Portfolio

Portfolio Selection
Selection

Chapter 7
Jones, Investments: Analysis and
Management

1
 Portfolio
Portfolio Selection
Selection
 Diversification is key to optimal risk
management
 Analysis required because of the infinite
number of portfolios of risky assets
 How should investors select the best risky
portfolio?
 How could riskless assets be used?
2
 Building
Building aa Portfolio
Portfolio
 Step 1: Use the Markowitz portfolio
selection model to identify optimal
combinations
 Step 2: Consider riskless borrowing and
lending possibilities
 Step 3: Choose the final portfolio based
on your preferences for return relative to
risk 3
 Portfolio
Portfolio Theory
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
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 An
An Efficient
Efficient Portfolio
Portfolio
 Smallest portfolio risk for a given level of
expected return
 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
» Lowest risk for given level of return 5
 An
An Efficient
Efficient Portfolio
Portfolio
 All other portfolios in attainable set are
dominated by efficient set
 Global minimum variance portfolio
– Smallest risk of the efficient set of portfolios
 Efficient set
– Part of the efficient frontier with greater risk
than the global minimum variance portfolio

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 Efficient
Efficient Portfolios
Portfolios
 Efficient frontier or
Efficient set (curved
B line from A to B)
x  Global minimum
E(R) A variance portfolio
(represented by point
y C A)
Risk = 
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 Selecting
Selecting an
an Optimal
Optimal
Portfolio
Portfolio of
of Risky
Risky Assets
Assets
 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
– Greater slope implies greater the risk aversion

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 Selecting
Selecting an
an Optimal
Optimal
Portfolio
Portfolio of
of Risky
Risky Assets
Assets
 Markowitz portfolio selection model
– Generates a frontier of efficient portfolios
which are equally good
– Does not address the issue of riskless
borrowing or lending
– Different investors will estimate the efficient
frontier differently
» Element of uncertainty in application
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 The
The Single
Single Index
Index Model
Model
 Relates returns on each security to the
returns on a common index, such as the S&P
500 Stock Index
 Expressed by the following equation
Ri   i   iR M  ei
 Divides return into two components
– a unique part, i
– a market-related part, iRM
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 The
The Single
Single Index
Index Model
Model
  measures the sensitivity of a stock to stock
market movements
– If securities are only related in their common
response to the market
» Securities covary together only because of their
common relationship to the market index
» Security covariances depend only on market risk
and can be written as:

 ij   i  j 2
M 11
 The
The Single
Single Index
Index Model
Model
 Single index model helps split a security’s
total risk into
– Total risk = market risk + unique risk
   M]  
2
i
2
i [
2
ei
 Multi-Index models as an alternative
– Between the full variance-covariance method
of Markowitz and the single-index model
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 Selecting
Selecting Optimal
Optimal Asset
Asset
Classes
Classes
 Another way to use Markowitz model is
with asset classes
– Allocation of portfolio assets to broad asset
categories
» Asset class rather than individual security
decisions most important for investors
– Different asset classes offers various returns
and levels of risk
» Correlation coefficients may be quite low 13
 Borrowing
Borrowing and
and Lending
Lending
Possibilities
Possibilities
 Risk free assets
– Certain-to-be-earned expected return and a
variance of return of zero
– No correlation with risky assets
– Usually proxied by a Treasury security
» Amount to be received at maturity is free of default
risk, known with certainty
 Adding a risk-free asset extends and changes
the efficient frontier 14
 Risk-Free
Risk-Free Lending
Lending
 Riskless assets can be
L combined with any
B portfolio in the
efficient set AB
E(R) T – Z implies lending
Z X  Set of portfolios on
RF
A
line RF to T
dominates all
portfolios below it
Risk
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 Impact
Impact of
of Risk-Free
Risk-Free
Lending
Lending
 If wRF placed in a risk-free asset
– Expected portfolio return
E(R p )  w RFRF  (1 - w RF )E(R X )
– Risk of the portfolio
 p  (1 - w RF ) X
 Expected return and risk of the portfolio
with lending is a weighted average
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 Borrowing
Borrowing Possibilities
Possibilities
 Investor no longer restricted to own wealth
 Interest paid on borrowed money
– Higher returns sought to cover expense
– Assume borrowing at RF
 Risk will increase as the amount of
borrowing increases
– Financial leverage
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 The
The New
New Efficient
Efficient Set
Set
 Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
 Addition of risk-free asset results in
– A change in the efficient set from an arc to a
straight line tangent to the feasible set without
the riskless asset
– Chosen portfolio depends on investor’s risk-
return preferences
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 Portfolio
Portfolio Choice
Choice
 The more conservative the investor the
more is placed in risk-free lending and
the less borrowing
 The more aggressive the investor the less
is placed in risk-free lending and the
more borrowing
– Most aggressive investors would use leverage
to invest more in portfolio T
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 The
The Separation
Separation Theorem
Theorem
 Investors use their preferences (reflected in
an indifference curve) to determine their
optimal portfolio
 Separation Theorem:
– The investment decision, which risky portfolio to
hold, is separate from the financing decision
– Allocation between risk-free asset and risky
portfolio separate from choice of risky portfolio,
T
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 Separation
Separation Theorem
Theorem
 All investors
– Invest in the same portfolio
– Attain any point on the straight line RF-T-L
by by either borrowing or lending at the rate
RF, depending on their preferences
 Risky portfolios are not tailored to each
individual’s taste
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 Implications
Implications of
of Portfolio
Portfolio
Selection
Selection
 Investors should focus on risk that cannot be
managed by diversification
 Total risk =systematic (nondiversifiable)
risk +nonsystematic (diversifiable) risk
– Systematic risk
» Variability in a security’s total returns directly
associated with economy-wide events
» Common to virtually all securities
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 Nonsystematic
Nonsystematic Risk
Risk
 Variability of a security’s total return not
related to general market variability
– Diversification decreases this risk
 The relevant risk of an individual stock is
its contribution to the riskiness of a well-
diversified portfolio
– Portfolios rather than individual assets most
important
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 Portfolio Risk and Diversification
p % Total risk
35
Diversifiable Risk

20
Systematic Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio