EDWARD F.
RENSHAW
Selecting
A Defensive
Portfolio
SINCE THE PUBLICATION OF Markowitz's article
and monograph on "Portfoho Selection" [4, 5], there
have been a number of efforts to simplify the pro-
cedures for estimating an efficient portfolio [6, 8, 9]
and several studies which indicate that there may
be some degree of predictive content to portfolios
that are obtained from historical data. Papers by
Smith [10, 11], Cohen and Pogue [1] have used
variations of the Sharpe-Markowitz programs to ob-
tain portfolios which have performed so well in sub-
sequent periods as to be possibly inconsistent with
the random walk hypothesis.
In a more recent paper Treynor and others [13]
have shown that the risk parameters for stocks in
one mutual fund have exhibited remarkable stabil-
ity. They were able to use historical parameters to
explain about half of the month-to-month variation
in the price of this fund, relative to a market aver-
age, over a two-year period. The implication is that
if we can predict the direction of the market, it
should be possible to select a portfolio that will out-
perform a representative market average.
Further evidence in support of parameter stability
is provided by a recent simulation of the Dow Jones
Industrial Average [7]. A simplified portfolio bal-
WINTER / 1970 / VOL. XIII / NO. 2
ance model is used here to obtain a reasonably effi-
cient portfolio to combine with a safe asset yielding
four percent in the period 1947 to 1965. The result-
ing portfolio was then compared with some simu-
lated portfolios which were randomly derived on
the basis of a model that was suggested by Osborne
[2:113]. Our main conclusions were:
» that distributions of stock returns which appear to
conform to Osbome's random walk model II can hide a
significant amount of internal structure
• that this structure may be of practical importance in
helping to identify portfolios that will be more defensive
in a bear market than a representative price index.
One of the more interesting findings to emerge
from tliis study was the discovery tliat it is not easy
to identify defensive securities using standard statis-
tical techniques. The ten stocks in the DJIA with
the least variable returns in the 1947 to 1965 period
actually performed less well than the industrial
average during the bear markets of 1966 and the
first six months of 1969. Those stocks in the DJIA
witli the lowest correlation with Standard and
Poor's industrial index performed even less well, on
the average, than the stocks with the lowest stan-
dard deviations. The ten stocks with the highest
19
TABLE I.—A COMPARISON OF SECURITY PROPORTIONS AND OIHER SELECTED PARAMETERS USED IN PORTFOLIO BALANCE
MODELS. T H E DOW JONES INDUSTRIAL AVERAGE 1947-1965

HealJzerJ Correlation The Least Squares

Standard Security Proportions for Portfolios
Security Average Ke- With S & P's Market Intercept
turn Index or Constant Term 1 3 .5

Eastman Kodak 1,207 ,203 ,442 1,118 ,231 .176 ,182 .128 ,089
General Foods 1.171 ,193 ,397 1,095 .173 .134 .140 .180 .249
General Electric 1.180 ,172 ,697 1,061 .126 ,086 ,054 ,095
United Aircraft 1.249 ,300 ,376 1,137 .123 ,147 ,246 .080 ,020
Procter & Gamble 1,158 ,196 ,456 1,069 .092 ,083 ,074 .201 ,197
Texaco 1,204 ,192 ,793 1.053 .079 ,069 ,033 ,144 ,172
Westinghouse Electric 1,152 ,'239 ,334 1.073 .068 ,072 ,084
Standard Oil/California 1,174 ,180 ,686' 1.052 .057 ,0«3 .029 ,088
Chrysler 1,203 ,387 .275 1,098 .041 ,074 .146 ,024
Aroerican Can 1,105 ,165 .368 1,045 .017 .031 .012 .030
Sears Roebuck 1,190 ,214 .717 1,037 ,034 .023
Standard Oil/N.J. 1,185 ,241 .640 1.032 ,022 .034
Swift 1,092 ,162 .856 1,035 ,008
AT&T 1,097 ,140 .473 1,031 ,000* .096 .028
American Tobacco 1,111 ,205 .411 1,028 .110

• The security proportion was positive but less than one tenth of one percent.

average rates of return in the nineteen-year period

studied did outperform the DJIA in the first half of
1969 but did not in 1966.
The defensive quality of the Sharpe-Markowitz
portfolio in botli of these bear markets would appear
to depend, therefore, on a judicious combination of
these three parameters rather than a dominant em-
phasis on any one of the more basic elements which
help to determine an efficient portfolio.
None of the basic parameters was particularly
useful as an individual indicator in helping to iden-
tify defensive securities, but it was discovered that
the constant terms, or market intercepts, obtained
when the returns for individual securities are re-
gressed on the percentage returns for a representa-
tive market average—are quite useful in helping to
predict those stocks which are likely to appear in an
efficient portfolio. The endeavor in this paper is to
sho^v why this is so and to indicate ways in which
the market intercept can be redefined so as to ob-
tain an even better definition of defensive securities.
Our most important conclusion is that it may be
possible to simplify the estimation procedures to the
point where most analysts unfamiliar with mathe-
matical programming can obtain a reasonably effi-
cient defensive portfolio by simply inspecting the
data.
Presumed-Defensive Comparisons
Table I contains security proportions and other
selected parameters obtained for stocks in the Dow
Jones Industrial Average during the nineteen-year
period from 1947-196.5. The first portfolio was ob-
tained by using the Shai-pe-Markowdtz security se-
lection program. It would have been the best port-
folio to have combined with a safe asset yielding
four percent during the original fitting period. (To-
bin has shown that there may be only one point on
the Sharpe-Markowitz investment frontier that can
be considered efficient if risk assets can be com-
bined with money or a safe asset yielding a fixed
return per period [12].)
Average rates of price appreciation for this port-
folio from 1966 through 1969 are presented in Table
II and can be compared to the average rate of price
appreciation for the DJIA as a whole. The Sharpe-
Markowitz model (portfolio 1) had an average re-
turn which was ten percentage points better than
the DJIA in 1966 and seven percentage points bet-
ter in thefirsthalf of 1969.
The model used to obtain the second portfolio in
Table I is described at the end of this paper. It is
based on a fairly simple algebraic formula that does
a remarkably good job of simulating those securities

20 California Management Revkto

which typically appear in the Sharpe-Markowitz TABLE n . — A V E R A G E R A T E S OF PHICE APPRECIATION FOR
model. One reason this portfolio did not do quite so THE Dow J O N E S INDUSTRIAL AVERAGE; T H E SHARPE-
MARKOWITZ M O D E L , AND OTHER PORTFOLIO
well during the bear markets of 1966 and 1969 is
BALANCE MODELS. SELECTED PERIODS,
the extra weight that was given to stocks such as 1966-1969
United Aircraft, V^'estinghouse, and Chrysler—all of
which had comparatively low correlations with S & Portfolios
P's industrial index during the original fitting period TUT A
but subsequently fiuctuated widely in relation to 1 2 3 4 5
the market average. In the last two instances it
1966 .811 .911 .883 .892 .924 .911
would have been quite reasonable to have expected
1967 1.152 1 .150 1 .182 1.219 1 .118 1 .101
a much higher index correlation in subsequent peri- 1968 1.043 1 .000 1 .001 .970 1 .028 1 .049
ods since similar type companies such as Ceneral 1969 .848 .918 .885 .850 .953 .980
Electric and Ceneral Motors had much higher index 1966-69 .964 .995 .988 .983 1 .006 1 .010
correlations during the original fitting period than
Westinghouse and Chrysler. The lower correlations rates than at higher rates.) See the least squares
for these two companies may, in the final analysis, market intercepts which are presented in the fourth
have been largely the result of temporary adversi- column of Table I. Security proportions for portfo-
ties that are infrequent and largely random in char- lio 3 were obtained by simply summing the index
acter. (One way to adjust the correlation coeffi- values for all securities with a positive index of effi-
cients for disturbances that are presumably ran- ciency and computing relative index proportions.
dom might be to sort firms on the basis of different This portfolio did not perform quite as well, on
industries and then regress the observed correlation the average, as the first two portfolios, yet its bear
coefficients on some indicator of intrinsic risk such performance in both instances was closer to the first
as market share or aggregate sales. The calculated two portfolios than to the performance of the DJIA.
correlation coefficients could then be substituted for (See Table II). Was this an accident, or is there a
the actual coefficients to obtain a normalized risk theoretical basis for supposing that a portfolio
parameter that is less influenced by historical acci- based on those stocks with the highest market inter-
dents that are peculiar to individual firms.) cepts should be more efficient than random selec-
The third portfolio in Table I is based on a dis- tion? Consider a linear regression of the form:
covery that the ten stocks which appeared in the Xi = a + bX, (2)
Sharpe-Markowitz portfolio also had the ten high- Let Rj equal the arithmetic average return on the
est constant terms when the returns for individual /•-th security and M equal the arithmetic average
securities were regressed on the percentage returns return for a representative market average. Since a
for S & P's industrial average. Where Ij equals an least squares regression must pass through the mean
index of efficiency, a; equals the market intercept, values for both tlie independent and dependent vari-
and i equals a rate of interest at which the portfolio ables, we can rewrite equation (2) so that the re-
manager can lend without risk, we can use the fol- gression coefficients are a function of expected
]o^ving criterion to rank stocks on the basis of effi- returns:
ciency:
Rj = Qj + hM (3)
Ij = fl, - i (1)
The slope coefficient in a linear regression is equal
When i was set to equal 1.04-tlie same rate of to the correlation coefficient, Cj, times the standard
interest used to obtain portfolios 1 and 2-we were deviation of the dependent variable, Sj, divided by
able to determine uniquely the ten stocks which ap- the standard deviation of the independent variable
peared in the Sharpe-Markowitz portfolio by
merely selecting those stocks with an index of effi-
ciency greater than zero. (This outcome may be 5 = C/ — (4)
partly an accident. Positive values for equation (1)
could be expected to do a better job of simulating Substituting equation (4) into (3) and solving
the Sharpe-Markowitz efficient set of portfolios at for tlie constant term, we learn that a, will he higher
lower and more defensive borrowing or lending —other things equal—the higher the expected re-

W I N T E R / 1970 / V O L . X I I I / N O . 2 21
turn for the /-th security, the smaller its standard
deviation, and the lower its market correlation.
aj = Rj- CA~ \M (5)
Equation (5) is not exactly the same as other
models that have been used to obtain reasonably ef-
ficient portfolios (see equation (6)), but it does en-
compass all of the more important parameters. The
direction of impact, moreover, is essentially the
same. We can be fairly confident, therefore, that
portfolio 3 is not just an accident and that the crite-
rion wliich was proposed in connection with equa-
tion (1) might be of significant value in helping to
obtain reasonably efficient defensive portfolios.
The most exciting aspect of the aj-i criterion is
the possibility of modifying equation (3) so as to
obtain an even better definition of defensive securi-
ties than would otherwise be obtained. Not much
analysis of the data is required to suggest that some
companies with comparatively low correlations with
a representative market average—such as United
Aircraft, Westinghouse Electric, and Chrysler—have
achieved this low correlation, not as a result of out-
standing performance in most bear markets, but as
a result of having performed rather dismally on oc-
casion when the market in general was having a
good year.
If our objective is to obtain a defensive portfolio
it is questionable whether a comparatively poor
performance in a bull market ought to be allowed
to influence the selection of stocks for a bear mar-
ket. One way to avoid most of this problem and also
simplify tlie procedures for obtaining an efficient
portfolio is to start with equation (3) and then ob-
tain an identified system by choosing one additional
point, besides the mean values for an individual se-
curity and the market average, which best describes
the sensitivity of a particular security to declines in
the market average.
This, in any event, was the principle that was
used to derive portfolios (4) and (5). For both we
started out with the mean returns for the individual
stocks in the DJIA and S & P's industrial average
during the nineteen-year period from 1947 to 1965.
To obtain portfolio (4) we then computed the aver-
age returns for the individual stocks and S & P's
average during the bear market years of 1957, 1960,
and 1962. A straight line was used to connect the
average bear market performance of the individual
22
securities and the market average to the mean values
that were established for the nineteen-year period.
The resulting values for aj were then used in con-
junction with equation (1) to obtain portfolio 4.
It seems clear from Table I that an emphasis on
bear market performance can lead to important
changes in portfolio composition. Three companies
—C.E., Westinghouse Electric, and American Can-
given proportions ranging from slightly over one to
more than 12 percent in the first three portfolios,
are not included in portfolio 4. The weight given to
Eastman Kodak, United Aircraft, and Chrysler is
also reduced in a fairly significant manner. Other
stocks which did not figure so prominently in the
first three portfolios—such as Procter & Camble,
Texaco, and Standard Oil of California—were given
considerably more weight.
Three additional stocks which did enter portfo-
lios 2 and 4 were excluded from 1 and 3. The most
dramatic diff^erence in portfolio composition was for
American Telephone—a near zero proportion in
portfolio 2 and a weight of almost ten percent in
portfolio 4.
Did these changes make a difference in subse-
quent performance? The differences in overall per-
formance were fairly small, yet it seems likely that
most investors would have preferred the results of
portfolio 4 over the results of the first three. None of
the first three did as well as in the bear markets of
1966 and 1969 or in the lackluster year of 1968. Nor
did they perform as weU for the four periods as a
whole.
The main difference between portfolios 4 and 5 is
that instead of basing our market line on the average
bear market performance of 1957, 1960, and 1962,
we selected that particular bear market year with a
median market slope to represent the most typical
experience of a security in a bear market situation.
This amounted to considering both the worst and
best relative performance to be suspect and possibly
unrepresentative of future behavior. The most dra-
matic difference between portfolio 5 and the other
four is American Tobacco, now American Brands.
This particular security was once considered to be
highly defensive. It has not been able to recover
fully from the shock of 1962, however, when it lost
more than 40 percent of its market value, despite
intensive efforts to diversify and improve its finan-
cial image.
Portfolio 5 did not perform quite as well as in
California Management Review
1966, but it was as defensive as 1 through 3 and
would have to be considered more eflBcient for the
four periods as a whole. The implication, it seems to
me, is that we might be able to train a security ana-
lyst with only rudimentary skills as a mathematician
to estimate a reasonably efficient defensive
portfolio, almost by inspection. If qualitative rea-
sons can be advanced for supposing that extreme
observations are likely to be umrepresentative of fu-
ture behavior there may be a real advantage to first
plotting the historical data and then fitting a mar-
ket line which is largely judgmental.
A Simplified Portfolio Balance Model
The model used here to obtain portfolio 2 was de-
rived by solving tlie two-asset case and noting that
a fairly simple formula will tell whether two securi-
ties should be in the same portfolio. The formula
can be used to compute an index of efficiency that
has been shown to generate reasonably efficient
portfolios of more than two risk assets [6]. The fol-
lowing list of symbols will be helpful in interpreting
the index.
7y = an index of efficiency which has been shown to do a
good job of simulating those stocks which are in-
cluded in the Sharpe version of the Markowitz
selection program.
Rj = the expected return on the j-th security.
Sj = the standard deviation of the returns for the j-th.
security.
Ro = the expected return on the security with the liighest
iRj—i)/sj ratio.
SQ — the standard deviation of the returns for the security
with the highest {Rj—i)/sj ratio.
i = a rate of interest at which the portfolio manager can
borrow or lend without risk.
C; = the correlation coefficient between the returns on
the j-th security and the returns on a representative
stock price index.
- i) So
(6)
{Ro — i)
Equation (6) can be interpreted in the following
way. The larger the difference (Rj-i) between the
return on the /-th security and the lending or bor-
rowing rate, the higher the index value and the more
likely it is that the /-th security will be included in
an efficient portfoho. A higher expected return can
be offset, however, either by a larger standardized
variance, Sj, or by a higher correlation, Cy, with
other securities.
WINTER / 1970 / VOL. XIII / NO. 2
The expression, So/{Ro-i), normalizes the index
values for different securities in relation to that se-
curity which would be the best to own if a person
were given the all-or-none choice of investing in only
one risk asset. The assumption is that a security
should not be included in a portfolio with more than
tv^^o risk assets unless it can qualify to be included in
a two-stock portfolio with that security which would
be the best to own in the absence of diversification.
The s^f (Ro-i) hurdle is not as restrictive as the
constraints that are built into some of the more
elaborate programs for achieving portfolio balance.
More securities will often qualify for inclusion,
under equation (6), than are obtained using the
Sharpe-Markowitz models. This could be a desirable
feature leading to more efficient realized portfolios if
secinrity analysts tend to overestimate their ability
to differentiate between high and low performers.
For a stock to be included in an efficient portfo-
lio, the index value for equation (6) should be posi-
tive. Security proportions are determined by sum-
ming the positive index values for included securi-
ties and computing relative index proportions. By
varying the interest rate, i, we can generate a set of
portfolios that are reasonably efficient for different
borrowing or lending rates.
Comments
In Markowitz' original monograph it was sug-
gested that the semi-variance might provide a bet-
ter measure of risk than the standard deviation for
all observations. Since most investors are not likely
to be bothered by an exceptionally good perfor-
mance in an above-average year, it is somewhat sur-
prising that students of portfolio theory have shovim
so little inclination to investigate alternative mea-
sures of risk.
Although the data presented in this paper do not
provide a very conclusive test of alternative defini-
tions, they are consistent with other studies which
suggest that there may be significant structure to
changes in security prices and would seem to indi-
cate that it may be worthwhile to give more atten-
Edward F. Remhaw is Professor of Economics
and Finance at the State University of New York
at Albany. He has written numerotis articles
on the stock market and other topics in public
and private finance.
23
tion to the defensive qualities of a variety of portfo-
lio balance models.
A not insignificant advantage of the a, criterion
from a statistical point of view is that we obtain an
objective measure of defensiveness for all securities
regardless of whether they appear in an efficient
portfolio or not. This variable could then be in-
cluded in a multiple regression along with other
technical and financial variables in the hopes of ob-
taining even better predictions of actual price be-
havior during bear market periods.
REFERENCES
1. K. ]. Cohen and J. A. Pogue, "An Empirical Eval-
uation of Alternative Portfolio-Selection Models," Jour-
nal of Business (April 1967), 166-193.
2. P. H. Cootner, The Random Character of Stock
Market Prices (Cambridge, iMass.; MJ.T. Press), 1964.
3. K. A. Eox, Intermediate Economic Statistics (New
York: Wiley), 1968.
4. H. M. Markowitz, "Portfolio Selection," Journal of
Finance (March 1952), 77-91.
5. , Portfolio Selection: Cowles Foundation
Monograph 16 (New York: Wiley), 1959.
24
6. E. F. Renshaw, "Portfolio Balance Models in Per-
spective: Some Ceneralizations that Can Be Derived
from the Two Asset Case," Journal of Financial and
Quantitative Analysis (June 1967), 123-149.
7. , and V. D. Renshaw, "Simulating the Dow
Jones Industrial Average: A Further Test of tlie Random
Walk Hypothesis," Financial Analysts Journal, forthcom-
ing.
8. W. F. Sharpe, "A Simplified Model for Portfolio
Analysis," Management Science (Januaiy 1963), 277-
293.
9. , "A Linear Programming Algorithm for Mu-
tual Fund Portfolio Selection," Management Science
(March 1967), 499-510.
10. K. V. Smith, "A Transition Model for Poitfolio
Revision," Journal of Finance (Sept. 1967).
11. , "Alternative Procedures for Revising In-
vestment Portfolios," Journal of Financial and Quantita-
tive Analysis (Dec. 1968).
12. J. Tobin, "Liquidity Preference as Behavior To-
wards Risk," Review of Economic Studies (Feb. 1958),
65-86.
13. J. L. Treynor, W. W. Priest, L. Fisher, and C. A.
Higgins, "Using Portfolio Composition to Estimate
Risk," Financial Analysts Journal (Sept.-Oct. 1968),
93-102.
California Management Review