OPTIMAL RISKY PORTOFLIOS

DIVERSIFICATION AND PORTFOLIO RISK

Suppose you have in your risky portfolio only one stock, say Dell Computer
Corporation. What would be the sources of risk affecting this “portfolio”?

You might think of two broad sources of uncertainty. The first is a risk that
comes from the conditions in the general economic such as the business cycle,
inflation, interest rates, and exchange rates. None of these macroeconomic
factors can be predicted with certainty, and all affect the rate of returns of Dell
stocks. In addition to these macroeconomic factors there are firm-specific
influences, such as Dell’s success in research and development, its management
style, personnel changes and so on. These factors affect the company without
noticeably affecting other firms in the economy.

Now consider a naive diversification strategy, in which you include another

security to the risky portfolio. Place half of your funds in Exxon Mobile and half
in Dell. What happens to portfolio risk? To the extent that the firm-specific
influences on the two stocks differ, diversification should reduce portfolio risk.
But why end diversification at only two stocks? If we diversify into many more
securities we continue to spread out our exposure to firm-specific factors, and
portfolio volatility should continue to fall. Ultimately, however, even with large
number of stocks we cannot avoid risk altogether, because virtually all securities
are affected by the common macroeconomic factors.

When all risk is firm-specific, as in Figure 7.1 (Panel A), diversification can
reduce risk to arbitrarily low levels. The reason is that with all risk sources
independent, the exposure to any particular source of risk is reduced to a
negligible level. The reduction of risk to very low levels in the case of
independent risk sources is sometimes called the insurance principle, because
of the notion that an insurance company depends on the risk reduction achieved
through diversification when it writes many policies insuring against many
independent sources of risk, each policy being a small part of the company’s
overall portfolio.

When common sources of risk affect all firms, however, even extensive
diversification cannot eliminate risk. In Figure 7.1 (Panel B), portfolio standard
deviation falls as the number of securities increases, but it cannot be reduced to
zero. The risk that remains even after extensive diversification is called market
risk, risk that is attributable to marketwide risk sources. Other names are
systematic risk, or non-diversifiable risk. In contrast, the risk that can be
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eliminated by diversification is called unique risk, firm-specific risk,
nonsystematic risk, or diversifiable risk.

PORTFOLIO OF TWO RISKY ASSETS

In the previous section we considered naive diversification using equally-

weighted portfolio of several securities. It is time now to study efficient
diversification, whereby we construct risky portfolio to provide the lowest
possible risk for any given level of expected return.

Portfolios of two risky assets are relatively easy to analyze, and they illustrate
the principles and considerations that apply to portfolio of many assets. It
makes sense to think about a two-asset portfolio as an asset allocation decision,
and so we consider a portfolio comprised of two mutual funds, a bond portfolio
specializing in long-term debt securities, denoted D, and a stock fund that
specialized in equity securities, E. The rate of return on this portfolio, rp, will
be:

rP  wD rD  wE rE , 7.1

where rd is the rate of return on the bond fund and re is the rate of return on the
equity fund; w is the proportion invested in the bond fund and (1 – w) is the
proportion invested in the equity fund.

The expected return on the portfolio is the weighted average of expected returns
on the component securities with portfolio proportions (w) as weights:

E(rP )  wD E(rD )  wE E(rE )

7.2
The variance of the two-asset portfolio is:

σ P2  wD2 σ D2  wE2 σ E2  2wD wE Cov(rD , rE ) 7.3

To understand the formula for the portfolio variance, recall that the covariance of
a variable with itself is the variance of that variable, that is:

Cov(rD , rD )   Pr(scenario)[rD  E(rD )][rD  E(rD )]

s

Cov(rD , rD )   Pr(scenario)[rD  E(rD )] 2

s

Cov(rD ,rD )  σ D2 7.4

Therefore, another way to express the variance of the portfolio is:

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 σ P2  wD wD Cov(rD , rD )  wE wE Cov(rE , rE )  2wD wE Cov(rD , rE ) 7.5

Table 7.2 in the textbook shows how the portfolio variance can be calculated
from a spreadsheet. Panel A of the table shows the bordered covariance matrix of
the returns of the two mutual funds. This is the covariance matrix with the
portfolio weights for each fund placed on the borders, that is, along the first raw
and column of the matrix. To find the portfolio variance, multiply each element
of the covariance matrix by the pair of portfolio weights in its row and column
border. Add up the resultant terms, and you have the formula for portfolio
variance given in Equation 7.5.

We perform these calculations in Panel B, which is the border-multiplied

covariance matrix. Each covariance has been multiplied by the weights from the
row and the column in the borders. This procedure works because the covariance
matrix is symmetric around the diagonal, that is Cov(rD , rE )  Cov(rE , rD ) . Thus,
each covariance term appears twice.

Equation 7.3 reveals that portfolio variance is reduced if the covariance term is
negative. It is important to recognize that even if the covariance term is positive,
the portfolio standard deviation still is less than the weighted average of the
individual security standard deviations, unless the two securities are perfectly
positively correlated. To see this, notice that the covariance can be computed
from the correlation coefficient as:

Cov(rD , rD )   DE σ D σ E 7.6

Therefore,

σ P2  wD2 σ D2  wE2 σ E2  2wD wE σ D σ E  DE 7.7

Other things equal, portfolio variance is higher when the correlation coefficient
is higher. In the case of perfect positive correlation, that is, DE = 1, the right-
hand side of the above equation is a perfect square and simplifies to”
σ P2  (wD σ D  wE σ E ) 2  σ P  wD σ D  wE σ E 7.8

Therefore, 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.
Therefore, other things equal, we will always prefer to add to our portfolio
assets with low or, even better, negative correlation with our existing position.

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Because the portfolio's 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 risk-return opportunities than
the individual component securities on their own. The lower the correlation
between the assets, the greater is the gain in efficiency.

How low can portfolio standard deviation be? The lowest possible value of the
correlation coefficient is -1, representing perfect negative correlation. In this
case, Euation 7.7 simplifies to:

σ P2  (wD σ D  wE σ E )2  σ P  wD σ D  wE σ E 7.9

When  = -1, a perfectly hedged position can be obtained by choosing the

portfolio proportions to solve for

wD σ D  wE σ E  0 7.10

The solution to this equation is

σE σD
wD  , wE   1  wD 7.11
σD  σE σD  σE

These weights drive the standard deviation of the portfolio to zero. We can
experiment with different portfolio proportions to observe the effect on portfolio
expected return and variance. Suppose we change the proportions invested in
bonds. The effect on expected return is tabulated in Table 7.3 and plotted in
Figure 7.3. When the proportion invested in debt varies from zero to 1 (so that
the proportion in equity varies from 1 to zero), the portfolio expected return
goes from 13% to 8%.

What happens when wD > 1 and wE < 0? In this case portfolio strategy would be
to sell the equity fund short and invests the proceeds of the short sale in the debt
fund. This will decrease the expected return of the portfolio. For example, when
wD = 2 and wE = -1, the value of the bond fund in the portfolio is twice the net
worth of the account. This extreme position is financed in part by short selling
stocks equal in value to the portfolio’s net worth. The reverse happens when wD
< 0 and wE > 1. This strategy calls for selling the bond funds short and using the
proceeds to finance additional purchase of the equity fund.

Of course, varying investment proportions also has an effect on portfolio

standard deviation. Table 7.3 in the textbook presents portfolio standard
deviations for different portfolio weights, calculates from equation 7.7, using the
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assumed value of the correlation coefficient (0.30), as well as other values of .
Figure 7.4 shows the relationship between standard deviation and portfolio
weights. The graph shows that as the portfolio weight in the equity fund
increases from zero to 1, portfolio standard deviation first falls with the initial
diversification from bonds into stocks, but then rises again as the portfolio
becomes heavily concentrated in stocks, and again is undiversified (see the solid
curve for  = 0.30 on Figure 7.4). (For a pair of assets with a large positive correlation
of returns, the portfolio standard deviation will increase monotonically from the low-risk asset
to the high-risk asset. Even in this case, however, there is a positive (if small) value from
diversification.)

What is the minimum level to which portfolio standard deviation can be held?
The portfolio weights that solve this minimization problem can be found using
the following formulas:

σ E2  Cov(rD , rE )
wMin (D)  2 ,
σ D  σ E2  2Cov(rD , rE )
wMin (E)  1  wMin (D) 7.12

Note that the minimum-variance portfolio in Fig.7.4 has a standard deviation

smaller than that of either of the individual components assets. This illustrates
the effect of diversification (see the solid colored line for  = 0.30.) The other
three lines in Figure 7.4 show how portfolio risk varies for other values of the
correlation coefficient, holding the variances of each asset constant. The
triangular broken line illustrates the perfect hedge potential when the two assets
are perfectly negatively correlated ( = -1.0).

We can combine Figures 7.3 and 7.4 to demonstrate the relationship between
portfolio risk (standard deviation) and expected return – given the parameters of
the available assets. This is done in Figure 7.5 in the textbook. For any pair of
investment proportions (wD and wE) we read the expected return from Figure 7.3
and the standard deviation from Figure 7.4.

The solid colored curve in Figure 7.5 shows the portfolio opportunity set for ρ
= 0.30 We call it the portfolio opportunity set because it shows all combinations
of portfolio expected return and standard deviation that can be constructed
from the two available assets. The other lines show the portfolio opportunity set
for other values of the correlation coefficient. The solid “black” line connecting
the undiversified portfolios of all stocks and all bonds shows that there is no
benefit from diversification when the correlation between the two assets is
positive (ρ = 1). The dashed colored line demonstrates the greater benefit from
diversification when ρ < 0.30. Finally, for ρ = -1, the portfolio opportunity set is
linear, but now it offers a perfect hedging opportunity and the maximum
advantage from diversification.
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To summarize, although the expected return of any portfolio is simply the
weighted average of the asset expected returns, this is not true of the standard
deviation. Potential benefits from diversification arise when correlation is less
than perfectly positive. The lower the correlation, the greater the potential
benefit from diversification. In the extreme case of perfect negative correlation,
we have a perfect hedging opportunity and can construct a zero-variance
portfolio. (Investors may desire different portfolios that lie on investment opportunity set.
These preferences mean that we can compare portfolios using a mean-variance criterion in
the following way: Portfolio A is said to dominate portfolio B if all investors prefer A over B.
This will be the case if it has higher returns and lower variance.)

7.3 ASSET ALLOCATION WITH STOCKS, BONDS AND BILLS

In the last section we derived the properties of portfolios formed by mixing two
risky assets. Given this background, we now reintroduce the choice of the
third, risk-free, portfolio. This will allow us to complete the basic problem of
asset allocation across three key asset classes: stocks, bonds, and risk-free
money market securities.

1. The Optimal Portfolio with Two Risky Assets and a Risk-Free Asset

What if our two risky assets (A and B) are still confined to the bond and stock
funds, but now we can also invest in risk-free T-bills yielding 5%? We start
with a graphical solution (see Figure 7.6 in the textbook). Two possible capital
allocation lines (CALs) are drawn from the risk-free rate (rf = 5%) to the two
feasible portfolios. The first possible CAL is drawn through the minimum-
variance portfolio A, which is invested 82% in bonds and 18% in stocks.
Portfolios A’s expected return is 8.90%and its standard deviation is 11.45%
(see Table 7.3, button panel). Now consider the CAL that uses portfolio B
instead of A. Portfolio B invests 70% in bonds and 30% in stocks. Its expected
return is 9.5%and its standard deviation is 11.70%.

With a T-bill rate of 5%, the reward-to-volatility (Sharpe) ratio, which is the
slope of the CAL combining T-bills and the minimum-variance portfolio A or
portfolio B, is:

E(rA )  r f E(rB )  r f
SA   0.34 , SB   0.38
σA σB

In this case portfolio B dominates A as the reward-to-volatility ratio on the

CAL that is supported by portfolio B is higher that the reward-to-volatility ratio
of the CAL that we obtained using portfolio A. But why stop at portfolio B?
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We can continue to ratchet the CAL upward until it ultimately reaches the
point of tangency with the investment opportunity set. This must yield the
CAL with the highest feasible reward-to-volatility ratio. Therefore, the tangency
portfolio, labeled P in Figure 7.7 in the textbook, is the optimal risky portfolio
to mix with T-bills. We can read the expected return and standard deviation of
Portfolio P (the “optimal”) from the graph in Figure 7.7.

In practice, when we try to construct optimal risky portfolios from more than
two risky assets we need to rely on a spreadsheet or another computer program.
To start, however, we will demonstrate the solution of the portfolio construction
problem with only two risky assets (in our example, long-term debt and equity)
and a risk-free asset. In this simpler two-asset case, we can derive an explicit
formula for the weights of each asset in the optimal portfolio. This will make it
easy to illustrate some of the general issues pertaining to portfolio optimization.

The objective is to find the weights wD and wE that result in the highest slope of
the CAL, i.e. the weights that result in the risky portfolio with the highest
reward-to-volatility ratio. Therefore, the objective is to maximize the slope of
the CAL for any possible portfolio, p. Thus our objective function is the slope
(equivalently, the Sharp ratio) that we will call Sp:

E(rP )  r f
SP 
σP

When we maximize the objective function, Sp, we have to satisfy the

constraint that the portfolio weights sum to 1.0 (100%), that is, wD + w E =
1. Therefore, we solve an optimization problem formally written as:
E(rP )  r f
Max S P  , 7.13
Wi
σP

subject to Σwi = 1. This is a maximization problem that can be solved

using standard tools of calculus. In the case of two risky assets, the
solution for the weights of the optimal risky portfolio, P, is given by
Equation 7.14. Notice that the formula in the textbook (7.13) employs
excess rates of returns (denoted R) rather than the total returns (denoted
r).

[E(rD )  rf ]σ E2  [E(rE )  r f ]Cov(rD ,rE )

wD 
[E(rD )  r f ]σ E2  [E(rE )  rf ]σ D2  [E(rD )  rf  E(rE )  rf ]Cov(rD ,rE )

wE  1  wD 7.14

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The expected return and standard deviation of this optimal risky portfolio is:

E(rp )  wD E(rD )  wE E(rE ) ,

σ P  [ wD2 σ D2  wE2 σ E2  2wD wE Cov(rD , rE )] 1/2 7.15

E(rP )  r f
Then, the CAL of this optimal portfolio has a slope of: S P  σP
, which
is the reward-to-volatility (Sharpe) ratio of portfolio P.

In the previous chapter we found the optimal complete portfolio given an

optimal risky portfolio and the CAL, generated by a combination of this
portfolio and T-bills. Now that we have constructed the optimal risky
portfolio, P, we can use the individual investor’s degree of risk aversion, A,
to calculate the optimal proportion of the complete portfolio to invest in the
risky component. An investor with a coefficient of risk aversion A would
take a position in portfolio P of:

E(rP )  r f
y 7.16
Aσ P2

Portfolio P consists of 40% invested in bonds and 60% in stocks. So, we can
find the fraction of wealth in bonds and in stocks for our portfolio (see
Example 7.3 in the textbook.)

Once we have reached this point, generalizing to the case of many risky
assets is straightforward. Before moving on, recall that our two risky assets,
the bond and stock mutual funds, are already diversified portfolios. The
diversification within each of these portfolios must be credited for a good
deal of the risk reduction compared to undiversified single securities. For
example , the standard deviation of the rate of return on an average stock
is about 50% (see Figure 7.2). In contrast, the standard deviation of our
stock-index fund is only 20%, about equal to the historical standard deviation
of the S&P 500 portfolio. This is evidence of the importance of diversification
within the asset class.

Optimizing the asset allocation between bonds and stocks contributed

incrementally to the improvement in the reward-to-volatility ratio of the
complete portfolio. The CAL using the optimal combination of stocks and bonds
(see Figure 7.8) shows that one can achieve an expected return of 13%
(matching that of the stock portofolio) with a standard deviation of 18%, which
is less than the 20% standard deviation of the stock portfolio.

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7.4 THE MARKOWITZ PORTOFLIO SELECTION MODEL

1. Security Selection

Now, we can generalize the portfolio construction problem to the case of

many securities and a risk-free asset. As in the two risky assets example, the
problem has three parts. First, we identify the risk-return combinations
available from the set of risky assets. Next, we identify the optimal portfolio
of risky assets by funding the portfolio weights that result in the steepest
CAL. Finally, we choose an appropriate complete portfolio by mixing the
risk0free asset with the optimal risky portfolio.

The first step is to determine the risk-return opportunities available to the

investor. These are summarized by the minimum-variance frontier of risky
assets. This frontier is a graph of the lowest possible variance that can be
attained for a given portfolio’s expected return. Given the input data for
expected returns, variances, and covariances, we can calculate the minimum-
variance portfolio for any targeted expected return. The plot of these expected
return-standard deviation pairs is presented in Figure 7.10 in the textbook.

Notice that all the individual assets lie to the right inside the frontier, at least
when we allow for short sales in the construction of risky portfolios. This tells
us that risky portfolios comprising only a single asset are inefficient.
Diversifying investment leads to portfolios with higher expected returns and
lower standard deviations.

All the portfolios that lie on the minimum-variance frontier from the global
minimum-variance portfolio and upward, provide the best risk-return
combinations, and thus are candidates for the optimal portfolio. The part of
the frontier that lies above the global minimum-variance portfolio, therefore,
is called the efficient frontier of risky assets. For any portfolio on the lower
portion of the minimum-variance frontier, there is a portfolio with the same
standard deviation and a greater expected return positioned directly above it.
Hence the bottom part of the minimum-variance frontier is inefficient.

The second part of the optimization plan involves the risk-free asset. As before,
we search for the CAL with the highest reward-to-volatility ratio (that is, the
steepest slope) as shown in Figure 7.11 in the textbook. The CAL that is
supported by the optimal portfolio, P, is tangent to the efficient frontier. This
CAL dominates all alternative feasible lines (the broken lines that are drawn
through the frontier). Portfolio P, therefore, is the optimal risky portfolio.

Finally, in the last part of the problem the individual investor chooses the
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appropriate mix between the optimal risky portfolio P and T-bills, exactly as in
Figure 7.8 in the textbook.

Now let us consider each part of the portfolio construction problem in more
details. In the first part of the problem, risk-return analysis, the portfolio
manager needs as inputs a set of estimates for the expected returns of each
security, and a set of estimates for the covariance matrix.

For now, we will assume that analysts already have spent the time and resources to prepare the
inputs. Suppose that the horizon of the portfolio plan is one year. Therefore, all estimates
pertain to a one-year holding period return. Suppose our security analysis covers n securities.
As of now, time zero, we observed these securities prices, P01…P0n, and derived estimates for
their expected end-of-year prices, E(P11)…E(P1n), and the expected dividend for the periods,
E(D1)… E(Dn). The set of expected rates of return is then computed from:

E(Pi 1 )  Pi 0  E(Di )
HPR  E(ri ) 
Pi 0

The covariances among the rates of return on the analyzed securities (the covariance matrix)
usually are estimated from historical data. Another method is to use scenario analysis of
possible returns from all securities instead of, or as a supplement to, historical analysis.

The portfolio manager is now armed with the n estimates of E(ri) and the n  n
estimates of the covariance matrix in which the n diagonal elements are
estimates of the variances, σ2i , and the n2 - n = n(n - 1) off-diagonal elements
are the estimates of the covariances between each pair of asset returns. We know
that each covariance appears twice in the covariance matrix, so actually we have
n(n - 1)/2 different covariance estimates. If our portfolio management unit
covers 50 securities, our security analysts need to deliver 50 estimates of
expected returns, 50 estimates of variances, and (50  49)/2 = 1,225 different
estimates of covariances. This is a daunting task!

Once these estimates are compiled, the expected return and variance of any
risky portfolio with weights in each security, wi, can be calculated from the
bordered covariance matrix or, equivalently, from the following formulas:
n
E(rP )   wi E(ri ) 7.17
i 1

n n
σ P2    wi w j Cov( ri ,r j ) 7.18
i 1 j 1

We mentioned earlier that the idea of diversification is age-old. The phrase

“don’t put all your eggs in one basket” existed long before modern finance
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theory. It was not until 1952, however, that Harry Markowitz published a
formal model of portfolio selection embodying diversification principles,
thereby paving the way for his 1990 Nobel Prize In Economics. His model is
precisely step one of portfolio management: the identification of the efficient set
of portfolios, or, as it is often called, the efficient frontier of risky assets. The
principle idea behind the frontier set of risky portfolios is that, for any risk
level, we are interested only in that portfolio with the highest expected return.
Alternatively, the frontier is the set of portfolios that minimizes the variance
for any target expected return. Indeed the two methods of computing the
efficient set of risky portfolios are equivalent. To see this, consider the
graphical representation of these procedures. Figure 7.12 in the textbook
shows the minimum-variance frontier.

When this step is completed, we have a list of efficient portfolios, because the
solution to the optimization program includes the portfolio proportions, wi, the
expected return, E(rp), and the standard deviation, σp.

Let us restate what our portfolio manager has done so far. The estimates
generated by the first-step analysts were transformed into a set of expected rates
of return and a covariance matrix. This group of estimates we shall call the
input list. This input list is then fed into the optimization program. Before we
proceed to the second step of choosing the optimal risky portfolio from the
frontier set, let us consider a practical point. Various constraints may preclude a
particular investor from choosing portfolios on the efficient frontier. For
example, many institutions are prohibited from taking short positions in any
asset. For these clients the portfolio manager will add to the optimization
program constraints that rule out negative (short) positions in the search for
efficient portfolios. In this special case it is possible that single assets may be, in
and of themselves, efficient risky portfolios.

Short-sales restrictions are by no means the only such constraint. For example,
some clients may want to assure a minimum level of expected dividend yield
from the optimal portfolio. In this case, the input list will be expanded to
include a set of expected dividend yields and the optimization program will
include an additional constraint that ensure that the expected dividend yield of
the portfolio will equal or exceed the desired level.

In principal, portfolio managers can tailor the efficient set to conform to any
desire of the client. Of course, any constraint carries a price tag in sense that an
efficient frontier constructed subject to extra constraints will offer a reward-to-
volatility ratio inferior to that of a less constrained one. The client should be
made ware of this cost and should carefully consider constraints that are not
mandated by law.

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2. Capital Allocation and Separation Property

Now that we have the efficient frontier, we proceed to step two and introduce the
risk0free asset. Figure 7.13 in the textbook shows the efficient frontier plus three
CALs representing various portfolios from the efficient set. As before, we ratchet
up the CAL by selected different portfolios until we reach portfolio P, which is
the tangency point of a line from F to the efficient frontier. Portfolio P
maximizes the reward-to-volatility ratio, the slope of the line from F to portfolios
on the efficient frontier. At this point our portfolio manager is done. Portfolio P
is the optimal risky portfolio for the manger’s clients.

The most striking conclusion of our analysis is that a portfolio manager will offer
the same risky portfolio, P, to all clients regardless of their degree of risk
aversion. The degree of risk aversion of the client comes into play only in the
selection of the desired point along the CAL. Thus the only difference between
clients' choices is that the more risk-averse client will invest more in the risk-
free asset and less in the optimal risky portfolio than will a less risk-averse client.
However, both will use portfolio P as their optimal risky investment vehicle

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This result is called a separation property, introduced by Nobel laureate James
Tobin (1958); it tells us that the portfolio choice problem may be separated into
two independent tasks. The first task, determination of the optimal risky
portfolio, is purely technical. Given the manager's input list, the best risky
portfolio is the same for all clients, regardless of risk aversion. The second task,
however, allocation of the complete portfolio to T-bills versus the risky
portfolio, depends on personal preference. Here the client is the decision maker.

In practice, however, different managers will estimate different input lists, thus
deriving different efficient frontiers, and offer different “optimal” portfolios to
their clients. The source of the disparity lies in the security analysis. It is worth
mentioning here that the universal rule of GIGO (garbage in-garbage out) also
applies ton security analysis. If the quality of the security analysis is poor, a
passive portfolio such as a market index fund will result in a better CAL than
an active portfolio that uses low-quality security analysis to tilt portfolio
weights toward seemingly favorable (mispriced) securities.

One particular input list that would lead to a worthless estimate of the efficient frontier is
based on recent security average returns. If sample average returns over recent years are
used as proxies for the true expected returns on the security, the noise in these estimates will
make he resultant efficient frontier virtually useless for portfolio construction.

As we have seen, optimal risky portfolios for different clients may also very
because of portfolio constraints such as dividend-yield requirements, tax
consideration, or other client preferences. Nevertheless, this analysis suggests
that a limited number of portfolios may be sufficient to serve the demand of a
wide range of investors. This is the theoretical basis of the mutual fund
industry.

3. Optimal Portfolios with Restrictions on the Risk-Free Assets

The availability of a risk-free asset greatly simplifies the portfolio decision.

When all investors can borrow and lend at that risk-free rate, we are led to a
unique optimal risky portfolio that is appropriate for all investors given a
common input list. This portfolio maximizes the reward-to-variability ratio. All
investors use the same risky portfolio and differ only in the proportion they
invest in this portfolio versus in the risk-free asset.

What if a risk-free asset is not available? Although T-bills are risk-free assets in
nominal terms, their real returns are uncertain. Without a risk-free asset, there is
no tangency portfolio that is best for all investors. In this case investors have to
choose a portfolio from the efficient frontier of risky assets (see the additional
hand-out). Each investor will now choose an optimal risky portfolio by
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superimposing a personal set of indifference curves on the efficient frontier.
An investor with indifference curves marketed U1, U2, and U3, will choose
portfolio P. More risk-averse investor with steeper indifference curves will
choose portfolios with lower means and smaller standard deviations such as
portfolio A, while more risk-tolerance investors will choose portfolios with
higher means and greater risk, such a portfolio B. The common feature of these
investors is that each chooses portfolios on the efficient frontier (portfolios P,
A and B).

Even if virtually risk-free lending opportunities are available, many investors

do face borrowing restrictions. They may be unable to borrow altogether, or,
more realistically, they may face a borrowing rate that is significantly greater
that the lending rate. In more realistic scenarios, individuals who wish to
borrow to invest in a risky portfolio will have to pay an interest rate higher than
the T-bill rate. For example, the call money rate charged by brokers on margin
account is higher that the T-bills rate.

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