1. Portfolio Selection Chapter 8
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons

2. Building a Portfolio Diversification is key to optimal risk management
Asset allocation is most important single decision
Using Markowitz Principles
Step 1: Identify optimal risk-return combinations using the Markowitz efficient frontier analysis
Estimate expected returns, variances and covariances
Step 2: Choose the final portfolio based on your preferences for return relative to risk

3. Portfolio Theory
Optimal diversification takes into account all available information
Assumptions in portfolio theory
A single investment period (one year)
Liquid position (no transaction costs)
Preferences based only on a portfolio’s expected return and risk

4. An Efficient Portfolio
Smallest portfolio risk for a given level of expected return
Or largest expected return for a given level of portfolio risk
From the set of all possible portfolios
Only locate and analyze the subset known as the efficient set

5. Efficient Portfolios
Efficient frontier or Efficient set (curved line from A to B)
Global minimum variance portfolio (represented by point A)
Portfolios on AB dominate those on AC x B A C y
Risk = 
E(R)

6. Selecting an Optimal Portfolio of Risky Assets
Portfolio weights are only variable that can change in Markowitz analysis
Assume investors are risk averse
Indifference curves help select from efficient set
Description of preferences for risk and return
Portfolio combinations which are equally desirable
Match investor preferences with portfolio possibilities

7. Selecting an Optimal Portfolio of Risky Assets
International diversification unlikely to offer as much risk reduction as it has in the past
Markowitz portfolio selection model
Assumes investors use only risk and return to decide
Generates a set of equally “good” portfolios
Does not address the issues of borrowed money or risk-free assets
Cumbersome to apply

8. Selecting Optimal Asset Classes
Another way to use Markowitz model is with asset classes
Allocation of portfolio assets to asset types
Asset class rather than individual security decisions likely most important for investors
Can be used when investing internationally
Different asset classes offers various returns and levels of risk
Correlation coefficients may be quite low

9. Asset Allocation Includes two dimensions Asset classes include
Diversifying between asset classes
Diversifying within asset classes
Asset classes include
International equities
Bonds
Treasury Inflation-Indexed Securities (TIPS)
Real estate
Gold
Commodities

10. Correlation among asset classes must be considered
Correlations change over time
For individual investors, allocation depends on
Time horizon
Risk tolerance
Diversified asset allocation doesn’t necessarily provide benefits or guarantee against loss
8-10

11. Index Mutual Funds and ETFs
Investors can buy funds covering various asset classes
Domestic large-cap stocks, domestic small-cap stocks
International stocks
Bond funds
Life Cycle Analysis
Varies asset allocation based on age of investor
Life-cycle funds (target-date funds) hold various asset classes and the allocation changes as investor ages
No one “correct” approach to allocation
8-11

12. Impact of Diversification on Risk
Total risk = systematic (nondiversifiable) risk + nonsystematic (diversifiable) risk
Systematic risk is market risk and common to virtually all securities
Nonsystematic risk is company-specific risk
Total risk can go no lower than systematic risk
Both risk components can vary over time
Affects number of securities needed to diversify

13. Portfolio Risk and Diversification
sp % 35 20
Total risk
Diversifiable (nonsystematic) risk
Nondiversifiable (systematic) risk
Number of securities in portfolio

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