Optimal Risky Portfolios

Chapter Overview

• The investment decision:

• Capital allocation (risky vs. risk-free)
• Asset allocation (construction of the risky
portfolio)
• Security selection
• Optimal risky portfolio
• The Markowitz portfolio optimization model
• Long- vs. short-term investing
 The Investment Decision

• Top-down process with 3 steps:

1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class
 Diversification and Portfolio Risk

• Market risk
• Risk attributable to marketwide risk sources and
remains even after extensive diversification
• Also call systematic or nondiversifiable
• Firm-specific risk
• Risk that can be eliminated by diversification
• Also called diversifiable or nonsystematic
 Market Risk / Systematic Risk Vs
Unsystematic Risk
• The risk that remains even after extensive
• diversification is called market risk, risk that is
attributable to market wide risk
• sources. Such risk is also called systematic
risk, or non-diversifiable risk.
• In contrast, the risk that can be eliminated by
diversification is called unique risk, firm-
specific risk, nonsystematic risk, or
diversifiable risk.
 Figure 7.1 Portfolio Risk and
the Number of Stocks in the Portfolio

Panel A: All risk is firm specific. Panel B: Some risk is systematic or marketwide.
Portfolio Diversification
 Portfolio diversification Refer
previous slide
• The average standard deviation of returns of
portfolios composed of only one stock was
49.2%.
• The average portfolio risk fell rapidly as the
number of stocks included in the portfolio
increased. In the limit, portfolio risk could be
reduced to only 19.2%.
 Portfolios of Two Risky Assets

• Portfolio risk (variance) depends on the

correlation between the returns of the
assets in the portfolio
• Covariance and the correlation coefficient
provide a measure of the way returns of
two assets move together (covary)
 Portfolios of Two Risky Assets:
Return
• Portfolio return: rp = wDrD + wErE
– wD = Bond weight
– rD = Bond return
– wE = Equity weight
– rE = Equity return

E(rp) = wD E(rD) + wEE(rE)

 Portfolios of Two Risky Assets:
Risk
• Portfolio variance:
 p2  wD2  D2  wE2 E2  2wD wE Cov  rD , rE 

–  D2 = Bond variance

–  2
E
= Equity variance

–Cov  rD , rE  = Covariance of returns for bond

– and equity
• Our first observation is that the variance of
the portfolio, unlike the expected return, is
• not a weighted average of the individual asset
variances.
Portfolios of Two Risky Assets: Covariance

• Covariance of returns on bond and equity:

Cov(rD,rE) = DEDE

– D,E = Correlation coefficient of returns

– D = Standard deviation of bond returns
– E = Standard deviation of equity returns
 Portfolios of Two Risky Assets:
Correlation Coefficients
• Range of values for 1,2
- 1.0 >  > +1.0
– If  = 1.0, the securities are perfectly positively
correlated
– If  = - 1.0, the securities are perfectly negatively
correlated
 Portfolios of Two Risky Assets:
Correlation Coefficients
• When ρDE = 1, there is no diversification

 P  wE E  wD D
• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
 D  E
Figure 7.3 Portfolio Expected Return
Figure 7.4 Portfolio Standard Deviation
Figure 7.5 Portfolio Expected Return as a Function
of Standard Deviation
 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
• The amount of possible risk reduction through
diversification depends on the correlation:
• If  = +1.0, no risk reduction is possible
• If  = 0, σP may be less than the standard deviation of
either component asset
• If  = -1.0, a riskless hedge is possible
The Opportunity Set of the Debt and Equity
Funds and Two Feasible CALs
 The Sharpe Ratio

• Maximize the slope of the CAL for any possible

portfolio, P
• The objective function is the slope:
E rp   rf
Sp 
p
• The slope is also the Sharpe ratio
Figure 7.7 Debt and Equity Funds with the
Optimal Risky Portfolio
Figure 7.8 Determination of the Optimal Overall
Portfolio
Figure 7.9 The Proportions of the Optimal
Complete Portfolio
Markowitz Portfolio Optimization Model

• Security selection
• The first step is to determine the risk-return
opportunities available
• All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations
Figure 7.10 The Minimum-Variance
Frontier of Risky Assets
Markowitz Portfolio Optimization Model

• Search for the CAL with the highest reward-to-

variability ratio
• Everyone invests in P, regardless of their
degree of risk aversion
• More risk averse investors put more in the risk-
free asset
• Less risk averse investors put more in P
Figure 7.11 The Efficient Frontier of
Risky Assets with the Optimal CAL
Markowitz Portfolio Optimization Model

• Capital Allocation and the Separation Property

• Portfolio choice problem may be separated into
two independent tasks
• Determination of the optimal risky portfolio is
purely technical
• Allocation of the complete portfolio to risk-free
versus the risky portfolio depends on personal
preference
Figure 7.13 Capital Allocation Lines with Various
Portfolios from the Efficient Set
Markowitz Portfolio Optimization Model

• The Power of Diversification

• Remember:
   wi w j Cov  ri , rj 
n n
2
p
i 1 j 1

• If we define the average variance and average

covariance of the securities as:
1 n 2
   i
2

n i 1

Cov  ri , rj 
n n
1
Cov  
n  n  1 j 1 i 1
j i
Markowitz Portfolio Optimization Model

• The Power of Diversification

– We can then express portfolio variance as
1 2 n 1
   
2
p Cov
n n
– Portfolio variance can be driven to zero if the
average covariance is zero (only firm specific risk)
– The irreducible risk of a diversified portfolio
depends on the covariance of the returns, which is
a function of the systematic factors in the
economy
Table 7.4 Risk Reduction of
Equally Weighted Portfolios
Markowitz Portfolio Optimization Model

• Optimal Portfolios and Nonnormal Returns

• Fat-tailed distributions can result in extreme
values of VaR and ES and encourage smaller
allocations to the risky portfolio
• If other portfolios provide sufficiently better VaR
and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions
 Risk Pooling and
the Insurance Principle
• Risk pooling
– Merging uncorrelated, risky projects as a means to
reduce risk
– It increases the scale of the risky investment by
adding additional uncorrelated assets
• The insurance principle
– Risk increases less than proportionally to the
number of policies when the policies are
uncorrelated
– Sharpe ratio increases
 Risk Sharing

• As risky assets are added to the portfolio, a

portion of the pool is sold to maintain a risky
portfolio of fixed size
• Risk sharing combined with risk pooling is the
key to the insurance industry
• True diversification means spreading a
portfolio of fixed size across many assets, not
merely adding more risky bets to an ever-
growing risky portfolio