Lecture 5 Optimal Risky Portfolios
Lecture 5 Optimal Risky Portfolios
(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).
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
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?
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
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
Std.
Asset Allocation with Stocks, Bonds and Bills
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 )
* 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.