Security Analysis and

Portfolio Management
Markowitz Portfolio Optimization Model
Objectives

Last class we discussed how to combine two risky assets with one
risk-free asset.

In this class:
Generalize to the case of multiple risky assets and one risk-free asset

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Markowitz Portfolio Optimization Model

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 finding the portfolio
weights that result in the steepest CAL.
Finally, we choose an appropriate complete portfolio by mixing the risk-free
asset with the optimal risky portfolio.

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Multiple Risky Assets
We first need to study the expected return and standard deviation of a
portfolio of multiple risky securities (numbered as i
denote the portfolio weight in risky security . Then:

The calculation of portfolio variance is best explained by a bordered

covariance matrix.

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Two Risky Assets Case (Last class)

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Multiple Security Case
When n = 3, then

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Multiple Security Case
We know that each covariance appears twice in this table, so actually we

If our portfolio management unit covers n=50 securities, our security

analysts need to deliver 50 estimates of expected returns, 50 estimates of
variances, and 50 49/2 = 1,225 covariances.

This is a daunting task! However, this is just feasibility; we also need to

study the optimality.
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Efficient Frontier of Risky Assets
The idea of diversification is age-old.

It was not until 1952 that Harry Markowitz published a formal model of
portfolio selection embodying principles of efficient diversification.
The principal idea behind the frontier set of risky portfolios is that, for any risk level,
we are interested only in the portfolio with the highest expected return.

Alternatively, the minimum-variance frontier is the set of portfolios that minimizes

the variance for any target expected return.

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Minimum-Variance Frontier

P
highest off

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Efficient Portfolio Set

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Capital Allocation Lines

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Tangency Portfolio with Excel
Download the Solver Example file from Canvas and load Excel solver
https://support.office.com/en-us/article/load-the-solver-add-in-in-excel-612926fc-d53b-46b4-
872c-e24772f078ca

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Review: Mean-variance Efficiency
We have learned how an investor chooses the optimal portfolio

Generally, the investor decides what actions to take through a three-

step process
What is desirable?
What is feasible?
The investor chooses the most desirable from among the feasible alternatives.

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Review: Mean-variance Efficiency

What is desirable?

We assume that investor thinks only for the next period. The investor likes

high expected return but dislikes high volatility.

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Review: Mean-variance Efficiency

What is feasible?
We analyze the feasibility in different scenarios
1. One risky asset and one risk-free asset

2. Two risky assets

3. Two risky assets and one risk-free asset

4. Many risky assets

5. Many risky assets and one risk-free asset

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Review: Mean-variance Efficiency
1. One risky asset and one risk-free asset
The blue lines are feasible

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Review: Mean-variance Efficiency
1. One risky asset and one risk-free asset
Investors only care about the solid blue line

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Review: Mean-variance Efficiency
1. One risky asset and one risk-free asset
Optimal choices for investors with different risk aversion
E(rc) A=4
A=5
CAL

E(rp) = 15%
E(rc) = 13.64% P

E(rc) = 9.64%
rf = 7%

0
sc= 7.26% sc = 18.26% sp = 22% sc
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(y = 0.33) (y = 0.41) (y=1)
Review: Mean-variance Efficiency
2. Two risky assets
The correlation ( ) determines the diversification benefit

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Review: Mean-variance Efficiency
2. Two risky assets: diversification
Investors care about combinations above the minimum variance portfolio

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Review: Mean-variance Efficiency
2. Two risky assets
Optimal choice for the investor
At the optimal (tangency) portfolio, the marginal rate of substitution of the
green line equals the technical rate of substitution of the blue line.
Indifference Curve
E(r)

E(rC) C

Optimal Portfolio
A
Minimum Variance Portfolio

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sC s
Review: Mean-variance Efficiency
3. Two risky assets and one risk-free asset
All the points on the blue lines (CALs) are possible
CAL (P)
E(r)
E(rP) P

Tangency portfolio
B
E(rA) = 8.9%
A (Minimum Variance Portfolio)

rf=5%

sA =11.45% sP s 22
Review: Mean-variance Efficiency
3. Two risky assets and one risk-free asset
Investors care about the CAL with the steepest slope.

CAL (P)
E(r)
E(rP) P

Tangency portfolio

rf=5%

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sP s
Review: Mean-variance Efficiency
3. Two risky assets and one risk-free asset
Optimal choices for investors with different risk aversion
U(r) with A=4

CAL (P)
E(r)
E(rP) P

U(r) with A=5

Tangency portfolio

rf

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sP
Review: Mean-variance Efficiency
4. Many risky assets
For a given level of expected returns, we look for the portfolio with the lowest
volatility. The collection of these portfolios forms the minimum variance
frontier.
Points to the east (i.e., right) of the minimum variance frontier are feasible.

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Review: Mean-variance Efficiency
4. Many risky assets
Investors only care about the minimum variance portfolios north of the global
minimum variance portfolio (the solid blue line).

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Review: Mean-variance Efficiency
5. Many risky assets and one risk-free asset
Points on CALs are feasible (similar to the two risky one risk-free case)

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Review: Mean-variance Efficiency
5. Many risky assets and one risk-free asset
Investors only care about the CAL with the steepest slope (again, similar to the
two risky one risk-free case).
CAL (P)

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Review: Mean-variance Efficiency
5. Many risky assets and one risk-free asset
Optimal choices for investors with different risk aversion (again, similar to the
two risky one risk-free case).
U(r) with A=4
E(r) CAL (P)
E(rP) P

U(r) with A=5

Tangency portfolio

rf

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sP s
Separation Property
An interesting result from modern portfolio theory is known as the
Separation Property.
Suppose an investment advisor has multiple clients with different
levels of risk aversions. In absence of the risk-free security, the advisor
will recommend different combinations of risky securities to different
clients.
But in presence of the risk-free security, the advisor will recommend
the same combination of risky securities to all clients.

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No Risk-free Asset
In absence of the risk-free security, the optimal portfolio will be
different for investors with different risk preferences.
E(r)

C (Less risk-

B (More risk-

G (Global minimum variance portfolio)

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With Risk-free Asset: Two-fund Separation
E(r) Indifference Curve CAL

Y (Less risk-

E(rP) P (Tangency portfolio)

X (More risk-

G (Global minimum variance portfolio)

rf

w (risky asset)
<0 0 1.0 >1. P
>1. 1.0 0 0
<0
1-wP (riskfree asset) 32
0
Two-fund Separation

Portfolio choice problem may be separated into two independent

tasks.
The first task is to determine the optimal risky portfolio, which is purely
technical. The best risky portfolio is the same for all clients regardless of risk
aversion.

The second task, capital allocation, depends on personal preference.

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Two-fund Separation
Investors with varying degrees of risk aversion would be satisfied with a universe of only
two mutual funds
a money market fund for risk-free investments
a mutual fund that holds the optimal risky portfolio P

Investors only care about expected return and volatility of the portfolio over the next period
Investors share the same estimates of expected return (N elements) as well as the variance-
covariance matrix (N(N+1)/2 estimates, with N~6000)

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Systematic vs. Unsystematic Risk
A portfolio can contain many assets, and it allows an investor to become
diversified.
Most risky securities, such as stocks and bonds, have two components of risk:
General economic uncertainty
Business cycle, inflation rate, interest rate, exchange rate, etc.
Affect all firms in the economy, cannot be diversified away
Nondiversifiable risk, systematic risk, or market risk
Firm-specific uncertainty
Sales growth, R&D, relative performance, etc.
Peculiar to the firm, and can be eliminated by diversification in a portfolio
Diversifiable risk, unsystematic risk, or idiosyncratic risk

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Portfolio Risk and Number of Securities
The figures show how the unsystematic risk declines as the number of
securities held in a portfolio increases.

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Portfolio Diversification

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Concept Exercise
Which statement about portfolio diversification is correct?
a) Proper diversification can reduce or eliminate systematic risk.
b)

c) As more securities are added to a portfolio, total risk typically can be expected to
fall at a decreasing rate.
d) The risk-reducing benefits of diversification do not occur meaningfully until at least
30 individual securities are included in the portfolio.

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Concept Exercise -- Answer
Which statement about portfolio diversification is correct?
a) Proper diversification can reduce or eliminate systematic risk.
b)

c) As more securities are added to a portfolio, total risk typically can be expected to
fall at a decreasing rate.
d) The risk-reducing benefits of diversification do not occur meaningfully until at least
30 individual securities are included in the portfolio.

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Concept Exercise

The correlation coefficients between several pairs of stocks are as

follows: Corr(A, B) = .85; Corr(A, C) = .60; Corr(A, D) = .45. Each
stock has an expected return of 8% and a standard deviation of 20%.
If your entire portfolio is now composed of stock A and you can add some of
only one stock to your portfolio, which one would you choose?

Would the answer change for more risk-averse or risk-tolerant investors?

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Concept Exercise -- Answer
The correct choice is Stock D. Intuitively, we note that since all stocks
have the same expected rate of return and standard deviation, we
choose the stock that will result in lowest risk. This is the stock that
has the lowest correlation with Stock A.
The answer would not change, as long as investors are not risk lovers.
Risk neutral investors would not care which portfolio they held since
all portfolios have an expected return of 8%.

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Exercise: Abigail Grace
Abigail Grace has a $900,000 fully diversified portfolio. She subsequently
inherits ABC Company common stock worth $100,000. Her financial
adviser provided her with the following forecast information:

The correlation coefficient of ABC stock returns with the original portfolio
returns is .40.
Should Grace keep the ABC stock if she wants to keep an optimal portfolio?

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