation and diversification, and the effectiveness, methods, and benefits of international diversification.
Describe the two components of risk, beta, and the capital asset pricing model (CAPM).
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

48. Chapter 5 Review (cont’d)
Learning Goals (cont’d)
Review traditional and modern approaches to portfolio management and reconcile them.
Describe the role of investor characteristics and objectives and of portfolio objectives and policies in constructing an investment portfolio.
Summarize why and how investors use an asset allocation scheme to construct an investment portfolio.
Copyright © 2005 Pearson Addison-Wesley. All rights reserved.