1. Chapter 5 Modern Portfolio Concepts

2. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-2 What is a Portfolio? Portfolio is a collection of investments assembled to meet one or more investment goals. Growth-Oriented Portfolio: primary objective is long-term price appreciation Income-Oriented Portfolio: primary objective is to produce regular dividend and interest income

3. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-3 The Ultimate Goal: An Efficient Portfolio Efficient portfolio –A portfolio that provides the highest return for a given level of risk –Requires search for investment alternatives to get the best combinations of risk and return –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 choose the one that has the least risk.

4. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-4 Portfolio Return and Risk Measures The return on a portfolio is simply the weighted average of the individual assets’ returns in the portfolio The standard deviation of a portfolio’s returns is more complicated, and is a function of the portfolio’s individual assets’ weights, standard deviations, and correlations with all other assets

5. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-5 Return on Portfolio Assets value W i R i W i * R i A 35000.700 8.756.125 B 15000.300 3.751.125 50000 7.25 Portfolio Beta and Returns

6. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-6 Correlation: Why Diversification Works! Correlation is a statistical measure of the relationship between two series of numbers representing data Positively Correlated items tend to move in the same direction Negatively Correlated items tend to move in opposite directions Correlation Coefficient is a measure of the degree of correlation between two series of numbers representing data

7. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-7 Correlation: Between DJIA and S&P500 Correlation

8. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-8 Figure 5.3 Portfolios of IBM and Celgene

9. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-9 Figure 5.4 Risk and Return for Combinations of Two Assets with Various Correlation Coefficients

10. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-10 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

11. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-11 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.

12. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-12 Methods of International Diversification Foreign company stocks listed on U.S. stock exchanges –Yankee Bonds –American Depository Shares (ADS’s) –Mutual funds investing in foreign stocks Global mutual funds International mutual funds –U.S. multinational companies (typically not considered a true international investment for diversification purposes)

13. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-13 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

14. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-14 Components of Risk

15. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-15 Figure 5.8 Portfolio Risk and Diversification

16. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-16 Figure 5.8 Portfolio Risk and Diversification: International Influence 0 # of Stocks Portfolio of both Domestic and International Assets Portfolio of Domestic Assets Only Portfolio Risk (SD) σMσM

17. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-17 Beta: A Popular Measure of Risk A measure of undiversifiable 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 1.0 Stocks may have positive or negative betas. Nearly all are positive. Stocks with betas greater than 1.0 are more risky than the overall market. Stocks with betas less than 1.0 are less risky than the overall market.

18. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-18 Figure 5.5 Graphical Derivation of Beta for Securities C and D*

19. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-19 Beta as a Measure of Risk Table 5.4 Selected Betas and Associated Interpretations

20. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-20 Beta and Returns The ABC Company has a beta of 1.5. What is your expected change in returns of the stock market increases by 15%? XYZ has a beta of.5. Change in return? portfolio beta and returns

21. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-21 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 websites such as yahoo.com

22. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-22 Interpreting Beta

23. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-23 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

24. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-24 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 Called the Security Market Line (SML) –Where can you find the risk free rate of return? –Where can you find a company’s beta? –Where can you find the average return on the stock market?

25. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-25 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

26. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-26 Two Approaches to Constructing Portfolios Traditional Approach versus Modern Portfolio Theory

27. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-27 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 liquid and available –Familiarity provides higher “comfort” levels for investors

28. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-28 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

29. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-29 Key Aspects of MPT: Efficient Frontier 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

30. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-30 Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier

31. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-31 Key Aspects of MPT: Portfolio Betas Portfolio Beta –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

32. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-32 Interpreting Portfolio Betas Portfolio betas are interpreted exactly the 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.

33. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-33 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 http://www.youtube.com/watch?v=LWsEJY PSw0k&feature=player_detailpagehttp://www.youtube.com/watch?v=LWsEJY PSw0k&feature=player_detailpage

34. Copyright ©2014 Pearson Education, Inc. All rights reserved.5-34 Figure 5.9 The Portfolio Risk-Return Tradeoff