Lecture 5: Optimal Risky Portfolios

Chapter 7, BKM
Part 1

INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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The Investment Decision

1. Capital allocation between the risky portfolio and risk-free asset
a. Determines the investors exposure to risk. b. The optimal capital allocation is determined by risk aversion & expectations for the riskreturn trade-off of the optimal risky portfolio.

2. Asset allocation across broad asset classes 3. Security selection of individual assets within each asset class

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Lecture Plan
1. Illustrate the potential gains from simple diversification into many assets
2. Efficient diversification
Two risky assets Two risky assets and a risk-free The entire universe of available risky securities.

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Diversification and Portfolio Risk

Market risk
Systematic or nondiversifiable E.g. conditions in the general economy, such as the business cycle, inflation, interest rates, and exchange rates

Firm-specific risk
Diversifiable or nonsystematic E.g. firms success in research and development, personnel changes

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Figure 7.1 Portfolio Risk as a Function of the Number of Stocks in the Portfolio

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Figure 7.2 Portfolio Diversification

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Efficient Diversification: The Two-Assets Case

Now consider efficient diversification, whereby we construct risky portfolios to provide the lowest possible risk for any given level of expected return. Suppose for now that we have only two assets in which to invest: a bond mutual fund (denoted by D) and a stock mutual fund (denoted by E).

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Two-Security Portfolio: Return

rp rP rD rE

Portfolio Return Bond Return Equity Return

wr
D

wE r E

wD Bond Weight wE Equity Weight

E (rp ) wD E (rD ) wE E (rE )

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Two-Security Portfolio: Risk

2 2 2 2 2 p wD D wE E 2wD wE Cov rD , rE

w w 2wD wE Corr rD , rE D E 2 D = Variance of Security D 2 = Variance of Security E E

2 p 2 D 2 D 2 E 2 E

Cov(rD , rE ) = Covariance of returns for

Security D and Security E

Corr (rD , rE ) = Correlation of returns for

Security D and Security E

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Covariance
Cov(rD,rE) = DEDE D,E = Correlation coefficient of returns D = Standard deviation of returns for Security D E = Standard deviation of returns for Security E

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Portfolio Variance
1. The formula for the portfolio variance reveals that variance is reduced if the covariance term is negative. 2. Even if the covariance term is positive, the portfolio standard deviation is less than the weighted average of the individual security standard deviations, unless the two securities are perfectly positively correlated.

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Correlation Coefficients
When DE = 1, there is no diversification:

P wE E wD D
the standard deviation of the portfolio with perfect positive correlation is just the weighted average of the component standard deviations. In all other cases, the correlation coefficient is less than 1, making the portfolio standard deviation less than the weighted average of the component standard deviations.

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Correlation Coefficients
When DE = -1, a perfect hedge is possible:

wE

D E

1 wD

The portfolio standard deviation is zero.

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Portfolios offer better risk-return tradeoffs

Because the portfolios expected return is the weighted average of its component expected returns, whereas its standard deviation is less than the weighted average of the component standard deviations, portfolios of less than perfectly correlated assets always offer better riskreturn opportunities than the individual component securities on their own.
The lower the correlation between the assets, the greater the gain in efficiency.

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Bond-stock portfolio: Data

Expected return: Stock 13% Bond 8% Standard deviation: Stock 20% Bond 12% Correlation coefficient: 0.3 What are the expected return and variance of the portfolio as functions of the weight on stocks?

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Portfolio Expected Return as a Function of Investment Proportions

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Portfolio Standard Deviation as a Function of Investment Proportions

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The Minimum Variance Portfolio

The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation, the portfolio with least risk.
2 D

When correlation is less than +1, the portfolio standard deviation may be smaller than that of either of the individual component assets.

When correlation is Cov(rD , rE ) equal to -1, the wMinVar ( E ) 2 2 D E 2Cov(rD , rE ) standard deviation of the minimum variance portfolio is zero. wMinVar ( D) 1 wMinVar ( E )

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Figure 7.5 Portfolio Expected Return as a Function of Standard Deviation

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Correlation Effects
The amount of possible risk reduction through diversification depends on the correlation. The risk reduction potential increases as the correlation approaches -1.
If = +1.0, no risk reduction is possible. If = 0, P may be less than the standard deviation of either component asset. If = -1.0, a riskless hedge is possible.