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Lecture 5 Optimal Risky Portfolios

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115 views28 pages

Lecture 5 Optimal Risky Portfolios

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LuisLo
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LECTURE 5:

OPTIMAL RISKY PORTFOLIOS


Outline
 Diversification (7.1)
 Portfolios of Two Risky Assets (7.2)

 Asset Allocation with Stocks, Bonds and Bills

(7.3)
 The Markowitz Portfolio Selection Model (7.4)
Outline
 In chapter 6, we discuss your optimal asset allocation when there are:
1. One risk-free asset
2. One risky asset and one risk-free asset
 In chapter 7, we will discuss the optimal asset allocation decisions.
However, it becomes more complicated because we have more than one
risky assets:
1. Two risky assets
2. Two risky assets and one risk-free asset
3. Many risky assets and one risk-free asset
Diversification
 These situations differ in the budget constraint
(portfolio opportunity set).

E(R 1 risk-free + 1 risky 2 risky


E(R
) )

Std Std
Diversification
 Two Stocks: A (Ice Cream) and B (Umbrella). Both
are selling at $100 per share.
Sunny (50%) Rainy (50%)

110 100

100 110
Diversification
State of the Probability Year-end Cash HPR
Market Price Dividends

Sunny 50% 110 0 10% E(A)= __%


Std(A)= __%
Rainy 50% 100 0 0%

State of the Probability Year-end Cash HPR


Market Price Dividends

Sunny 50% 100 0 0% E(B)= __%


Rainy 50% 110 0 10% Std(B)= __%
Diversification
 What portfolio would you hold?
50% in Stock A and 50% in Stock B
State of the Probability Year-end Cash HPR
Market Price Dividends
Sunny 50% 105 0 5%
Rainy 50% 105 0 5%

This portfolio’s expected return is 5% and standard deviation is 0%


Diversification
 Back to the graph,
2 risky
E(R
) Perfectly negatively correlated

Perfectly positively correlated

Std
Diversification
 If you include additional securities in your
portfolio (diversification strategy), you can
stabilize portfolio return.
 But, why end diversification with only two stocks?

 We can include more securities in the portfolio and

portfolio volatility should continue to fall.


Diversification
 Diversification
Ris
k
Unique risk (non-systematic
risk, firm-specific risk)

Market risk (systematic risk)

Number of stocks in portfolio


Portfolios of Two Risky Assets
Portfolio of Two Risky Assets:
E(r)
1. Minimum variance portfolio
2. Optimal complete portfolio

Std.
Portfolios of Two Risky Assets
 Two risky assets: bond (D) and stock (E)
rp =wD ×rD + wE ×rE
E(rp ) =wD ×E(rD ) + wE ×E(rE )
s =w ×s + w ×s + 2 ×wD ×wE ×cov(rD , rE )
2
p
2
D
2
D
2
E
2
E

s =w ×s + w ×s + 2 ×wD ×wE ×s D ×s E ×r DE
2
p
2
D
2
D
2
E
2
E
Portfolios of Two Risky Assets
 Solving for the minimum variance portfolio
Min s =w ×s + w ×s + 2 ×wD ×wE ×cov(rD , rE )
2
p
2
D
2
D
2
E
2
E

Min s p2 =wD2 ×s D2 + (1- wD )2 ×s E2 + 2 ×wD ×(1- wD )×cov(rD , rE )


WD
s E2 - Cov(rD , rE )
wD = 2
s D + s E2 - 2Cov(rD , rE )
wE =1- wD
Portfolios of Two Risky Assets
 Solving for the optimal complete portfolio (when
there are two risky assets):
Max U =E(rp ) - 0.5×A ×s p2
wD

E(rp ) =wD ×E(rD ) + wE ×E(rE )

s =w ×s + w ×s + 2 ×wD ×wE ×cov(rD , rE )


2
p
2
D
2
D
2
E
2
E
Portfolios of Two Risky Assets
 Solving for the optimal complete portfolio
(cont’d)
First-order condition:

Optimal E(r
complete
) - E(r ) portfolio:
+ A[(s E - s Ds E r DE ]
2
wD = D E
A(s D2 + s E2 - 2s Ds E rDE )
wE =1- wD
Portfolios of Two Risky Assets
 Numerical Example (refer to Table 7.1):
Debt Equity
Expected return 8% 13%
Standard deviation 12% 20%
Covariance 0.0072
Correlation coefficient 0.3

 Minimum variance portfolio: WD=82% WE=18%


 Optimal complete portfolio: WD=50.75% WE=49.25%
Assume A=4
Asset Allocation with Stocks, Bonds and Bills
 Suppose we have two risky assets and one risk-free
asset. Again, we want to find the optimal complete
portfolio.
 Two steps:
1. Optimal risky portfolio
2. Optimal complete portfolio
Asset Allocation with Stocks, Bonds and Bills

Portfolio of One risky-free Asset and Two Risky Assets:


1. Optimal risky portfolio E(r)
2. Optimal complete portfolio

Std.
Asset Allocation with Stocks, Bonds and Bills

Step 1: Optimal risky portfolio:

E(r) Best feasible CAL

Optimal risky
portfolio

Std.
Asset Allocation with Stocks, Bonds and Bills
Step 2: Optimal complete portfolio
E(r)
Best feasible CAL

Optimal complete
portfolio

Std.
Asset Allocation with Stocks, Bonds and Bills
 Solving for the optimal complete portfolio when
there are one risk-free asset and two risky assets
Step 1: Solving for the optimal risky portfolio
E(rp ) - rf
Max S p =
WD sp
E(rp ) =wD ×E(rD ) + wE ×E(rE )

s p2 =wD2 ×s D2 + wE2 ×s E2 + 2 ×wD ×wE ×cov(rD , rE )


Asset Allocation with Stocks, Bonds and Bills
E(RD )s E2 - E(RE )Cov(RD , RE )
WD =
E(RD )s E2 + E(RE )s D2 - [E(RD ) + E(RE )]Cov(RD , RE )
WE =1- WD
where E(RD ) =E(rD ) - rf ; E(RE ) =E(rE ) - rf
Asset Allocation with Stocks, Bonds and Bills
 Solving for the optimal complete portfolio when
there are one risk-free asset and two risky assets
Step 2: Solving for the optimal complete portfolio
Recall what you learn in Ch 6

* E(rp ) - rf
y = 2
A ×s p
Asset Allocation with Stocks, Bonds and Bills
 Numerical Example:
Debt Equity T-bill
Expected return 8% 13% 5%
Standard deviation 12% 20%
Covariance 0.0072
Correlation coefficient 0.3

E(rp)=11%
 Optimal Risky Portfolio:WD=40% WE=60%
Stdp=14.2%
 Optimal Complete Portfolio:
y*=(11%-5%)/4*(14.2%)2=74.39%
25.61% in T-bills, 44.63% in Equity; 29.76% in Debt
Asset Allocation with Stocks, Bonds and Bills
 Separation Property: the portfolio choice
problem may be separated into two
independent task:
1. Determine the optimal risky portfolio (objective)
2. Determine the optimal complete portfolio
(subjective)
The Markowitz Portfolio Selection Model
 Many risky assets and one risk-free asset
E(r)
Best feasible CAL
Efficient frontier

Std.
Should we diversify?
 Burton Malkiel’s view: Why Diversification Works?
 SEC’s view: The Magic of Diversification
 Warren Buffet’s view: Diversification
 Mark Cuban’s view (0:00-3:40) : Diversification is for Idiots
Some Practical Takeaways
1. Asset allocation is the most important investment decision you will make. (Recipe
for successful investing: asset allocation explain 90% of the return earned while
security selection explain 10%.) (link)
2. Many investors suffer from two common allocation sins: being too conservative
and/or poorly diversified. (link)
(1) Being too conservative often comes in the form of too much cash and bonds
and not enough stocks (more on cash in the next section). The consequence of
being too conservative too soon could be running out of money. (
An economist’s story)
(2) A properly diversified stock portfolio, for instance, should have exposure to all
economic sectors. You should also aim for exposure across different styles, sizes,
regions, and to the extent possible, sub-industries. Spread out your risk. Doing this
reduces portfolio volatility and can actually improve expected return.

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