Chapter 7

Charles P. Jones, Investments: Analysis and Management,

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 Involve uncertainty
 Focus on expected returns
◦ Estimates of future returns needed to consider and
manage risk
◦ Investors often overly optimistic about expected
returns
 Goal is to reduce risk without affecting
returns
◦ Accomplished by building a portfolio
◦ Diversification is key

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 Risk that an expected return will not be
realized
 Investors must think about return
distributions
 Probabilities weight outcomes
◦ Assigned to each possible outcome to create a
distribution
◦ History provides guide but must be modified for
expected future changes
◦ Distributions can be discrete or continuous

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 Expected value
◦ The weighted average of all possible return
outcomes included in the probability distribution
 Each outcome weighted by probability of occurrence
◦ Referred to as expected return
m
E(R )   R ipri
i1

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 Variance and standard deviation used to
quantify and measure risk
◦ Measure the spread or dispersion around the mean
of the probability distribution
◦ Variance of returns: σ² = (Ri - E(R))²pri
◦ Standard deviation of returns:
σ =(σ²)1/2
◦ σ is expected (ex ante)
 Actual (ex post) σ useful but not perfect estimate of
future

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Modern Portfolio Theory
 Provides framework for selection of portfolios
based on expected return and risk
 Used, to varying degrees, by financial
managers
 Shows benefits of diversification
 The risk of a portfolio does not equal the sum
of the risks of its individual securities
◦ Must account for correlations among individual
risks
 Weighted average of the individual security
expected returns
◦ Each portfolio asset has a weight, w, which
represents the percent of the total portfolio value

n
E(R p )   w iE(R i )
i 1

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 Portfolio risk not simply the sum or the
weighted average of individual security risks
 Emphasis on the risk of the entire portfolio
and not on risk of individual securities in the
portfolio
 Diversification almost always lowers risk
 Measured by the variance or standard
deviation of the portfolio’s
n
return
   wi
2
p i
2

i 1

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 Assume all risk sources for a portfolio of
securities are independent
◦ This assumption is unrealistic when investing
◦ Market risk affects all firms, cannot be diversified
away
 If risks independent, the larger the number of
securities the smaller the exposure to any
particular risk
◦ “Insurance principle”
◦ Only issue is how many securities to hold

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 Random (or naïve) diversification
◦ Diversifying without looking at how security returns
are related to each other
◦ Marginal risk reduction gets smaller and smaller as
more securities are added
 Beneficial but not optimal
◦ Risk reduction kicks in as soon as additional
securities added
◦ Research suggests it takes a large number of
securities for significant risk reduction

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 Needed to calculate risk of a portfolio:
◦ Weighted individual security risks
 Calculated by a weighted variance using the proportion
of funds in each security
 For security i: (wi × i)2
◦ Weighted co-movements between returns
 Return covariances are weighted using the proportion
of funds in each security
 For securities i, j: 2wiwj × ij

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 Statistical measure of relative association
 ij = correlation coefficient between
securities i and j
◦ ij = +1.0 = perfect positive correlation
◦ ij = -1.0 = perfect negative (inverse) correlation
◦ ij = 0.0 = zero correlation

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 When does diversification pay?
◦ With perfectly positive correlation, risk is a
weighted average, therefore there is no risk
reduction
◦ With perfectly negative correlation, diversification
assures the expected return
◦ With zero correlation
 If many securities, provides significant risk reduction
 Cannot eliminate risk
 Negative correlation or low positive
correlation ideal but unlikely

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 Absolute, not relative, measure of association
◦ Not limited to values between -1 and +1
◦ Sign interpreted the same as correlation
◦ Size depends on units of variables
◦ Related to correlation coefficient

m
 AB   [R A ,i  E(R A )][R B,i  E(R B )]pri
i 1

 AB   AB  A  B

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 Encompasses three factors
◦ Variance (risk) of each security
◦ Covariance between each pair of securities
◦ Portfolio weights for each security
 Goal: select weights to determine the
minimum variance combination for a given
level of expected return

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 Generalizations
◦ the smaller the positive correlation between
securities, the better
◦ Covariance calculations grow quickly
◦ As the number of securities increases:
 The importance of covariance relationships increases
 The importance of each individual security’s risk
decreases

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 Markowitz full-covariance model
◦ Requires a covariance between the returns of all
securities in order to calculate portfolio variance
◦ [n(n-1)]/2 set of covariances for n securities
 Markowitz suggests using an index to which
all securities are related to simplify

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