Financial Economics and

Investments, Spring 25
Topic 5b

The Markowitz Portfolio

Optimization Model
 Contents
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
– Minium-Variance Portfolio
– Portfolio Opportunity Set
3. Asset Allocation with a Risky Portfolio and a Risk-Free Asset
4. The Markowitz Portfolio Optimization Model
5. The Power of Diversification
 Asset Allocation with a Risky Portfolio and a Risk-
Free Asset
• In principle, asset allocation and security selection are
technically identical; both aim at identifying the optimal risky
portfolio, specifically, the combination of risky assets that
provides the best risk–return trade-off or, equivalently, the
highest Sharpe ratio.
𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 =
𝑆𝐷 𝑜𝑓 𝑒𝑥𝑐𝑒𝑠𝑠 𝑟𝑒𝑡𝑢𝑟𝑛
– The higher the Sharpe ratio, the greater the expected return
corresponding to any level of volatility.
– Steeper CALs provide greater rewards for bearing any level of risk
 Asset Allocation with a Risky Portfolio and a Risk-
Free Asset
Consider two mutual funds, a bond portfolio specializing in long-term debt
securities, denoted as 𝐷, and a stock fund that specializes in equity securities, 𝐸.
We can now also invest in risk-free T-bills, denoted as 𝐹, yielding 5%.
1. Solve for the optimal risky portfolio to mix with the risk-free asset.
2. Assume borrowing is allowed at the risk-free rate and there is no margin
requirement. Determine the optimal complete portfolio for an investor with
utility function is 𝑈 = 𝐸[𝑟] − ½ 𝐴𝜎 2 with 𝐴 = 4.
The portfolio opportunity
set shows all combinations
of portfolio expected return
and standard deviation that
can be constructed from the
two available assets.

• 𝜌 < 1: “pushed” to the

northwest
Figure 6.3 shows the
capital allocation line
(CAL), the set of feasible
expected return and
standard deviation pairs
of all portfolios resulting
from different values of 𝛼.
• The graph is a straight
line originating at point
𝐹 (𝑟𝑓 ) and going
through the point 𝑃
(risky portfolio)
• The slope of the CAL
equals the Sharpe ratio
(reward-to-volatility
ratio)
• For the minimum-variance portfolio
𝐴
– CAL(𝐴) is drawn through portfolio 𝐴
and risk-free asset 𝐹
8.9−5
– 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = = 0.34
11.45

• For a portfolio 𝐵 invests 70% in

bonds and 30% in stocks
– CAL(𝐵) is drawn through portfolio 𝐵
and risk-free asset 𝐹
9.5−5
– 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 = = 0.38
11.7

• 𝐵 dominates 𝐴
• CAL(𝐵) provides a higher expected
return than CAL(𝐴) for any level of
standard deviation
Steeper CALs
provide greater
rewards for
bearing any level
of risk
• The tangency
portfolio,
labeled 𝑃 in
Figure 7.7, is
the optimal
risky portfolio
to mix with the
risk-free asset.
 Asset Allocation with a Risky Portfolio and a Risk-
Free Asset
• Solve an optimization problem
𝐸 𝑟𝑝 − 𝑟𝑓
max 𝑆ℎ𝑎𝑟𝑝𝑒 𝑅𝑎𝑡𝑖𝑜𝑝 =
𝑤𝑖 𝜎𝑝
– subject to 𝑤𝐷 + 𝑤𝐸 = 1

• The weights of the optimal risky portfolio, 𝑃, are

𝐸 𝑅𝐷 𝜎𝐸2 − 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )
𝑤𝐷 =
𝐸 𝑅𝐷 𝜎𝐸2 + 𝐸 𝑅𝐸 𝜎𝐷2 − 𝐸 𝑅𝐷 + 𝐸 𝑅𝐸 𝐶𝑜𝑣(𝑅𝐷 , 𝑅𝐸 )

– where 𝐸 𝑅𝐷 = 𝐸[𝑟𝐷 − 𝑟𝑓 ] and 𝐸 𝑅𝐸 = 𝐸[𝑟𝐸 − 𝑟𝑓 ] are the excess returns

 𝑈 = 𝐸[𝑟] − ½ 𝐴𝜎 2

Assume borrowing is
allowed at the risk-free
rate and there is no
margin requirement.
• Identify the highest
possible indifference
curve that still touches
the CAL.
• The tangency point
corresponds to the
complete portfolio that
maximizes utility.
• The individual investor
chooses the
appropriate mix
between the optimal
risky portfolio 𝑃 and a
risk-free asset, exactly
as in Figure 7.8.
• Optimal complete
portfolio: 𝐶
– the highest possible
indifference curve
that still touches the
CAL
 Contents
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
– Minium-Variance Portfolio
– Portfolio Opportunity Set
3. Asset Allocation with a Risky Portfolio and a Risk-Free Asset
4. The Markowitz Portfolio Optimization Model
5. The Power of Diversification
 The Markowitz Portfolio Optimization Model
As in the two risky assets example, the problem has three steps. We
can now generalize the portfolio construction problem to the case of
many risky securities and a risk-free asset.

1. Step I: we identify the risk–return combinations available from

the set of risky assets.
2. Step II: we identify the optimal portfolio of risky assets by finding
the portfolio weights that result in the steepest CAL.
3. Step III: we choose an appropriate complete portfolio by mixing
the risk-free asset with the optimal risky portfolio.
 Markowitz Mean Variance Analysis
The estimates generated by the security
Single-Period Analysis
• 𝑛 risky assets: 𝑖 = 1,2, … , 𝑛
analysts were transformed into a set of
• Single-period returns: 𝑛-variate random vector
expected rates of return and a
𝑟1 covariance matrix. These estimates are
𝒓= ⋮ the input list
𝑟𝑛 • The portfolio manager is now armed
Mean and Variance/Covariance of Returns:
with
𝜇1 Σ1,1 … Σ1,𝑛
𝐸 𝒓 = 𝝁 = ⋮ , 𝐶𝑜𝑣 𝑟 = 𝚺 = ⋮
1. the 𝑛 estimates of 𝐸 𝒓 and
𝜇𝑛 Σ𝑛,1 … Σ𝑛,𝑛 2. the 𝑛 × 𝑛 estimates of the
• Portfolio: 𝑛-vector of weights indicating the fraction of portfolio wealth held in covariance matrix 𝚺 in which
each asset – the 𝑛 diagonal elements are
𝑛
𝒘′ = 𝑤1 , 𝑤2 , … , 𝑤𝑛 : ෍ 𝑤𝑖 = 1 estimates of the variances 𝜎𝑖2 and
𝑖=1 the 𝑛2 − 𝑛 = 𝑛(𝑛 − 1) off-
• Portfolio return: 𝑟𝑃 = 𝒘′ 𝒓 = σ𝑛𝑖=1 𝑤𝑖 𝑟𝑖 with diagonal elements are the
𝑛
𝜇𝑝 = 𝐸 𝑟𝑝 = ෍ 𝑤𝑖 𝐸[𝑟𝑖 ] = 𝒘′ 𝝁 estimates of the covariances
𝑛
𝑖=1
𝑛 between each pair of asset
𝜎𝑝2 = 𝑉𝑎𝑟 𝑟𝑝 = ෍ ෍ 𝑤𝑖 𝑤𝑗 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 ) = 𝒘′𝚺𝒘 returns.
𝑖=1 𝑗=1
– 𝑛(𝑛 − 1)/2 different covariance
estimates
 Markowitz Mean Variance Analysis:
Efficient Frontier
• Evaluate different portfolios 𝒘 using the mean-variance pair of the portfolio: (𝜇𝑝 , 𝜎𝑝2 ) with
preferences for higher expected returns 𝜇𝑝 and lower variance 𝜎𝑝2
– Risk minimization

• For a given choice of target mean return 𝜇0 , choose the portfolio 𝒘 to

1
𝑚𝑖𝑛𝑖𝑚𝑖𝑧𝑒 𝒘′𝚺𝒘
2
′
𝑠𝑢𝑏𝑗𝑒𝑐𝑡 𝑡𝑜 𝒘 𝝁 = 𝜇0 𝑎𝑛𝑑 𝒘′𝟏𝑛 = 1
where 𝟏𝑛 = (1,1, … , 1)′ is a 𝑛-dimensional vector of 1s.

Apply the method of Lagrange multipliers to the convex optimization (minimization) problem
subject to linear constraints:
https://sites.math.washington.edu/~burke/crs/408/fin-proj/mark1.pdf

• https://sites.math.washington.edu/~burke/crs/408/fin-proj/mark1.pdf
 Markowitz Mean Variance Analysis:
Efficient Frontier
• Define the Lagrangian
1 ′
𝐿 = 𝒘, 𝜆1 , 𝜆2 = 𝒘 𝚺𝒘 + 𝜆1 𝜇0 − 𝒘′ 𝝁 + 𝜆2 (1 − 𝒘′𝟏𝑛 )
2
• Derive the FOCs
𝜕𝐿
= 𝚺𝒘 − 𝜆1 𝝁 − 𝜆2 𝟏𝒏 = 𝟎𝒏
𝜕𝒘
𝜕𝐿
= 𝜇0 − 𝒘′ 𝝁 = 0
𝜕𝜆1
𝜕𝐿
= 1 − 𝒘′𝟏𝑛 = 0
𝜕𝜆2
• Solve for 𝒘 in terms of 𝜆1 and 𝜆2
𝒘𝟎 = 𝜆1 𝚺 −1 𝝁 + 𝜆2 𝚺 −1 𝟏𝒏

Not required for the exam

 Markowitz Mean Variance Analysis:
Efficient Frontier
• Solve for 𝜆1 and 𝜆2 substituting for 𝒘
𝜇0 = 𝒘′𝟎 𝝁 = 𝜆1 𝝁′ 𝚺 −𝟏 𝝁 + 𝜆2 (𝝁′ 𝚺 −𝟏 𝟏𝒏 )
1 = 𝒘′𝟎 𝟏𝒏 = 𝜆1 𝝁′ 𝚺 −𝟏 𝟏𝒏 + 𝜆2 (𝟏′𝒏 𝚺 −𝟏 𝟏𝒏 )
• Therefore
𝜇0 𝝁′ 𝚺 −𝟏 𝝁 𝝁′ 𝚺 −𝟏 𝟏𝒏 𝜆1
= ′ −𝟏
1 𝝁 𝚺 𝟏𝒏 𝟏′𝒏 𝚺 −𝟏 𝟏𝒏 𝜆2
𝝁′ 𝚺 −𝟏 𝝁 𝝁′ 𝚺 −𝟏 𝟏𝒏 𝑎 𝑏
• Let ′ −𝟏 =
𝝁 𝚺 𝟏𝒏 𝟏′𝒏 𝚺 −𝟏 𝟏𝒏 𝑏 𝑐
−1
𝜆1 𝑎 𝑏 𝜇0
=
𝜆2 𝑏 𝑐 1
Not required for the exam
 Markowitz Mean Variance Analysis:
Efficient Frontier
Variance of optimal portfolio with return 𝜇0
• With the given values of 𝜆1 and 𝜆2 , the solution portfolio
𝒘𝟎 = 𝜆1 𝚺 −𝟏 𝝁 + 𝜆2 𝚺 −𝟏 𝟏𝒏
• has a minimum variance equal to
𝜎02 = 𝒘′𝟎 𝚺𝒘𝟎 = 𝜆12 𝝁′ 𝚺 −𝟏 𝝁 + 2𝜆1 𝜆2 𝝁′ 𝚺 −𝟏 𝟏𝒏 + 𝜆22 𝟏′𝒏 𝚺 −𝟏 𝟏𝒏
𝜆1 ′ 𝑎 𝑏 𝜆1 𝜇0 ′ 𝑎 𝑏 −1 𝜇0 1 2
= = = (𝑐𝜇0 − 2𝑏𝜇0 + 𝑎)
𝜆2 𝑏 𝑐 𝜆2 1 𝑏 𝑐 1 𝑎𝑐 − 𝑏 2
Not required for the exam

• Optimal portfolio has variance 𝜎02 : parabolic in the mean

• Efficient Frontier: { 𝜇0 , 𝜎02 |𝑤0 𝑜𝑝𝑡𝑖𝑚𝑎𝑙}
The step I 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 expected return.
• Given the input data for
expected returns, variances,
and covariances, we can
calculate the minimum-
variance portfolio consistent
with any targeted expected
return.
• 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.
• 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 portion of the
frontier that lies
above the global
minimum-variance
portfolio, therefore,
is called the efficient
frontier of risky
assets.
 Markowitz Mean Variance Analysis:
Efficient Frontier
• All the individual assets lie to the right inside the frontier, at least when we allow short sales
in the construction of risky portfolios.
– When short sales are prohibited, single securities may lie on the frontier. For example, the
security with the highest expected return must lie on the frontier, as that security represents the
only way that one can obtain a return that high, and so it must also be the minimum-variance
way to obtain that return.
• When short sales are feasible, however, portfolios can be constructed that offer the same
expected return and lower variance. These portfolios typically will have short positions in
low-expected-return securities.
– Many institutions are prohibited from taking short positions. For these clients, the portfolio
manager will add to the optimization program constraints that rule out negative (short) positions.
– In this special case, it is possible that single assets may be, in and of themselves, efficient risky
portfolios.
– For example, the asset with the highest expected return will be a frontier portfolio because,
without the opportunity of short sales, the only way to obtain that rate of return is to hold the
asset as one’s entire risky portfolio.
 Markowitz Mean Variance Analysis:
Efficient Frontier
• It was not until 1952, however, that Harry Markowitz published a formal
model of portfolio selection embodying principles of efficient
diversification, thereby paving the way for his 1990 Nobel Prize in
Economics.
• His model, now commonly called the Markowitz model, is precisely step
one of portfolio management: the identification of the efficient set of
portfolios, or the efficient frontier of risky assets.
• The principal 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.
• The frontier is the set of portfolios that minimizes variance for any target
expected return.
 The Markowitz Portfolio Optimization Model
As in the two risky assets example, the problem has three steps. We
can now generalize the portfolio construction problem to the case of
many risky securities and a risk-free asset.

1. Step I: we identify the risk–return combinations available from

the set of risky assets
2. Step II: we identify the optimal portfolio of risky assets by finding
the portfolio weights that result in the steepest CAL.
3. Step III: we choose an appropriate complete portfolio by mixing
the risk-free asset with the optimal risky portfolio.
The Step II of the
optimization plan involves
the risk-free asset.
• As before, we search for
the capital allocation
line with the highest
Sharpe ratio
– The steepest slope
• The CAL generated by
the optimal portfolio, 𝑃,
is the one tangent to
the efficient frontier.
 The Markowitz Portfolio Optimization Model
As in the two risky assets example, the problem has three steps. We
can now generalize the portfolio construction problem to the case of
many risky securities and a risk-free asset.

1. Step I: we identify the risk–return combinations available from

the set of risky assets.
2. Step II: we identify the optimal portfolio of risky assets by finding
the portfolio weights that result in the steepest CAL.
3. Step III: we choose an appropriate complete portfolio by mixing
the risk-free asset with the optimal risky portfolio.
 𝑈 = 𝐸[𝑟] − ½ 𝐴𝜎 2

Assume borrowing is
allowed at the risk-free
rate and there is no
margin requirement.
• Identify the highest
possible indifference
curve that still touches
the CAL.
• The tangency point
corresponds to the
complete portfolio that
maximizes utility.
• In the last part of the
problem, the
individual investor
chooses the
appropriate mix
between the optimal
risky portfolio 𝑃 and
a risk-free asset,
exactly as in Figure
7.8.
 The Markowitz Portfolio Optimization Model
Summarize the steps we followed to arrive at the complete portfolio 𝐶:
1. Specify the return characteristics of all securities (expected returns, variances,
covariances).
2. Establish the risky portfolio (asset allocation):
a. Calculate the optimal risky portfolio, 𝑃
• Determining the optimal 𝒘
b. Calculate the properties of portfolio 𝑃 using the weights determined in step (2-a)
3. Allocate funds between the risky portfolio and the risk-free asset (capital
allocation):
a. Calculate the fraction of the complete portfolio allocated to portfolio 𝑃 (the risky
portfolio) and to the risk-free asset
• Determining the optimal 𝛼
b. Calculate the share of the complete portfolio invested in each asset and in risk-free
asset.
Capital Allocation and the
Separation Property
• The program maximizes
the Sharpe ratio with no
constraint on expected
return or variance (we
use only the constraint
that portfolio weights
must sum to 1.0).
• Examination of Figure
7.13 shows that the
solution strategy is to find
the portfolio producing
the highest slope of the
CAL (Sharpe ratio)
regardless of expected
return or standard
deviation.
Capital Allocation and the Separation Property
• The most striking conclusion is that a portfolio manager will offer
the same risky portfolio, 𝑃, to all clients regardless of their degree
of risk aversion.
– The client’s risk aversion comes into play only in capital allocation, 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.
• This result is called a separation property; it tells us that the
portfolio choice problem may be separated into two independent
tasks.
Capital Allocation and the Separation Property
• 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.
• However, the second task, capital allocation, depends on personal
preference. Here the client is the decision maker.
– Clients who impose special restrictions (constraints) on the manager, such as
dividend yield, will obtain another optimal portfolio. Any constraint that is added
to an optimization problem leads, in general, to a different and inferior optimum
compared to an unconstrained program.
• The separation property was first noted by Nobel Laureate James Tobin,
“Liquidity Preference as Behavior toward Risk,” Review of Economic
Statistics 25 (February 1958), pp. 65–86.
Capital Allocation and the Separation Property
• This result makes professional management more efficient and hence less
costly. One management firm can serve any number of clients with
relatively small incremental administrative costs.
– Optimal risky portfolios for different clients also may vary because of portfolio
constraints such as dividend-yield requirements, tax considerations, or other
client preferences.
– This analysis suggests that a limited number of portfolios may be sufficient to
serve the demands of a wide range of investors. This is the theoretical basis of
the mutual fund industry.

• In practice, 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
 Portfolio Constraints
Some clients may be subject to additional constraints.
• For example, many institutions are prohibited from taking short positions.
– For these clients, the portfolio manager will add to the optimization program constraints that
rule out negative (short) positions.
– In this special case, it is possible that single assets may be, in and of themselves, efficient risky
portfolios.
– For example, the asset with the highest expected return will be a frontier portfolio because,
without the opportunity of short sales, the only way to obtain that rate of return is to hold the
asset as one’s entire risky portfolio.
• Some clients may demand a minimal dividend yield from the optimal portfolio.
• Another type of constraint is aimed at ruling out investments in industries or countries
considered ethically or politically undesirable.
– socially responsible investing, or SRI
• A similar orientation is called ESG (environmental, social, and governance-focused)
investing.
Not required for the exam
 Asset Allocation and Security Selection
• A large investment company is likely to invest both in domestic and
international markets and in a broad set of asset classes, each of which
requires specialized expertise.
• Hence, the management of each asset-class portfolio needs to be
decentralized, and it becomes impossible to simultaneously optimize the
entire organization’s risky portfolio in one stage, although this would be
prescribed as optimal on theoretical grounds.
• Typical practice is, to optimize the security selection of each asset-class
portfolio independently. At the same time, top management continually
updates the asset allocation of the organization, adjusting the investment
budget allotted to each asset-class portfolio.
 Contents
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
– Minium-Variance Portfolio
– Portfolio Opportunity Set
3. Asset Allocation with a Risky Portfolio and a Risk-Free Asset
4. The Markowitz Portfolio Optimization Model
5. The Power of Diversification
 The Power of Diversification
Consider the naïve diversification strategy in which an equally weighted portfolio is constructed,
meaning that 𝑤𝑖 = 1/𝑛 for each security.
• The variance of a risky portfolio composed of 𝑛 risky assets:
𝑛 𝑛 𝑛
2
1 2 1
𝜎𝑝 = 2 ෍ 𝜎𝑖 + ෍ ෍ 2 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )
𝑛 𝑛
𝑖=1 𝑗=1,𝑗≠𝑖 𝑖=1
• The average variance and average covariance of the risky assets:
1
𝜎𝑖2 = σ𝑛𝑖=1 𝜎𝑖2
𝑛
𝑛 𝑛
1 1
𝐶𝑜𝑣 = ෍ ෍ 2 𝐶𝑜𝑣(𝑟𝑖 , 𝑟𝑗 )
𝑛(𝑛 − 1) 𝑛
𝑗=1,𝑗≠𝑖 𝑖=1
• The variance of the risky portfolio:
1 2 𝑛−1
𝜎𝑝2 = 𝜎𝑖 + 𝐶𝑜𝑣
𝑛 𝑛
 The Power of Diversification
1 2 𝑛−1
𝜎𝑝2 = 𝜎𝑖 + 𝐶𝑜𝑣
𝑛 𝑛
1 2
• 𝜎𝑖 → 0 𝑎𝑠 𝑛 → ∞
𝑛
• 𝜎𝑝2 → 𝐶𝑜𝑣 𝑎𝑠 𝑛 → ∞
– We can think of this limit as the “systematic variance” of the security market.
– The correlation among security returns limits the power of diversification.
– When we hold diversified portfolios, the contribution to portfolio risk of a
particular security will depend on the covariance of that security’s return with
those of other securities, and not on the security’s variance.
• Equilibrium risk premiums will depend on covariances rather than total variability of returns.
 The Power of Diversification
1 2 𝑛−1
𝜎𝑝2 = 𝜎𝑖 + 𝐶𝑜𝑣
𝑛 𝑛

𝜎𝑝2 → 𝐶𝑜𝑣 𝑎𝑠 𝑛 → ∞

• Suppose for simplicity that all securities have a common standard deviation 𝜎 and all security pairs
have a common correlation coefficient 𝜌.
– For 𝜌 = 0, we obtain the insurance principle, where portfolio variance approaches zero as 𝑛 becomes
greater.
• Theoretically, if all risk were firm-specific, it would be possible to drive portfolio variance to zero.
• When security returns are uncorrelated, the power of diversification to reduce portfolio risk is unlimited.
– For 𝜌 > 0, portfolio variance remains positive.
– For 𝜌 = 1, portfolio variance equals the common variance regardless of 𝑛, demonstrating that
diversification is of no benefit.
• In the case of perfect correlation, all risk is systematic.
 𝜎 = 50%

• For 𝑛 = 100 and 𝜌 = 0.40, the standard deviation is high, 31.86%, yet it is
very close to the undiversifiable systematic standard deviation in the
infinite-sized security universe, 𝜌𝜎 2 = 0.4 × 502 = 31.62%.
– At this point, further diversification is of little value.
 The Power of Diversification
Suppose that the universe of available risky securities consists of a large number of
stocks, each identically distributed with 𝐸(𝑟𝑖 ) = 15% and 𝜎𝑖 = 60% for all 𝑖 =
{1,2, … , ∞}, and a common correlation coefficient of 𝜌 = 0.5.
1. What are the expected return and standard deviation of an equally weighted
risky portfolio of 25 stocks?
2. For an an equally weighted risky portfolio, what is the minimum number of
stocks necessary to generate an efficient portfolio with a standard deviation
equal to or less than 43%?
3. What is the systematic risk in this equally weighted security universe?
4. If T-bills are available and yield 10%, what is the slope of the CML? (Because of
the symmetry assumed for all securities in the investment universe, the market
index in this economy will be an equally weighted portfolio of all stocks.)
Risk Pooling, Risk Sharing, and Time Diversification
• Many argue that investing over long periods offers “time diversification.”
– This means that although the market index may underperform compared to T-
bills in any given year, overall (because the market index has a positive risk
premium), it will outperform T-bills over extended investment periods.
Therefore, they believe that investors with longer horizons can wisely allocate a
larger portion of their portfolios to the market index.
• Is this a valid argument?
• That would be like saying that a gambler who returns to the roulette table
for one more spin is reducing his risk by diversifying across his many bets.
• Time diversification is based on a misinterpretation of the theory of
portfolio diversification.
Risk Pooling, Risk Sharing, and Time Diversification
• Risk pooling is pooling together many sources of independent risk sources.
– Assuming policies are independent, if ↑ the number of polices in the pool
• ↑ overall exposure to risk (faced by the insurance carrier)
• ↓ average exposure to risk (faced by the insurance carrier) for a single policy

• If your client has a $100,000 portfolio solely invested in Microsoft and want to
diversify it, which of the following options would reduce the total risk?
A. Adding another $100,000 investment in various other companies.
B. Splitting the existing $100,000 between Microsoft shares and shares of other
companies.
• True diversification requires that the given investment budget be allocated
across a large number of different assets, thus limiting the exposure to any
particular security.
Risk Pooling, Risk Sharing, and Time Diversification
• If your client is a one-year investor with a $100,000 portfolio and considering a time
diversification strategy, which of the following options would reduce their total risk
exposure?
A. Holding the $100,000 portfolio for two years.
B. Investing the $50,000 portfolio (with capital, asset, and security allocation unchanged) for two
years.
C. Investing the $25,000 portfolio (with capital, asset, and security allocation unchanged) for four
years.

• Longer investment horizons alone do not reduce risk.

• Extending your investment horizon to another year may make your average annual return
more predictable. However, by keeping your money at risk for an additional year, the
uncertainty of your total cumulative return will inevitably increase.
Risk Pooling, Risk Sharing, and Time Diversification
• Diversification is based on the allocation of a portfolio of fixed size across
several assets, limiting the exposure to any one source of risk.
• Adding additional risky assets to a portfolio, thereby increasing the total
amount invested, does not reduce dollar risk, even if it makes the rate of
return more predictable.
– This is because that uncertainty is applied to a larger investment base.
• Nor does investing over longer horizons reduce risk.
• Analogously, the key to the insurance industry is risk sharing—the
spreading of many independent sources of risk across many investors, each
of whom takes on only a small exposure to any particular source of risk.