Chapter 11

Diversification and Risky Asset

Allocation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Diversification and Risky Asset
Allocation

“It is the part of a wise man not to venture

all his eggs in one basket.”
–Miguel de Cervantes

© McGraw-Hill Education. 11-2

 Learning Objectives

To get the most out of this chapter, spread

your study time across:
1. How to calculate expected returns and
variances for a security.
2. How to calculate expected returns and
variances for a portfolio.
3. The importance of portfolio diversification.
4. The efficient frontier and the importance of
asset allocation.

© McGraw-Hill Education. 11-3

 Diversification

• Intuitively, we all know that if you hold many

investments:
– Through time, some will increase in value
– Through time, some will decrease in value
– It is unlikely that their values will all change in
the same way
• Diversification has a profound effect on portfolio
return and portfolio risk.
• But, exactly how does diversification
work?

© McGraw-Hill Education. 11-4

Diversification and Asset Allocation
(1 of 2)
• Our goal in this chapter is to examine the
role of diversification and asset allocation in
investing.
• In the early 1950s, professor Harry
Markowitz was the first to examine the role
and impact of diversification.

© McGraw-Hill Education. 11-5

Diversification and Asset Allocation
(2 of 2)
• Based on his work, we will see how
diversification works, and we can be sure that
we have “efficiently diversified portfolios.”
– An efficiently diversified portfolio is one that
has the highest expected return, given its risk.
– You must be aware that diversification
concerns expected returns.

© McGraw-Hill Education. 11-6

 Expected Returns, I. (1 of 2)

• Expected return is the “weighted average”

return on a risky asset, from today to some
future date. The formula is:
n
expected returni   p
s 1
s  returni,s 

• To calculate an expected return, you must first:

– Decide on the number of possible economic
scenarios that might occur.
– Estimate how well the security will perform in each
scenario, and

© McGraw-Hill Education. 11-7

 Expected Returns, I. (2 of 2)

– Assign a probability, ps, to each scenario.

– (BTW, finance professors call these economic
scenarios, “states.”)
• The upcoming slides show how the expected return
formula is used when there are two states.
̶ Note that the “states” are equally likely to occur in
this example.
̶ BUT! They do not have to be equally likely--they
can have different probabilities of occurring.

© McGraw-Hill Education. 11-8

 Expected Return, II. (1 of 2)

• Suppose:
– There are two stocks:
 Starcents
 Jpod
– We are looking at a period of one year.
• Investors agree that the expected return:
– for Starcents is 25 percent
– for Jpod is 20 percent

© McGraw-Hill Education. 11-9

 Expected Return, II. (2 of 2)

• Why would anyone want to hold Jpod

shares when Starcents is expected to have
a higher return?

© McGraw-Hill Education. 11-10

 Expected Return, III.

• The answer depends on risk.

• Starcents is expected to return 25 percent.
• But the realized return on Starcents could be
significantly higher or lower than 25 percent.
• Similarly, the realized return on Jpod could be
significantly higher or lower than 20 percent.

© McGraw-Hill Education. 11-11

 Calculating Expected Returns
(1 of 2)
States of the Economy and Stock Returns

State of Probability of Security Returns If State Security Returns If

Economy State of Occurs: Starcents State Occurs: Jpod
Economy
Recession .50 -20% 30%
Boom .50 70 10
1.00

© McGraw-Hill Education. 11-12

Calculating Expected Returns (2 of 2)

Calculating Expected Returns

(1) State (2) Starcents : Starcents : (4) Jpod: (5) Jpod: (6)
of Probability (3) Return Product (2) × Return if Product
Economy of State of if State (3) State (2) × (5)
Economy occurs occurs

Recession .50 -20% -10% 30% 15%

Boom .50 70 35 10 05

100 E(RS)= 25% E(RJ)= 20%

© McGraw-Hill Education. 11-13

 Expected Risk Premium (1 of 2)

• Recall:
• Suppose risk free investments have an 8%
return. If so,
– The expected risk premium on Jpod is 12%.
– The expected risk premium on Starcents is
17%.

© McGraw-Hill Education. 11-14

 Expected Risk Premium (2 of 2)

• This expected risk premium is simply the

difference between
– The expected return on the risky asset in
question and
– The certain return on a risk-free investment.

© McGraw-Hill Education. 11-15

 Calculating the Variance of
Expected Returns (1 of 2)
• The variance of expected returns is calculated
using this formula:

 p 
n
 returns  expected return
2 2
Variance  σ  s
s 1

• This formula is not as difficult as it appears.

• This formula says:
̶ add up the squared deviations of each return from
its expected return
̶ after it has been multiplied by the probability of
observing a particular economic state (denoted by
“s”).
© McGraw-Hill Education. 11-16
 Calculating the Variance of
Expected Returns (2 of 2)

Standard Deviation  σ  Variance

• The standard deviation is simply the square
root of the variance.

© McGraw-Hill Education. 11-17

 Example: Calculating Expected
Returns and Variances: Equal State
Probabilities (1 of 2)
Calculating Expected Returns

(1) State of (2) Probability Starcents : Starcents : (4) Jpod: (5) Jpod: (6)
Economy of State of (3) Return if Product (2) × (3) Return if Product (2)
Economy State Occurs State Occurs × (5)

Recession 0.50 -0.20 -0.10 0.30 0.15

Boom 0.50 0.70 0.35 0.10 0.05

Sum: 1.00 E(Ret): 0.25 E(Ret): 0.20

© McGraw-Hill Education. 11-18

 Example: Calculating Expected
Returns and Variances: Equal State
Probabilities (2 of 2)
Calculating Variance of Expected Returns

(1) State (2) Probability

State Expected Difference: Squared: Product: (2)
of of State of
Occurs Return: (3) – (4) (5) × (5) × (6)
Economy Economy
Recession 0.50 -0.20 0.25 -0.45 0.2025 0.10125

Boom 0.50 0.70 0.25 0.45 0.2025 0.10125

Sum=the=
Sum: 1.00 0.20250
Variance:
Standard
0.45
Deviation:

Note that the lower part of the spreadsheet is only for

Starcents. What would you get for Jpod?

© McGraw-Hill Education. 11-19

Expected Returns and Variances,
Starcents and Jpod

Starcents Jpod
Expected return, E(R) 0.25, or 25% 0.20, or 20%
Variance of expected
0.2025 0.0100
return, σ2
Standard deviation of
0.45, or 45% 0.10, or 10%
expected return, σ

© McGraw-Hill Education. 11-20

 Calculating Expected Returns
Unequal Probabilities (1 of 2)
• Suppose you thought a boom would occur 20
percent of the time instead of 50 percent (So
Recession probability = 1.00 – 0.20 = 0.80.
• What are the expected returns on Starcents
and Jpod in this case? If the risk-free rate is 10
percent, what are the risk premiums?

© McGraw-Hill Education. 11-21

 Calculating Expected Returns
Unequal Probabilities (2 of 2)
(1) State (2) Starcents: Starcents: (4) Jpod: (5) Jpod: (6)
of Probability (3) Return Product (2) × Return if Product
Economy of State of if State (3) State (2) × (5)
Economy occurs occurs

Recession .80 -20% -16% 30% 24%

Boom .20 70 14 10 2

1.00 E(Rs)= -2% E(RJ)= 26%

The risk premium for Jpod is 26% - 10% = 16%.

The risk premium for Starcents is negative: -2% -
10% = -12%. (Unusual, but not impossible).

© McGraw-Hill Education. 11-22

 Portfolios

• Portfolios are groups of assets, such as

stocks and bonds, that are held by an investor.
• One convenient way to describe a portfolio is
by listing the proportion of the total value of
the portfolio that is invested into each asset.
• These proportions are called portfolio
weights.
– Portfolio weights are sometimes expressed in
percentages.
– In calculations, make sure you use proportions
(i.e., decimals).

© McGraw-Hill Education. 11-23

 Portfolios: Expected Returns

• The expected return on a portfolio is a linear

combination, or weighted average, of the
expected returns on the assets in that portfolio.
• The formula, for “n” assets, is:

n
ER P    wi  ER i 
i1

In the formula : E(RP )  expected portfolio return

wi  portfolio weight for portfolio asset i
E(Ri )  expected return for portfolio asset i

© McGraw-Hill Education. 11-24

 Example: Calculating Portfolio
Expected Returns
The portfolio weight in Jpod = 1 – portfolio weight in
Starcents.
Calculating Expected Portfolio Returns
(1) State (2) (3) (4) (5) Starcents (6) Jpod (7) (8) Jpod (9) Sum: (10)
of Prob. Starcent Portfolio Contribution Return if Portfolio Contribution (5) + (8) Portfol
Economy of s Return Weight Product: (3) State Weight Product: (6) io
State if State in × (4) Occurs in Jpod: × (7) Return
Occurs Starcent Produc
s: t: (2)
× (9)

Recession 0.50 -0.20 0.50 -0.10 0.30 0.50 0.15 0.05 0.025

Boom 0.50 0.70 0.50 0.35 0.10 0.50 0.05 0.40 0.200

The Sum is
Expected
Sum: 1.00 0.225
Portfolio
Return:

© McGraw-Hill Education. 11-25

 Variance of Portfolio Expected
Returns
• Note: Unlike returns, portfolio variance is generally
not a simple weighted average of the variances of the
assets in the portfolio.
• If there are “n” states, the formula is:

 
n
VAR R P    ps  ER p,s   ER P 
2

s 1

In the formula, VAR(RP )  variance of portfolio expected return

ps  probability of state of economy, s
E(Rp,s )  expected portfolio return in state s
E(Rp )  portfolio expected return
Note that the formula is like the formula for the
variance of the expected return of a single asset.
© McGraw-Hill Education. 11-26
 Example: Calculating Variance of
Portfolio Expected Returns (1 of 2)
• Suppose we put half our money in Starcents and
half in Jpod.
• The expected portfolio return is 0.225, or 22.5%.
• We might think that half of our money has a
standard deviation of 45 percent and the other
half has a standard deviation of 10 percent, or
27.5%.
• This thinking is COMPLETELY incorrect!
• Here’s how to calculate portfolio variance:

© McGraw-Hill Education. 11-27

 Example: Calculating Variance of
Portfolio Expected Returns (2 of 2)

Prob. of
State of Expected Difference: Squared: (5) Product:
State State Occurs
Economy Return: (3) – (4) × (5) (2) × (6)

Recession 0.50 0.050 0.225 -0.18 0.0306 0.01531

Boom 0.50 0.400 0.225 0.18 0.030625 0.01531
Sum is
Sum: 1.00 0.03063
Variance:
Standard
0.175
Deviation:

The portfolio standard deviation is 17.5%

© McGraw-Hill Education. 11-28

The portfolio standard deviation is
17.5%
• It is possible to construct a portfolio of
risky assets with zero portfolio variance!
What? How? (Open this spreadsheet, scroll
up, and set the weight in Starcents to 2/11ths.)
• Notice that the return of the portfolio in this
case is 0.209, or 20.9%.

© McGraw-Hill Education. 11-29

 Example II: Calculating Variance
of Portfolio Expected Returns
Calculating Variance of Expected Portfolio Returns:

(1) State of (2) Prob. (3) Return if (4) (5) (6) Squared: (7)
Economy of State State Occurs Expected Difference: (5) × (5) Product:
Return: (3) – (4) (2) × (6)
Recession 0.50 0.209 0.209 0.00 0.0000 0.00000
Boom 0.50 0.209 0.209 0.00 0 0.00000
Sum is
Sum: 1.00 0.00000
Variance:
Standard
0.000
Deviation:

Financial Alchemy:
Mixing two risky assets just right, and out comes a
riskless portfolio.

© McGraw-Hill Education. 11-30

 Diversification and Risk, I.
(1) (2) (3)
Number of Stocks Average Standard Deviation of Ratio of Portfolio Standa Deviation to
in Portfolio Annual Portfolio Returns Standard Deviation of a Single Sto
1 49.24% 1.00
2 37.36 .76
4 29.69 .60
6 26.64 .54
8 24.98 .51
10 23.93 .49
20 21.68 .44
30 20.87 .42
40 20.46 .42
50 20.20 .41
100 19.69 .40
200 19.42 .39
300 19.34 .39
400 19.29 .39
500 19.27 .39
1,000 19.21 .39

© McGraw-Hill Education. 11-31

Diversification and Risk, II.

© McGraw-Hill Education. 11-32

 The Fallacy of Time Diversification,
I.
• Young people are often told that they should hold a
large percent of their portfolio in stocks.
• The advice could be correct, but often the typical
argument used to support this advice is incorrect.
– The Typical Argument: Even though stocks are
more volatile, over time, the volatility “cancels
out.”
– Sounds logical, but the typical argument is incorrect.
• This argument is called the fallacy of time
diversification.
• How can such a plausible argument be incorrect?

© McGraw-Hill Education. 11-33

The Fallacy of Time Diversification,
II. (1 of 3)
• What IS true about this piece of advice?
• Recall that the average yearly return of large-cap
stocks over about the last 90 individual years is
11.9 percent, and the standard deviation is 20.0
percent.
• For most investors, however, time horizons are
much longer than one year.
• So, let’s look at the average returns of longer
investment horizons.
• Using data in the book, we compute returns for
rolling investment holding periods.

© McGraw-Hill Education. 11-34

 The Fallacy of Time Diversification,
II. (2 of 3)
TABLE 11.8 Average Geometric Returns by Investment
Holding Period
Investment Holding Period (in years)

1 5 10 15 20 25 30 35 40
Average
11.9% 9.9% 10.3% 9.8% 9.8% 9.7% 9.6% 9.5% 9.3%
return
Standard
deviation 20.0% 8.6% 5.7% 4.6% 3.4% 2.6% 1.8% 1.1% 0.7%
of return

© McGraw-Hill Education. 11-35

 The Fallacy of Time Diversification,
II. (3 of 3)
TABLE 11.9 Average Ending Wealth by Investment Holding
Period
Investment Holding Period (in years)

1 5 10 15 20 25 30 35 40
Average
$1,119 $1,699 $2,974 $4,777 $7,659 $11,907 $17,650 $25,563 $47,388
wealth
Standard
deviation of $200 $611 $1,408 $2,730 $4,562 $6,998 $8,858 $9,447 $15,286
return

© McGraw-Hill Education. 11-36

The Fallacy of Time Diversification,
III. (1 of 2)
• As the time period grows, the average
geometric return falls.
• Look at the pattern of the standard deviation
of average returns.
• Notice that as the time period increases, the
standard deviation of the geometric averages
also falls (it actually approaches zero).

© McGraw-Hill Education. 11-37

The Fallacy of Time Diversification,
III. (2 of 2)
• The problem is that even though the standard
deviation of the geometric return tends to
zero as the time horizon grows, the standard
deviation of your wealth does not tend to
zero.
As investors, we care about wealth levels
AND the standard deviation of wealth levels
over time.

© McGraw-Hill Education. 11-38

The Fallacy of Time Diversification,
IV. (1 of 2)
• Suppose someone invested a lump sum of $1,000
in 1926.
– Using the return data from Table 1.1, it grows to
$1,486.97 five years later.
– Make calculations for all possible five-year
investment periods and others.
• What do you notice about the wealth averages and
standard deviations?
• The average ending wealth amount is larger over
longer time periods.

© McGraw-Hill Education. 11-39

The Fallacy of Time Diversification,
IV. (2 of 2)
• Makes sense—after all, we are investing for longer
time periods.
• Notice that the standard deviation of wealth
increases with the time horizon.
Wealth volatility INCREASES over time: it does
not “cancel out” over time.
Investing in equity has a greater chance of
having an extremely large value AND increases
the probability of ending with a really low value.

© McGraw-Hill Education. 11-40

The Very Definition of Risk—a Wider
Range of Possible Outcomes from
Holding Equity

© McGraw-Hill Education. 11-41

 So, Should Younger Investors Put a
High Percent of Their Money into
Equity?
• The answer is probably still yes, but for logically sound
reasons that differ from the reasoning underlying the
fallacy of time diversification.
• If you are young and your portfolio suffers a steep
decline in a particular year, what could you do?
• You could make up for this loss by changing your work
habits (e.g., your type of job, hours, second job).
• People approaching retirement have little future earning
power, so a major loss in their portfolio will have a much
greater impact on their wealth.
• Thus, the portfolios of young people should contain
relatively more equity (i.e., risk).
© McGraw-Hill Education. 11-42
 Why Diversification Works, I.

• Correlation: The tendency of the returns on two

assets to move together. Imperfect correlation is the
key reason why diversification reduces portfolio risk
as measured by the portfolio standard deviation.
• Positively correlated assets tend to move up and
down together.
• Negatively correlated assets tend to move in
opposite directions.
• Imperfect correlation, positive or negative, is why
diversification reduces portfolio risk.

© McGraw-Hill Education. 11-43

 Why Diversification Works, II.

• The correlation coefficient is denoted by

Corr( RA , RB ) or simply, ρ A ,B .

• The correlation coefficient measures correlation

and ranges from -1 to 1:

-1 (perfect negative correlation)

0 (uncorrelated)

+1 (perfect positive correlation)

© McGraw-Hill Education. 11-44

Why Diversification Works, III.

© McGraw-Hill Education. 11-45

 Why Diversification Works, IV.

Year Stock A Stock B Portfolio AB

2012 10% 15% 12.5%
2013 30 -10 10.0
2014 -10 25 7.5
2015 5 20 12.5
2016 10 15 12.5
Average returns 9% 13% 11.0%
Standard
14.3% 13.5% 2.2%
deviations

© McGraw-Hill Education. 11-46

Why Diversification Works, V.

© McGraw-Hill Education. 11-47

 Calculating Portfolio Risk

• For a portfolio of two assets, A and B, the variance

of the return on the portfolio is:

σ p2  x2A σ 2A  xB2 σ B2  2x A xBCOV(A,B)

σ p2  x2A σ 2A  xB2 σ B2  2x A xBσ A σ BCORR(R AR B )
Where: x A  portfolio weight of asset A
xB  portfolio weight of asset B
Note: x A  xB  1.

(Important: Recall Correlation Definition!)

© McGraw-Hill Education. 11-48
 The Importance of Asset
Allocation, Part 1.
• Suppose that as a very conservative, risk-
averse investor, you decide to invest all of your
money in a bond mutual fund. Very conservative,
indeed?
Uh, is this decision a wise one?

© McGraw-Hill Education. 11-49

 Correlation and Diversification, I.
(1 of 2)
Portfolio Weights: Portfolio Weights: Expected Return Standard
Stocks Bonds Deviation (Risk)

1.00 .00 12.00% 15.00%

.95 .05 11.70 14.31
.90 .10 11.40 13.64
.85 .15 11.10 12.99
.80 .20 10.80 12.36
.75 .25 10.50 11.77
.70 .30 10.20 11.20
.65 .35 9.90 10.68
.60 .40 9.60 10.21
.55 .45 9.30 9.78

© McGraw-Hill Education. 11-50

 Correlation and Diversification, I.
(2 of 2)
Portfolio Weights: Portfolio Weights: Expected Return Standard
Stocks Bonds Deviation (Risk)
.50 .50 9.00 9.42
.45 .55 8.70 9.12
.40 .60 8.40 8.90
.35 .65 8.10 8.75
.30 .70 7.80 8.69
.25 .75 7.50 8.71
.20 .80 7.20 8.82
.15 .85 6.90 9.01
.10 .90 6.60 9.27
.05 .95 6.30 9.60
.00 1.00 6.00 10.00

© McGraw-Hill Education. 11-51

Correlation and Diversification, II.

© McGraw-Hill Education. 11-52

Correlation and Diversification, III.

• The various combinations of risk and return

available all fall on a smooth curve.
• This curve is called an investment opportunity
set, because it shows the possible combinations of
risk and return available from portfolios of these
two assets.
• A portfolio that offers the highest return for its
level of risk is said to be an efficient portfolio.
• The undesirable portfolios are said to be
dominated or inefficient.

© McGraw-Hill Education. 11-53

 More on Correlation and the Risk-
Return Trade-Off (The Next Slide is an
Excel Example)

© McGraw-Hill Education. 11-54

Example: Correlation and the Risk-
Return Trade-Off, Two Risky Assets
Inputs Expected Return Standard Deviation
Risky Asset 1 14.0% 20.0%
Risky Asset 2 8.0% 15.0%
Correlation 30.0%

© McGraw-Hill Education. 11-55

 The Importance of Asset
Allocation, Part 2. (1 of 2)
• We can illustrate the importance of asset allocation
with 3 assets.
• How? Suppose we invest in three mutual funds:
− One that contains Foreign Stocks, F
− One that contains U.S. Stocks, S
− One that contains U.S. Bonds, B
Expected Return Standard Deviation
Foreign Stocks, F 18% 35%
U.S. Stocks, S 12 22
U.S. Bonds, B 8 14

© McGraw-Hill Education. 11-56

 The Importance of Asset
Allocation, Part 2. (2 of 2)
• The next slide shows the results of calculating
various expected returns and portfolio standard
deviations with these three assets.

© McGraw-Hill Education. 11-57

Risk and Return with Multiple
Assets, I.

© McGraw-Hill Education. 11-58

 Risk and Return with Multiple
Assets, II. (1 of 2)
• We use these formulas for portfolio return and
variance in the previous slide:
• But, we made a simplifying assumption. We
assumed that the assets are all
uncorrelated.
• If so, the portfolio variance becomes:

© McGraw-Hill Education. 11-59

Risk and Return with Multiple
Assets, II. (2 of 2)

rp  xFR F  xSR S  xBR B

σ p2  xF2σ F2  x2Sσ 2S  xB2 σ B2
 2xF xSσ F σ SCORR(R FR S )
 2xF xBσ F σ BCORR(R FR B )
 2x SxBσ Sσ BCORR(R SR B )
σ p2  xF2σ F2  x2Sσ 2S  xB2 σ B2

© McGraw-Hill Education. 11-60

 The Markowitz Efficient Frontier

• The Markowitz Efficient frontier is the set of

portfolios with the maximum return for a given risk
AND the minimum risk given a return.
• For the plot, the upper left-hand boundary is the
Markowitz efficient frontier.
• All the other possible combinations are inefficient.
That is, investors would not hold these portfolios
because they could get either:
– more return for a given level of risk
or
– less risk for a given level of return.

© McGraw-Hill Education. 11-61

 Useful Internet Sites

• www.earningswhispers.com (source for expected

returns)
• www.investopedia.com (for more on risk measures)
• www.teachmefinance.com (also contains more on risk
measure)
• www.moneychimp.com (review modern portfolio
theory)
• www.efficientfrontier.com (check out the reading list)
• jmdinvestment.blogspot.com (reference for current
financial information)

© McGraw-Hill Education. 11-62

 Chapter Review, I.

• Expected Returns and Variances

– Expected returns
– Calculating the variance
• Portfolios
– Portfolio weights
– Portfolio expected returns
– Portfolio variance

© McGraw-Hill Education. 11-63

 Chapter Review, II.

• Diversification and Portfolio Risk

– The principle of diversification
– The fallacy of time diversification
• Correlation and Diversification
– Why diversification works
– Calculating portfolio risk
– More on correlation and the risk-return trade-off
• The Markowitz Efficient Frontier
– Risk and return with multiple assets

© McGraw-Hill Education. 11-64

 End of Presentation

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11-65
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.