Investment Analysis and

Portfolio
Management (ACFN 632)
Chapter 4 – Portfolio
Management and theories

1
 Topics to be discussed
• Portfolio management objectives

• Concepts of diversification, and the

effectiveness
• Traditional and modern approaches to portfolio
management
• Components of risk, beta, and the capital
asset pricing model (CAPM).

2
 What is a Portfolio?
• Portfolio is a collection of investment vehicles
assembled
to meet one or more investment goals.

– Growth-Oriented Portfolio: primary objective is long-

term price appreciation

– Income-Oriented Portfolio: primary objective is

current dividend and interest income
3
 The Ultimate Goal: An Efficient
• Portfolio
Efficient portfolio

– A portfolio that provides the highest return for a given

level of risk

– Given the choice between two equally risky investments,

an
investor will chose the one with the highest potential
return.

– Given the choice between two investments offering the

same 4
 Portfolio Return and Risk Measures
• Return on a Portfolio is the weighted average of
returns on the individual assets in the portfolio.

• Standard Deviation of a portfolio’s returns is

calculated using all of the individual assets in
the portfolio.

5
 
Return
Proportion of
on Portfolio
  Proportion 
Return  portfolio's Return of  portfolio's Return 
on  totaldollar  on asset 
 
 dollar  on asset  
 total 
portfoli  represented
value 1 
value represented 2 

by asset by asset 2 
o 
1
 Proportion of 
 portfolio's Return   Proportion of
n  portfolio's Return 
total  on    on
 dollar  asset dollar
total
 
value
 represented n  j   represented
value assetj  
by asset  1
 by asset
 
 n j 

n
rp   rj
 r1    r2  w n  rn  
w1   6
 Illustration

Assume that Ato Tulu has Br.10,000 and wants to invest Br.4,000 on stock A and
Br.6,000 on stock B. Data related with the two stocks are presented as follow:
State Probabilty Return on A Return on B
1 20% 0.3 0.15
2 10% 0.1 -0.1
3 30% 0.2 0.4
Calculate:
i. Expected Return on A
ii. Expected Return on B
iii. Expected Return on portfolio
 Solution

A. Expected Rate on Individual Stock

E(ra) = (0.2x0.3) + (0.1x0.1) + (0.3x0.2) = 0.13
E(rb) = (0.2x0.15) + (0.1x-0.1) + (0.3x0.4) = 0.14
B. Expected Rate of Portfolio
It is the sun of multiplying weight of each asset with their expected
return.
Expected Rp = 0.4xE(ra) + 0.6xE(rb)
= 0.4x0.13 +0.6x0.14
= 0.052 + 0.084
= 0.136
= 13.6%
Note W(a)=4000/10000=0.4
W(b)= 6000/10000=0.6
 Correlation:
Why Diversification Works!
• Correlation is a statistical measure of the
relationship
between two series of numbers representing data.

– Positively Correlated items move in the same

direction.

– Negatively Correlated items move in opposite

directions.

– Correlation Coefficient is a measure of the degree

of correlation between two series of numbers 9
 Correlation Coefficients
• Perfectly Positively Correlated describes two positively
correlated series having a correlation coefficient of
+1

• Perfectly Negatively Correlated describes two

negatively correlated series having a correlation
coefficient of -1

• Uncorrelated describes two series that lack any

relationship and have a correlation coefficient of
nearly zero 10
The Correlation Between Series M,
N,
and P

11
 Correlation:
Why Diversification Works!
• To reduce overall risk in a portfolio, it is best to
combine
assets that have a negative
(or low-positive) correlation.
• Uncorrelated assets reduce risk somewhat,
but not as effectively as combining negatively
correlated assets.

• Investing in different investments with high

positive correlation will not provide sufficient 12 10
Combining Negatively Correlated Assets
to
Diversify Risk

13
 Why Use
International Diversification?
• Offers more diverse investment alternatives than only local
based investing

• Foreign economic cycles may move independently from

local economic cycle

• Foreign markets may not be as “efficient” as local markets,

allowing true gains from superior research

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 International Diversification
• Advantages of International Diversification

– Broader investment choices

– Potentially greater returns and reduced portfolio

risk

• Disadvantages of International Diversification

– Currency exchange risk

– Less convenient to invest than local stocks

– More expensive to invest – transaction cost

15
 Components of Risk
• Diversifiable (Unsystematic) Risk

– Results from uncontrollable or random events that

are firm-specific
– Can be eliminated through diversification

• Nondiversifiable (Systematic) Risk

– Attributable to forces that affect all similar

investments
– Cannot be eliminated through diversification
16
 Two Approaches
to Constructing Portfolios

Traditional

Approach

versus

Modern Portfolio Theory

17
 Traditional Approach
• Emphasizes “balancing” the portfolio using a wide variety
of
stocks and/or bonds

• Uses a broad range of industries to diversify the

portfolio

• Tends to focus on well-known companies

– Perceived as less risky
– Stocks that are more liquid and available
– Familiarity provides higher “comfort” levels for investors 18
 Modern Portfolio Theory
• (MPT)
Emphasizes statistical measures to develop a portfolio
plan

• Focus is on:
– Expected returns
– Standard deviation of returns
– Correlation between returns

• Combines securities that have negative (or low-positive)

correlations between each other’s rates
of return 19
Feasible or Attainable Set and the Efficient
Frontier

20
 Key Aspects of MPT:
• Efficient Frontier
Efficient Frontier

– The leftmost boundary of the feasible set of portfolios

that include all efficient portfolios: those providing the
best attainable tradeoff between risk and return

– Portfolios to the right of the efficient frontier

are not desirable because their risk return tradeoffs
are inferior

– Portfolios that fall to the left of the efficient frontier are

21
 Key Aspects of MPT: Portfolio
Betas
• Portfolio Beta

– The beta of a portfolio; calculated as the

weighted average of the betas of the individual
assets the portfolio includes

– To earn more return, one must bear more risk

– Only non-diversifiable risk (relevant risk) provides

a
positive risk-return relationship
22 20
Portfolio Risk and Diversification

23
 Reconciling the Traditional
Approach and MPT
• Recommended portfolio management policy uses aspects
of both approaches:

– Determine how much risk you are willing to bear

– Seek diversification between different types of securities

and industry lines

– Pay attention to correlation of return between securities

– Use beta to keep portfolio at acceptable level of risk

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 Portfolio theory – mean variance analysis
• Investing usually needs to deal with uncertain outcomes.

• That is, the unrealized return can take on any one of a

finite number of specific values, say r1, r2, …, rS.

• This randomness can be described in probabilistic terms.

That is, for each of these possible outcomes, they are
associated with a probability, say p1, p2, …, pS.

• For asset i, its expected return is:

E(ri) = p1* r1 + p2* r2 + … + pS * rS.

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• The table below provides a probability distribution for the returns on stocks
Expected Return
A
and B State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
• The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a
growth economy.
• The probability reflects how likely it is that the state will occur.
The sum of the probabilities must equal 100%.
• The last two columns present the returns or outcomes for stocks
A
and B that will occur in each of the four states. 26
 Expected Return
• Given a probability distribution of returns, the
expected
return can be calculated using the following equation:
E[R] = N
 (piRi)
i=1

• Where:
– E[R] = the expected return on the
stock
– N = the number of states
– pi = the probability of state i
– Ri = the return on the stock in state i.
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 Expected Return
• In this example, the expected return for stock A
would be calculated as follows:

E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%)

= 12.5%

• Now you try calculating the expected return for stock

B!

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• Did you get 20%?Expected Return
If so, you are correct.

• If not, here is how to get the correct answer:

E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%

• So we see that Stock B offers a higher expected

return
than Stock A.
• However, that is only part of the story; we
haven't considered risk.

29
 Measures of Risk
• Risk reflects the chance that the actual return on an
investment may be different than the expected
return.
• One way to measure risk is to calculate the variance
and
standard deviation of the distribution of returns.
• We will once again use a probability distribution in
our
calculations. 30
•
Measures
Probability Distribution:
of Risk
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

E[R]A = 12.5%
E[R]B = 20%

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 Measures
• Given an asset's expected return, its of Riskcan be calculated
variance
using the following equation:
N
Var(R) = i=1 2 =  pi(Ri – E[R])2
• Where:
– N = the number of states
– pi = the probability of state i

– Ri = the return on the stock in state i

– E[R] = the expected return on the
stock

32 30
 Measures of Risk
• The variance and standard deviation for stock A is calculated
as follows:
2 2 2
A = .2(.05 -.125) + .3(.1 -.125) + .3(.15 -.125) +

2 .2(.2 -.125)2 = .002625

   = 

• Now you try the variance and standard deviation for stock
B!
• If you got .042 and 20.49% you are correct.

33
 Measures of Risk
• If you didn’t get the correct answer, here is how to get
it:
2 2 2 2
B = .2(.50 -.20) +.3(.30 -.20) + .3(.10 - .20) + .2(-.10 - .20) =.

2 042
       

• Although Stock B offers a higher expected return than Stock A,

it also is riskier since its variance and standard deviation are
greater than Stock A's.

• This, however, is still only part of the picture because most

investors
choose to hold securities as part of a diversified portfolio.
34
• Most investorsPortfolio
do not hold Risk
stocksand Return
in isolation.
• Instead, they choose to hold a portfolio of several stocks.
• When this is the case, a portion of an individual stock's risk
can be eliminated, i.e., diversified away.
• From our previous calculations, we know that:
– the expected return on Stock A is 12.5%
– the expected return on Stock B is 20%
– the variance on Stock A is .00263
– the variance on Stock B is .04200
– the standard deviation on Stock A is 5.12%
– the standard deviation on Stock B is 20.49%
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 Portfolio Risk and Return
• The Expected Return on a Portfolio is the weighted average of
the
expected returns on the stocks which comprise the portfolio.

• The weights is the proportion of portfolio invested in the stocks.

N

E[Rp] =  wiE[Ri]
i=1
• Where:
– E[Rp] = the expected return on the portfolio
– N = the number of stocks in the portfolio
– wi = the proportion of the portfolio invested in stock i 36
 Portfolio Risk and Return
• For a portfolio consisting of two assets, the above equation
can be expressed as:

E[Rp] = w1E[R1] + w2E[R2]

• If we have an equally weighted portfolio of stock A and stock B

(50% in each stock), then the expected return of the portfolio
is:

E[Rp] = .50(.125) + .50(.20) = 16.25%

37
 Portfolio Risk and Return
• The variance/standard deviation of a portfolio reflects not only the
volatility of the stocks that make up the portfolio but also how the
returns on the stocks which comprise the portfolio vary together.

• Two measures of how the returns on a pair of stocks vary together

are
the covariance and the correlation coefficient.
– Covariance is a measure that combines the variance of a stock’s
returns
with the tendency of those returns to move up or down at the same
time

– Since it is difficult to interpret the magnitude of the covariance terms, a

related statistic, the correlation coefficient, is often used to measure the 38
 Portfolio Risk and Return
The Covariance between the returns on two
stocks can be calculated as follows:

• Where:
  A,B = the covariance between the returns on stocks A
and B
– N = the number of states
– pi = the probability of state i
– RAi = the return on stock A in state i
– E[RA] = the expected return on stock A
– RBi = the return on stock B in state i
– E[RB] = the expected return on stock B
39
 Portfolio Risk and Return
• The Correlation Coefficient between the returns on two stocks
can be calculated as follows:

• Where:
–  A,B=the correlation coefficient between the returns on stocks
A and B
–  A,B=the covariance between the returns on stocks A and B,
– A =the standard deviation on stock A, and
– B =the standard deviation on stock B

40
 Portfolio Risk and Return
• The covariance between stock A and stock B is
as follows:
 A,B = .2(.05-.125)(.5-.2) + .3(.1-.125)(.3-.2) +
.3(.15-.125)(.1-.2) +.2(.2-.125)(-.1-.2) =
-.0105
• The correlation coefficient between stock A and stock
B is as follows:

 A,
-.0105
(.0512)(.2049) = -1.00

B =
41
 Portfolio Risk and Return
• Using either the correlation coefficient or the covariance, the
Variance on a Two-Asset Portfolio can be calculated as
follows:
p = (wA)  A + (wB)  B + 2wAwB A,B
2 2 2 2

2  A B

2 2 OR 2 2
p = (wA ) A + (wB)  B + 2wAwB

2  A,B
• The Standard Deviation of the Portfolio equals the
positive square root of the variance.

42 40
 Portfolio Risk and
• Return
Let’s calculate the variance and standard deviation of a portfolio
comprised of 75% stock A and 25% stock B:

 2
p =(.75)22+(.25)2(.2049)2+2(.75)(.25)

(-1)(.0512)(.2049)= .00016

 p = .00016 = .0128 = 1.28%

• Notice that the portfolio formed by investing 75% in Stock A and 25% in
Stock B has a lower variance and standard deviation than either Stocks
A or B and the portfolio has a higher expected return than Stock A.

• This is the purpose of diversification; by forming portfolios, some of

the risk inherent in the individual stocks can be eliminated.
43 41
 What do we know about portfolio risk?
• Most stocks are positively correlated.

– Average correlation between two stocks is 0.65 in the US.

• If the stocks in the portfolio are not perfectly correlated, the

standard deviation of the portfolio will be less than the
weighted average of the standard deviation of the stocks in the
portfolio.

• When we add more securities in the portfolio, we can lower

– This
the risk is
ofbecause the added
the portfolio securities would not be
even further.
perfectly correlated with existing securities in the
43
 Stand-alone Risk in Individual Securities
• Stand-alone risk consists of:

– Diversifiable risk/ unsystematic, unique, or idiosyncratic risk

• Company or industry specific

– Non-diversifiable risk/systematic, portfolio, or market risk

• Related to market as a whole

• It shows the degree to which a stock moves

systematically with other stocks.
• Total risk of security = unsystematic risk + portfolio risk

• We can eliminate unsystematic risk by adding more securities

the portfolio. 45 44
into
 The Systematic Risk Principal
• The reward for bearing risk depends only on the systematic risk
of an investment since unsystematic risk can be diversified
away.
• This implies that the expected return on any asset depends
only
on that asset’s systematic risk.
• If investors are well diversified, they only care how a stock
correlates with the rest of their portfolio (the “market
portfolio”). The variance of that stock ( i
2 ) is, essentially,
irrelevant. 46
 Measuring
• Beta (β) measures aSystematic Risk
stock’s market (or systematic) risk. It shows
the relative volatility of a given stock compared to the average
stock. An average stock (or the market portfolio) has a beta =
1.0.
• Beta shows how risky a stock is if the stock is held in a
well- diversified portfolio.
– β=1 → stock has average risk.
– β>1 → stock is riskier than average.
– β<1 → stock is less risky than average.
– β=0 → risk free assets/unrelated to market risk (e.g.,
Treasury
47
bills)
 Portfolio Betas
• The beta of a portfolio (βP) is the weighted average of
• the betas from its constituent securities.

• βP = w1 β1 + w2 β2 + … + wN βN for N securities

• Example 1: You have $6,000 invested in IBM, $4,000 in GM.

You estimate that IBM has a beta of 0.95 and GM has a beta of
1.15. What is the beta of your portfolio?

•• βP = 0.6*0.95 + 0.4*1.15 = 1.03

48
 The Capital Asset Pricing Model
It is a model based on Security Market Line.

E(RA) = Rf + A[E(RM) – Rf] This is CAPM!!

• The CAPM describes the relationship between the expected

risk
premium on a security, E(Ri)-Rf, and the risk, .

• The CAPM holds for individual assets as well as portfolios of

those assets.
 An Example of CAPM
• Suppose the risk-free rate is 4%, the market risk
premium is 8.6%, and a stock has a beta of 1.3.
Based on the CAPM, what is the expected return on
this stock? What would the expected return be if the
beta were to double?

– E(R) = Rf + [E(RM) – Rf] = 4% + 1.3*8.6% = 15.18%

– E(R) = Rf + [E(RM) – Rf] = 4% + 2.6*8.6% = 26.36%

50
The Security Market Line (SML)

51
 The Security Market Line (SML)
CAPM: E(Ri) = Rf + i[E(RM) – Rf]
• The security market line (SML) is a line that shows the
relationship between risk () and the required rate of return on
individual securities.
Required
Rate of SML: E(Ri) = Rf + i*[E(RM)-Rf]
Return
= E (RM) – Rf
E (RM)

Rf

M = Risk, i
1.0 52
End

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