CAPITAL ALLOCATION TO

RISKY ASSESTS
 AGENDA
1. Risk and Risk Aversion
2. Utility Theory and Indifference Curves
3. Portfolios of One Risky Asset and a Risk
Free Asset
4. Efficient Frontier and Investor’s Optimal
Portfolio
Materials to study
1. Bodie, Kane, Marcus –
Investments:
– Ch 6. Capital Allocation to Risky
Assets., Ch 7. Optimal Risky
Portfolios.
2. SchweserNotes. Level I. CFA exam
prep. Study session 12. p. 148-
165.
3. Lecture notes.
RISK AND RISK
AVERSION
THE CONCEPT OF RISK AVERSION

The concept of risk aversion is related to the behavior of

individuals under uncertainty.

Types of Investors: Risk loving - the investor gets extra “utility”

from the uncertainty associated with the
I. Risk seeking gamble.
Risk neutrality means that the investor cares
II. Risk neutral only about return and not about risk, so higher
return investments are more desirable even if
III. Risk averse they come with higher risk.

Risk averse refers to an investor who, when

faced with two investments with a similar
expected return, prefers the one with the
lower risk. He expects to be compensated for
additional risk.
THE CONCEPT OF RISK TOLERANCE

Risk Tolerance

1. Risk tolerance refers to the amount of risk an investor is

willing to tolerate to achieve an investment goal.
2. The higher the risk tolerance, the greater is the willingness
to take risk.
3. Risk tolerance is negatively related to risk aversion.

Key factors that can affect your investment risk tolerance:

1. Investment time frame

2. Capital available/Level of Income
3. Investment experience
4. Investment objectives
Articles and papers:

Beyond the Questionnaire: New Tools for Risk Profiling (CFA)

https://annual.cfainstitute.org/2015/04/27/beyond-the-questionnaire-
new-tools-for-risk-profiling/

Building a Client’s Risk Profile: Using Questionnaires to Develop

Investment Policy
https://www.cfapubs.org/doi/pdf/10.2469/cp.v2000.n3.3016

Adviser KnowHow: how to use risk-profiling tools - Citywire

http://citywire.co.uk/new-model-adviser/news/adviser-knowhow-how-t
o-use-risk-profiling-tools/a683792
Utility Theory and Indifference Curves
In general terms, utility is a measure of relative satisfaction
from consumption of various goods and services or in the
case of investments, the satisfaction that an investor derives
from different portfolios.

• We assume that investors are risk averse. They always

prefer greater return to lesser return.
• Because individuals are different in their preferences, all
risk-averse individuals may not rank investment
alternatives in the same manner.
• They are able to rank different portfolios in the order of
their preference.
Utility Function
1. An investor's utility function represents
the investor's preferences in terms of
risk and return (i.e., his degree of risk
aversion).

2. It provides a score for the attractiveness

of candidate overall portfolios on the
basis of expected return and risk.

3. By choosing the portfolio with the

highest score, investors maximize their
The utility model also reveals the satisfaction with their choice of
appropriate objective function for investments; that is, they achieve the
the construction of an optimal risky optimal allocation of capital to risky
portfolio assets.
On a scale of 1 to 5, which number (A) should we assign to the risk aversion of an investor?
we attributed a number from 1 (lowest risk aversion) to 5 (highest risk aversion) to an
investor. On average, we could assign an A of 2.5.
Utility Function

Consider three investors with different degrees of risk aversion: A 1 = 2, A

2 = 3.5, and A 3 = 5.
"risk aversion coefficient“

• The high-risk portfolio, H, would be chosen only by the investor with

the lowest degree of risk aversion, A1 = 2, while
• the low-risk portfolio, L, would be passed over even by the most risk-
averse of our three investors.
 Practice Problems
Problems Utility Theory and Investor’s Risk Tolerance
Utility Theory and
Indifference Curves
Indifference Curve

The indifference curve connects all portfolio points with the same utility
value

• It’s a tool from economics that plots

combinations of risk (standard
deviation) and expected return
among which an investor is
indifferent.
• The investor's expected utility is the
same for all points along a single
indifference curve.
• The indifference curves for the same
individual can never touch or
intersect.
Indifference Curve

Indifference curve II represents

Here we show three the most preferred portfolios
indifference curves for
in Figure
an investor.

A more risk-averse investor will

have steeper indifference
curves, reflecting a higher risk
aversion coefficient.

Indifference curves slope upward for risk-averse investors because an

investor who is relatively more risk averse requires a relatively greater
increase in expected return to compensate for a given increase in risk.
Indifference Curves for Various Types of Investors
 Practice Problems
Excel _Utility Curve

Utility Curve - Markowitz Portfolio Theory | Portfolio Management (9 min)

https://www.youtube.com/watch?v=pic6JqnGIl4
Portfolios of One Risky
Asset and a Risk Free
Asset
Application of Utility to Portfolio Selection
 Application of Utility to Portfolio Selection

• The simplest application of utility theory and risk aversion is to a

portfolio of two assets, a risk-free asset and a risky asset.

We can construct a portfolio of these two assets with a portfolio expected

return, E(Rp), and portfolio risk, σp

* Because σf = 0 for the risk-free asset

• The two-asset portfolio is drawn by varying w1 from 0 percent to 100 %.

• Rearranging the formulas we arrive to the line: E (r) vs. σ
 Portfolios of One Risky Asset and a Risk Free Asset

1. If only these two assets are available in the economy and the risky asset
represents the market, the line here is called the capital allocation line (CAL) .
2. It represents the portfolios available to an investor.

Figure . The investment opportunity set with a risky asset and a risk-free asset in the
expected return–standard deviation plane
 Portfolios of One Risky Asset and a Risk Free Asset

I. The line begins with the

risk-free asset as the leftmost
point with zero risk and a
risk-free return, Rf. At that
point, the portfolio consists
of only the risk-free asset.

II. If 100 % is invested in the

portfolio of all risky assets,
however, we have a return of
E(Rp) = 15% with a risk of σp
= 22%.

III. We can move further along the line in pursuit of higher returns by borrowing at the
risk-free rate and investing the borrowed money in the portfolio of all risky assets.

If 50 % is borrowed at the risk-free rate, then w1 = –0.50 and 150 percent is placed in
the risky asset, giving a return = 1.50E(Rp) – 0.50Rf, which is > E(Rp) because E(Rp) > Rf.
 Portfolio Selection for Two Investors with Various
Levels of Risk Aversion

The line plotted is comprised of an Which one of these portfolios

unlimited number of risk–return should be chosen by an investor?
pairs or portfolios…

Combining indifference
curves with the capital
allocation line will
provide us with the
optimal portfolio for
particular investor.
 Portfolio Selection for Two Investors with Various
Levels of Risk Aversion

Points under the CAL may be

attainable but are not
preferred by any investor
because the investor can get
a higher return for the same
risk by moving up to the
capital allocation line.

Points above the CAL are

desirable but not achievable
with available assets.

The optimal portfolio maximizes the return per unit of risk (as it is on the
capital allocation line), and it simultaneously supplies the investor with
the most satisfaction (utility).
Efficient Frontier and
Investor’s Optimal
Portfolio
Investment Opportunity Set

• As the number of available assets increases, the

number of possible combinations of portfolios
increases rapidly.
• When all investable assets are considered, we can
construct an opportunity set of investments.
• We begin with individual investable assets and
gradually form portfolios that can be plotted to form a
curve.
 Investment Opportunity Set

• All points on the curve and

points to the right of the
curve are attainable by a
combination of one or more
of the investable assets.
• Initially, the opportunity set
consists of domestic assets
only.

As long as the new asset class is not perfectly correlated with the existing asset
class, the investment opportunity set will expand out further to the northwest,
providing a superior risk–return trade-off.
Minimum-Variance portfolios
There are a large number of portfolios available for investment, but we
must choose a single optimal portfolio.
Minimum Variance Frontier

We begin the selection process by

narrowing the choice to fewer
portfolios.
 Global Minimum-Variance Portfolio

GMVP – (the left-most point on the minimum-variance frontier) is the

portfolio with the minimum variance among all portfolios of risky assets.

• An investor cannot hold a

portfolio consisting of risky
assets that has less risk than
that of GMVP

* Later, the introduction

of a risk-free asset will
allow us to relax this
constraint.
 Efficient Frontier of Risky Assets

• Portfolios on the curve below the global

minimum-variance portfolio and to the
right of the global minimum-variance
portfolio are not beneficial and are
inefficient portfolios for an investor. (No
one will choose Portfolio C. )
• The curve that lies above and to the
right of the global minimum-variance
portfolio is referred to as the Markowitz
efficient frontier because it contains all
portfolios of risky assets that rational,
risk-averse investors will choose.
Slope

The slope at various points on the efficient frontier:

• The increase in return with every unit increase in risk keeps decreasing !!! as we
move from left. Therefore, investors obtain decreasing increases in returns as they
assume more risk!!!
 Practice Problems
Excel

Tutorial: Graphing the efficient frontier for a two-stock portfolio in Excel (12 min)
https://www.youtube.com/watch?v=VsQZEgyTKeA
 A Risk-Free Asset and Many Risky Assets

• The addition of a risk-free asset makes the investment opportunity set

much richer than the investment opportunity set consisting only of
risky assets!!!

1. A risk-free asset (Rf) has zero risk.

2. It can now be combined with a portfolio of risky assets.
3. The combination of a risk-free asset with a portfolio of risky assets
is a straight line:

4. Modifying risk asset’s weight, investor can construct a portfolio with

various risk/return characteristics.
 Risk-free asset and risky asset portfolio

• All portfolios on the

efficient frontier are
candidates for being
combined with the
risk-free asset.

• We have many risky

portfolios to choose
from instead of a single
risky portfolio.

• Comparing capital allocation line A and capital allocation line P reveals that
the portfolios on CAL(P) dominate the portfolios on CAL(A).
• We would like to move further northwest to achieve even better portfolios. However,
none of those portfolios is attainable because they are above the efficient frontier.
 Risk-free asset and risky asset portfolio

Not only does CAL(P)

dominate CAL(A) but it
also dominates the
Markowitz efficient
frontier of risky assets!!!

• Thus, with the addition of the risk-free asset, we are able to narrow
our selection of risky portfolios to a single optimal risky portfolio, P,
which is at the tangent of CAL(P) and the efficient frontier of risky
assets!!!
The two fund separation theory
Theorem states that all investors regardless of taste, risk preferences, and initial
wealth will hold a combination of two portfolios or funds:
 A risk-free asset and
 An optimal portfolio of risky assets.

It allows us to divide an investor’s investment problem into two distinct steps:

the investment decision and the financing decision.

Step 1. The investor

identifies the
optimal risky
portfolio.

Step 2. Each investor’s optimal portfolio on the CAL(P) is determined (considering

individual investor’s risk preference, using indifference curves).

* The investor’s risk preference determines the amount of financing (i.e., lending to the
government instead of investing in the optimal risky portfolio or borrowing to purchase
additional amounts of the optimal risky portfolio).
Risk-free asset and risky asset portfolio

 Lending portfolio efficient frontier:

Xf < 0, XT > 1
G С
Xf = 0, XT = 1 D
М
D’
В

rf
Xf = 1, XT = 0
А
Risk-free asset and risky asset portfolio

 Borrowing portfolio efficient frontier:

Xf < 0, XT > 1
F
G С
Xf = 0, XT = 1 D
М
D’
В

rf
Xf = 1, XT = 0
А
Optimal Investor Portfolio

The optimal portfolio for the

investor with this indifference
curve is portfolio C on CAL(P),
which is tangent to the
indifference curve.
 Investor Preferences and Optimal Portfolios

 The location of an optimal investor portfolio depends on the

investor’s risk preferences.
 A highly risk-averse investor may invest a large proportion, even
100 % of his/her assets in the risk-free asset. The optimal
portfolio in this investor’s case will be located close to the y-
axis.
 A less risk-averse investor, may invest a large portion of his/her
wealth in the optimal risky asset. The optimal portfolio in this
case will lie closer to Point P.
 Investors with a high risk tolerance may wish to accept even
more risk . They may borrow money to invest more in the risky
portfolio.
 Investor Preferences and Optimal Portfolios

 Thus, moving from the risk-free asset along the capital

allocation line, we encounter investors who are willing to
accept more risk.
 Note that we are able to accommodate all types of
investors with just two portfolios: the risk-free asset and the
optimal risky portfolio.
 The optimal investor portfolio is selected on the capital
allocation line by overlaying the indifference curves that
incorporate investor preferences.
 Practice Problems
Case 1: Choosing the Right Portfolio
Case 2: Portfolio Selection
 Practice Problems
Excel

Tutorial: Capital market line and sharpe ratio in excel (portfolio of two assets + risk free
rate) https://www.youtube.com/watch?v=6HXoxzZwbCA