Chapter 8

Portfolio Selection
 Learning Objectives

• State three steps involved in building a portfolio.

• Apply the Markowitz efficient portfolio selection
model.
• Describe the effect of risk-free borrowing and
lending on the efficient frontier.
• Discuss the separation theorem and its
importance to modern investment theory.
• Separate total risk into systematic and non-
systematic risk.
 Portfolio Selection
• Diversification is key to optimal risk
management
• Analysis required because of the infinite
number of portfolios of risky assets
• How should investors select the best risky
portfolio?
• How could riskless assets be used?
• Investors can invest in both risky and riskless
assets and buy assets on margin or with
borrowed funds
 Building a Portfolio

• Step 1: Use the Markowitz portfolio selection

model to identify optimal combinations
• Step 2: Consider borrowing and lending
possibilities
• Step 3: Choose the final portfolio based on
your preferences for return relative to risk
 Portfolio Theory

• Optimal diversification takes into account all

available information (as opposed to random
diversification)
• Assumptions in portfolio theory
 A single investment period (e.g., one year)
 Liquid position (e.g., no transaction costs)
 Preferences based only on a portfolio’s expected
return and risk
 An Efficient Portfolio

• Smallest portfolio risk for a given level of

expected return
• Largest expected return for a given level of
portfolio risk
• From the set of all possible portfolios
 Only locate and analyze the subset known as
the efficient set
• Lowest risk for given level of return
 An Efficient Portfolio
• Fig. 8.1 pg 219
• All other portfolios in attainable set are dominated
by efficient set
• Global minimum variance portfolio
 Smallest risk of the efficient set of portfolios
• Efficient set (frontier)
 Segment of the minimum variance frontier above
the global minimum variance portfolio
 The set of efficient portfolios composed entirely of
risky securities generated by the Markowitz
portfolio model
 Efficient Portfolios

• Efficient frontier or
Efficient set
B (curved line from A
x to B)
E(R) A • Global minimum
variance portfolio
y (represented by
C
Risk =  point A)
 Efficient Portfolios
• The basic Markowitz model is solved by a
complex technique called quadratic
programming
• The expected returns, standard deviations,
and correlation coefficients for the securities
being considered are inputs in the Markowitz
analysis
• The portfolio weights are the only variables
that can be manipulated to solve the portfolio
problem of determining efficient portfolios
 1- Selecting an Optimal Portfolio of
Risky Assets
• In finance we assume investors are risk averse (i.e.,
they require additional expected return for assuming
additional risk)
• Indifference curves describe investor preferences for
risk and return (Fig. 8.2 pg 221)
• Indifference curves
 Cannot intersect since they represent different levels of
desirability
 Are upward sloping for risk-averse investors
 Greater slope implies greater risk aversion
 Investors have an infinite number of indifference curves
 Higher indifference curves are more desirable
 Selecting an Optimal Portfolio of
Risky Assets
• The optimal portfolio for a risk-averse
investor occurs at the point of tangency
between the investor’s highest indifference
curve and the efficient set of portfolios (Fig.
8.3 pg 221)
• This portfolio maximizes investor utility
because the indifference curves reflect
investor preferences, while the efficient set
represents portfolio possibilities
 Selecting an Optimal Portfolio of
Risky Assets
• Markowitz portfolio selection model
 Generates a frontier of efficient portfolios which are
equally good
 Does not address the issue of riskless borrowing
or lending (investors are not allowed to use leverage)
 Different investors will estimate the efficient frontier
differently (this results from estimating the inputs to
the Markowitz model differently)
• Element of uncertainty in application (i.e., uncertainty
is inherent in security analysis)
 Alternative Methods of Obtaining the
Efficient Frontier

• For a portfolio of n securities:

 The full variance-covariance model of Markowitz
requires [n (n + 3)] / 2 estimates
 The single-index model requires (3n + 2)
estimates
 Example: calculate the required number of
estimates needed by both models for a portfolio
of 250 securities
 Selecting Optimal Asset Classes
• Another way to use the Markowitz model is with
asset classes
 Allocation of portfolio assets to broad asset
categories (i.e., how much of the portfolio’s assets are to
be invested in stocks, bonds, money market securities,
etc.)
• Asset class rather than individual security decisions
most important for investors
 The rationale behind the asset allocation approach is
that different asset classes offer various returns and
levels of risk
• Correlation coefficients may be quite low
 Example: Selecting Optimal Asset
Classes
• (Pg 223) Consider the performance of two Canadian
portfolio managers, A and B, between 1999 and 2003.
• Manager A maintained an equally weighted portfolio with
respect to T-bills, long-term government bonds, and
common stocks.
• Manager B was more conservative and allocated 20% of
funds to each stocks and bonds, with the remaining 60% to
T-bills.
• Assume each manager matched the risk-return
performance on the relevant asset class benchmark index
for the proportion of their portfolio invested in each of the
three asset classes.
 Example: Selecting Optimal Asset
Classes
• Over the period, the average annual return and
standard deviation for the asset classes were:
• T-bills: 4.01% & 1.29%
• Government bonds: 5.6% & 7.96%
• Common stocks: 7.68% & 20.42%
• Calculate the annual return earned by managers A
& B and the standard deviations of their portfolios.
 Optimal Risky Portfolios

Investor Utility Function

E (R)

Efficient Frontier
*


2- Borrowing and Lending Possibilities
• Risk-free assets
 Certain-to-be-earned expected return (this is
nominal return and not real return which is
uncertain since inflation is uncertain)
 Zero variance
 No covariance or correlation with risky assets
(ρ_RF = 0 since the risk-free rate is a constant
which by nature has no correlation with the
changing returns on risky securities)
 Usually proxied by a Treasury Bill
• Amount to be received at maturity is free of default
risk, known with certainty
Borrowing and Lending Possibilities

• Adding a risk-free asset extends and

changes the efficient frontier
• Investors can now invest part of their wealth
in the risk-free asset and the remainder in
any of the risky portfolios in the Markowitz
efficient set
• It allows the Markowitz portfolio theory to be
extended in such a way that the efficient
frontier is completely changed
 Risk-Free Lending

• Riskless assets can be

L
combined with any
B portfolio in the efficient
E(R) T set AB (comprised only of
risky assets)
Z X
 Z implies lending
RF
A • Set of portfolios on line
RF to T dominates all
portfolios below it
Risk
 Impact of Risk-Free Lending
• If wRF placed in a risk-free asset and (1- wRF) in risky
portfolio X:
 Expected portfolio return
E(R p )  w RFRF  (1 - w RF )E(R X )

▪ Risk of the portfolio (correlation and covariance

for the risk-free asset is zero)
 p  (1 - w RF ) X

• Expected return and risk of the portfolio with lending

is a weighted average
 Example: Impact of Risk-Free Lending

• (Pg 226) Assume that portfolio X has an expected

return of 15% with a standard deviation of 30%,
and that the risk-free security has an expected
return of 3%.
• If 60% of investable funds is placed in RF and 40%
in portfolio X, calculate the expected return and
standard deviation of the resulting portfolio.
 Impact of Risk-Free Lending
• An investor could change positions on the line RF-X
by varying wRF. As more of the investable funds are
placed in the risk-free asset, both the expected
return and the risk of the portfolio decline.
• It is apparent that the segment of the efficient
frontier below X (i.e., A to X) is now dominated by
the line RF-X.
• Therefore, the ability to invest in RF provides
investors with a more efficient set of portfolios from
which to choose which lies along line RF-T.
 Borrowing Possibilities
• Investor no longer restricted to own wealth
• One way to accomplish this borrowing is to buy
stocks on margin
• Interest paid on borrowed money
 Higher returns sought to cover expense
 Assume borrowing at risk-free rate (RF)
• Risk will increase as the amount of borrowing
increases
 Financial leverage
 Borrowing Possibilities
• Borrowing additional investable funds and investing
them together with the investor’s own wealth allows
investors to seek higher expected returns while
assuming greater risk
• These borrowed funds can be used to leverage the
portfolio position beyond the tangency point T,
which represents 100% of an investor’s wealth in
Risky asset portfolio T
• The straight line RF-T is now extended upward,
and can be designated RF-T-L
 The New Efficient Set
• Risk-free investing and borrowing creates a
new set of expected return-risk possibilities
• Addition of risk-free asset results in
 A change in the efficient set from an arc to a
straight line tangent to the feasible set without
the riskless asset
 Chosen portfolio depends on investor’s risk-
return preferences (i.e., investors can be
anywhere they choose on line RF-T-L,
depending on their risk-return preference)
 The New Efficient Set

• In real life, it is unlikely that the typical

investor can borrow at the same rate as that
offered by riskless securities because
borrowing rates generally exceed lending
rates
• The straight line RF-T-L will be transformed
into a line with a “kink” at point T (Fig. 8.6 pg
230)
 3- Portfolio Choice
• The more conservative the investor, the more that
is placed in risk-free lending and the less in
borrowing (i.e., closer to the risk-free rate RF)
• The more aggressive the investor, the less that is
placed in risk-free lending and the more in
borrowing (i.e., closer to, or on, point T,
representing full investment in a portfolio of risky
assets)
• Even more aggressive investors could go beyond
point T by using leverage to move up the line RF-T-
L
 The Separation Theorem
• Investors use their preferences (reflected in
an indifference curve) to determine their
optimal portfolio along the new efficient
frontier RF-T-L
• Separation Theorem
 The investment decision (which portfolio
of risky assets to hold) is separate from
the financing decision (how to allocate
investable funds between the risk-free
asset and the risky asset)
 Separation Theorem
• All investors
 Invest in the same portfolio of risky assets T
 Attain any point on the straight line RF-T-L by
either borrowing or lending at the rate RF,
depending on their preferences
• Risky portfolios are not tailored to each
individual’s taste
• The separation theorem argues that the
tailoring process is inappropriate
Implications of Portfolio Selection

• Investors should focus on risk that cannot be

managed by diversification
• Total risk =
 Systematic (non-diversifiable) risk
+
 Non-systematic (diversifiable) risk
 Systematic risk

• Systematic risk (unavoidable)

 Variability in a security’s total returns directly
associated with economy-wide events
 Common to virtually all securities
 E.g., interest rate risk, market risk, and inflation
risk
 Non-Systematic Risk
• Non-Systematic Risk
 Variability of a security’s total return not related to
general market variability
 Diversification decreases this risk
• The relevant risk of an individual stock is its
contribution to the riskiness of a well-diversified
portfolio
Portfolios rather than individual assets most
important
Recent Canadian research suggests that 70 or more
stocks are required to obtain a well diversified
portfolio
 Portfolio Risk and Diversification

p % Total risk
35
Diversifiable
Risk
20
Systematic Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
Appendix 8-A: Modern Portfolio Theory
and the Portfolio Management Process

• Demonstrated by the impact on regulations

governing the investment behaviour of professional
money managers
• Require them to adhere to “prudence, loyalty,
reasonable administrative cost, and diversification”
• Portfolio management process:
 Designing an investment policy
 Developing and implementing an asset mix
 Monitoring the economy, the markets, and the client
 Adjusting the portfolio and measuring performance