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CHAPTER 7: An Introduction to Portfolio Management

PORTFOLIO combination of securities such as bonds and other instruments.


PORTFOLIO MANAGEMENT includes range of professional services to manage an
individual or companys securities.
Why Portfolio Management Matters?
Investing in securities and other assets can be complicated and risky. Relying in a portfolio
manager for professional services or relying on your knowledge regarding portfolio management
can be helpful to ensure that investment goals are within reach and levels of risk are within
tolerance levels.
Background Assumptions basic assumption & ground rules
Basic Assumption As an investor, you want to maximize returns for a given level of risk. To
deal with that, we have
Ground Rules
Your portfolio includes all of your assets and liabilities.
Relationship between returns for assets in the portfolio is important.
A good portfolio is not simply a collection of individually good investments.
Risk Aversion - Given a choice between two assets with equal rates of return, most investors will
select the asset with the lower level of risk.
Evidence That Investors are Risk Averse - Many investors purchase insurance for: Life,
Automobile, Health, and Disability Income. The purchaser trades known costs for unknown risk
of loss. But NOT ALL INVESTORS ARE RISK AVERSE. Risk preference may have to do with
amount of money involved - risking small amounts, but insuring large losses.
Definition of Risk
1. Uncertainty of future outcomes or
2. Probability of an adverse outcome
Markowitz Portfolio Theory

Developed by Dr. Harry M. Markowitz in 1952


Quantifies risk
Derives the expected rate of return for a portfolio of assets and an expected risk measure
Shows that the variance of the rate of return is a meaningful measure of portfolio risk
Derives the formula for computing the variance of a portfolio, showing how to effectively
diversify a portfolio

Assumptions of Markowitz Portfolio Theory


1. Investors consider each investment alternative as being presented by a probability
distribution of expected returns over some holding period.
2. Investors minimize one-period expected utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected
returns.

4. Investors base decisions solely on expected return and risk, so their utility curves are a
function of expected return and the expected variance (or standard deviation) of returns
only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a
given level of expected returns, investors prefer less risk to more risk.
Under these five assumptions, a single asset or portfolio of assets is considered to be efficient
if no other asset or portfolio of assets offers higher expected return with the same (or lower)
risk, or lower risk with the same (or higher) expected return.
Alternative Measures of Risk
Variance or standard deviation of expected return
Range of returns
Returns below expectations
Semivariance a measure that only considers deviations below the mean
These measures of risk implicitly assume that investors want to minimize the damage
from returns less than some target rate
Expected Rates of Return
For an individual asset - sum of the potential returns multiplied with the corresponding
probability of the returns
For a portfolio of assets - weighted average of the expected rates of return for the individual
investments in the portfolio
Computation of Expected Return for an Individual Risky Investment

Computation of the Expected Return for a Portfolio of Risky Assets

Variance (Standard Deviation) of Returns for an Individual Investment


Standard deviation is the square root of the variance
Variance is a measure of the variation of possible rates of return R i, from the expected
rate of return [E(Ri)]

EXAMPLE:

Covariance of Returns
A measure of the degree to which two variables move together relative to their
individual mean values over time.
For two assets, i and j, the covariance of rates of return is defined as:
Covij = E{[Ri - E(Ri)][Rj - E(Rj)] n}
Correlation Coefficient
The correlation coefficient is obtained by standardizing (dividing) the covariance by the
product of the individual standard deviations.

It can vary only in the range +1 to -1.


A value of +1 would indicate perfect positive correlation. This means that returns for the two
assets move together in a completely linear manner.
A value of 1 would indicate perfect negative correlation. This means that the returns for two
assets have the same percentage movement, but in opposite directions

RELATIONSH
IP

DISPERSIO
N

COVARIAN
CE

VARIANCE

COEFFICIE
NT

STANDAR
D
DEVIATIO

If you want to measure the dispersion of


random variable, you will use Variance which
is the measure of dispersion or scatter.

If you have two random variables and you


want to consider the relationship between
them, the strength of their relationship or
how do they move together, you have to
look at the Covariance.

The problem in variance and covariance is that, although they are mathematically convenient,
they are not intuitive for us to use these measures that is why we translate them into intuitive
measures which are standard deviation and correlation coefficient.
The variance is expressed in units squared so we translate it into standard deviation which is
expressed in units to be understandable to us.
We translate the covariance into correlation coefficient which is unit-less wherein it runs from
-1.0 to +1.0. Because it is unit-less, we automatically understand it, the closer it is to +1.0, the
greater the strength of relationship between two random variables.
PORTFOLIO RISK AND RETURN
Portfolio Risk is the variability of the portfolio as a whole

-our measure of portfolio risk is the standard deviation of returns for a portfolio of
assets
Portfolio Standard Deviation Formula

*The PSDF has to components: the assets own variance of returns and the covariance between
the returns of this asset and the returns of every other asset that is in the portfolio.

Analysis of Risk Behavior:


A. Assets with Equal Risk and Return Changing Correlations:
The lower the correlation/ covariance, the lower the standard deviation/ risk of the
portfolio
If correlation is perfectly positive, the portfolio standard deviation is equal to the
weighted average of the standard deviation of each asset.
If correlation is perfectly negative, portfolio standard deviation is reduced to zero.
B. Assets with Different Risk and Return Changing Correlations:
Just like in the first situation, the lower the correlation/ covariance, the lower the
standard deviation/ risk of the portfolio
Also, if correlation is perfectly positive, the portfolio standard deviation is equal to the
weighted average of the standard deviation of each asset.
But, a perfectly negative correlation does not reduce the risk to zero. This is because
the assets have different risks but with the same weight.
C. Constant Correlation with Changing Weights
Holding two assets with different risks and returns, having a constant correlation
coefficient, at any possible combinations will lead us to different portfolio risks and
portfolio returns. If we plot all these points in a graph, we would derive with a set of
combinations that trace an ellipse starting at Asset 2 and ending at Asset 1.

Portfolio Risk Return Plots for Different Weights

With two perfectly correlated assets, it is only possible to create a two asset portfolio
with risk-return along a line between either single asset.
With uncorrelated assets, it is possible to create a two asset portfolio with lower risk
than either single asset.
With correlated assets, it is possible to create a two asset portfolio between the first
two curves.
With negatively correlated assets, it is possible to create a two asset portfolio with
much lower risk than either single asset.
With perfectly negatively correlated assets, it is possible to create a two asset portfolio
with almost no risk.

EFFICIENT FRONTIER
- represents the set of portfolios that has the maximum rate of return for every given
level of risk, or the minimum risk for every level of return.
- the frontier will be portfolios of investments rather than individual securities
(exceptions being the asset with the highest return and the asset with the lowest risk)

*Portfolios that lie below


the efficient frontier are
sub-optimal, because they
do not provide enough
return for the level of risk.
Portfolios that cluster to
the right of the efficient
frontier are also suboptimal, because they have
a higher level of risk for
the defined rate of return.

The Efficient Frontier and Investor Utility

Investors Utility Curve specifies the trade-offs he is willing to make between expected return
and risk.

Optimal portfolio
- is one that provides the most satisfaction the greatest return for an
investor based on his tolerance for risk.
-it lies at the point of tangency between the efficient frontier and the utility
curve with the highest possible utility