INVESTMENT MANAGEMENT

Study unit 5
Portfolio theory
and practice –
Part 2
Chapters 7, 8

Slides by
Prof J Krüger

1
 Introduction
 So many options, which portfolio should you choose?

 What risks will you have to incur to receive your required

return?

 Can you get rid of all or at least some of the risks?

 Learning Outcomes
1 Be able to calculate standard deviation and return for two
security portfolios and be able to find the minimum
variance combinations of two securities.
2 Have a full understanding of systematic and firm-specific
risk.
3 Be able to demonstrate how diversification can reduce
the amount of firm-specific risk in the portfolio by
combining securities with differing patterns of returns.
4 Be able to quantify this risk-reduction concept by
calculating and interpreting covariance and correlation
coefficients.
3
 Learning Outcomes (cont)
5 Be able to conceptualise the importance of
diversification.
6 Be able to demonstrate how one can reduce the amount
of firm-specific risk in the portfolio by combining
securities with differing patterns of returns.
7 Understand and interpret beta (or systematic risk) as the
relevant risk measure for the portfolio.
8 Be able to identify inputs required to use the index model
and understand the characteristic line.

4
 Chapter Seven Overview
 The investment decision
 Capital allocation (risky vs. risk-free)
 Asset allocation (construction of the risky portfolio)
 Security selection
 Optimal risky portfolio
 The Markowitz portfolio optimization model
 Long- vs. short-term investing

5
 The Investment Decision
p 193 (193; 205)

 Top-down process with 3 steps

 Capital allocation between risky portfolio and risk-free
asset
 Asset allocation across broad asset classes
 Security selection of individual assets within each
asset class

6
 Diversification and Portfolio Risk
pp 194 – 195 (194 – 195; 206 – 207)

 Market risk
 Risk attributable to marketwide risk sources and
remains even after extensive diversification
 Systematic or nondiversifiable
 Measured by beta (β)
 Firm-specific risk
 Risk eliminated by diversification
 Diversifiable or nonsystematic

7
Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio p 194 (194; 207)

8
Figure 7.2 Portfolio Diversification p 195 (195; 207)

9
 Portfolios of Two Risky Assets
pp 195 – 202 (195 – 202; 208 – 214)

 Portfolio risk (variance) depends on correlation between

returns of assets in portfolio
 Covariance and correlation coefficient provide a
measure of way returns of two assets move together
(covary)

Debt Equity
Expected return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov(rD, rE) 72
Correlation coefficient, ρDE 0.30

10
 Portfolios of Two Risky Assets (cont)
pp 195 – 202 (195 – 202; 208 – 214)

 Portfolio return: rp = wDrD + wErE

 wD = Bond weight
 rD = Bond return
 wE = Equity weight
 rE = Equity return
E(rp) = wD E(rD) + wEE(rE)
Debt Equity
Expected return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov(rD, rE) 72

 Equally weighted: Correlation coefficient, ρDE 0.30

E(rp) = 0.5(8) + 0.5(13) 11

Table 7.2 Computation of Portfolio Variance from
the Covariance Matrix pp 195 – 202
(195 – 202; 208 – 214)

A Bordered Covariance Matrix

Portfolio weights wD wE

wD

wE

B Bordered Multiplied Covariance Matrix

Portfolio weights wD wE

wD

wE

wD + wE = 1

Portfolio variance
12
Portfolios of Two Risky Assets: Risk
pp 195 – 202 (195 – 202; 208 – 214)

 Portfolio variance:

= Covariance of returns for bond and equity

13
 Portfolios of Two Risky Assets:
Covariance pp 195 – 202 (195 – 202; 208 – 214)
 Covariance of returns on bond and equity
Cov(rD,rE) = ρDEσDσE
= 0.3(12)(20)
= 72
D,E = Correlation coefficient of returns
 D = Standard deviation of bond returns
 E = Standard deviation of equity returns
Debt Equity
Expected return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov(rD, rE) 72
Correlation coefficient, ρDE 0.30 14
 Portfolios of Two Risky Assets: Correlation
coefficient pp 195 – 202
(195 – 202; 208 – 214)
 Range of values for 1,2

-1.0 > r > +1.0

 If  = 1.0, the securities are perfectly positively

correlated
 If  = -1.0, the securities are perfectly negatively
correlated
 If  = 0.0, the securities are not correlated at all

15
 Portfolios of Two Risky Assets: Correlation
coefficient pp 105 – 202
(195 – 202; 208 – 214)
 When ρDE = 1, there is no diversification

 When ρDE = -1, a perfect hedge is possible

Debt Equity
Expected return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov(rD, rE) 72
Correlation coefficient, ρDE 0.30

wE = 12 / (12 + 20) = 37.5%

wD = 62.5%
16
Table 7.3 Portfolios of Two Risky Assets:
Correlation coefficient pp 195 – 2020
(195 – 202; 208 – 214)

Portfolio Standard deviation for given correlation

wD wE E(rp)
ρ = -1 ρ=0 ρ = 0.30 ρ=1

17
Figure 7.3 Portfolio Expected Return as a Function
of Investment Proportions pp 195 -202 (195 – 202; 208 – 214)

18
Figure 7.4 Portfolio Standard Deviation as a
Function of Investment Proportions
pp 195 – 202 (195 – 202; 208 – 214)

Wmin(D, ρ=-1) = σE / (σ D + σ E)
= 20 / (12 + 20)
19
= 62.5%
 The Minimum Variance Portfolio
pp 195 – 202 (195 – 202; 208 – 214)

 Minimum variance portfolio is portfolio composed of risky

assets that has smallest standard deviation; portfolio
with least risk

 Amount of possible risk reduction through diversification

depends on correlation:
 If r = +1.0, no risk reduction is possible
 If r = 0, σP may be less than standard deviation of
either component asset
 If r = -1.0, a riskless hedge is possible

20
Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation pp 195 – 202
(195 -202; 208 – 214)

21
 The Sharpe Ratio
pp 203 – 208 (203 – 208; 215 – 219)

 Maximise slope of CAL for any possible portfolio, P

 Objective function is slope

E rp  rf
Sp 
p
 Slope is also Sharpe ratio

E(RA) = 8.90% E(RB) = 9.5%

σA = 11.45 σB = 11.70
T-bill = 5%
22
Figure 7.6 The Opportunity Set of the Debt and
Equity Funds and Two Feasible CALs
pp 203 – 208 (203 -208; 215 – 219)

Slope A = (8.9 – 5) / 11.45 = 0.34 (82% D, 18% E)

Slope B = (9.5 – 5) / 11.70 = 0.38 (70% D, 30% E)
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 The Optimal Risky Portfolio
pp 205 – 206 (205 – 206; 217 – 218)

 Weights for Optimal risky portfolio

 Employs excess rather than total returns

wD = (8 – 5)202 – (13 – 5)72 . Debt Equity

(8 – 5)202 +(13 – 4)122 – [(8 – 5 + 13 – 5)72] E(r) 8% 13%

σ 12% 20%
= 0.40 Cov(rD, rE) 72
ρDE 0.30
wE = 1 – 0.40 = 0.60
Expected return and standard deviation of optimal risky portfolio
E(rp) = (0.4 x 8) + (0.6 x 13) = 11%
σp = [(0.42 x 122) + (0.62 x 202) + (2 x 0.4 x 0.6 x 72)]1/2 =
24
14.20%
Figure 7.7 Debt and Equity Funds with the
Optimal Risky Portfolio pp 203 – 208 (203 – 208; 215 – 219)

Optimal risky portfolio

25
 The Optimal Complete Portfolio
pp 203 – 208 (203- 208; 217 – 219)

 Asset allocation decision made – find optimal capital allocation

 Investor with a coefficient of risk aversion A = 4 position in portfolio
P
y = E(rp) – rf = 0.11 – 0.05
Aσ2p 4 x 0.1422
= 0.7439
 Invest 74.39% in portfolio P and remaining 25.61% in T-bills –
optimal complete portfolio
 Portfolio P comprises of 40% investment in bonds and 60%
investment in equity
 Investment in optimal complete portfolio (see Figures 7.8 & 7.9)
Bonds = 0.4 x 0.7439 = 29.76%
Equity = 0.6 x 0.7439 = 44.63% 26
Figure 7.8 Determination of the Optimal
Overall Portfolio pp 203 – 208 (203 – 208; 215 – 219)

27
Figure 7.9 The Proportions of the Optimal
Complete Portfolio pp 203 – 208 (203 – 208; 215 – 219)

28
 Steps to Arrive at
Optimal Complete Portfolio
p 207 (206; 218)
 Specify return characteristics of all securities
(expected returns, variances, covariances)
 Establish risky portfolio (asset allocation)
 Calculate optimal risky portfolio P
 Calculate properties of portfolio P using determined
weights
 Allocate funds between risky portfolio and risk-free
asset (capital allocation)
 Calculate fraction of complete portfolio allocated to
portfolio P (risky portfolio) and to T-bills (risk-free
asset)
 Calculate share of complete portfolio invested in each
asset and in T-bills
29
 Markowitz Portfolio Optimization
Model pp 208 – 217 (208 – 217; 220 – 229)
 Security selection
 First step – determine risk-return opportunities
available
 All portfolios on minimum-variance frontier from global
minimum-variance portfolio and upward provide best
risk-return combinations

30
Figure 7.10 The Minimum-Variance Frontier of
Risky Assets pp 208 – 217 (208 – 217; 220 – 229)

31
 Markowitz Portfolio Optimization
Model (cont) pp 208 – 217 (208 – 217; 220 – 229)
 Search for CAL with highest reward-to-variability ratio
 Everyone invests in P, regardless of their degree of risk
aversion
 More risk averse investors put more in risk-free asset
 Less risk averse investors put more in P

32
Figure 7.11 The Efficient Frontier of Risky
Assets with the Optimal CAL pp 208 – 217
(208 – 217; 220 – 229)

33
 Markowitz Portfolio Optimization
Model (cont) pp 208 – 217 (208 – 217; 220 – 229)
 Capital Allocation and Separation Property
 Portfolio choice problem may be separated into two
independent tasks
 Determination of optimal risky portfolio is purely
technical (all investors will invest)
 Allocation of complete portfolio to risk-free versus
risky portfolio depends on personal preference
 Risk averse – less in risky portfolio, more in risk-
free assets

34
Figure 7.13 Capital Allocation Lines with
Various Portfolios from the Efficient Set pp 208 – 217
(208 – 217;220 – 229)

35
 Markowitz Portfolio Optimization
Model (cont) pp 208 – 217 (208 – 217; 220 – 229) (TR)
 Power of Diversification
 Remember
n n
 p2   wi w j Cov  ri , rj 
i 1 j 1

 If we define average variance and average

covariance of the securities a

1 n 2
   i
2

n i 1
n n
1
Cov   Cov  ri , rj 
n  n  1 j 1 i 1
j i
36
 Markowitz Portfolio Optimization
Model (cont) pp 208 – 217 (208 – 217; 220 – 229) (TR)
 Power of Diversification
 We can then express portfolio variance as

1 2 n 1
   
2
p Cov
n n

 Portfolio variance can be driven to zero if average

covariance is zero (only firm specific risk)
 Irreducible risk of a diversified portfolio depends on
covariance of the returns, which is a function of
systematic factors in economy

37
Table 7.4 Risk Reduction of Equally
Weighted Portfolio pp 208 – 217 (208 – 217; 220 – 229) (TR)
ρ = 0.00 ρ = 0.40
Portfolio Standard Standard
Universe Reducion Reducion
weights devaiation devaiation
size n in σ in σ
w = 1/n (%) (%) (%)
1
2
5
6
10
11
20
21
100
101 38
 Markowitz Portfolio Optimization Model
(cont) pp 208 – 217 (208 – 217; 220 – 229) (TR)

 Optimal Portfolios and Nonnormal Returns

 Fat-tailed distributions can result in extreme values of
VaR and ES and encourage smaller allocations to
risky portfolio
 If other portfolios provide sufficiently better VaR and
ES values than mean-variance efficient portfolio, we
may prefer these when faced with fat-tailed
distributions

39
 Risk Pooling and the Insurance
Principle pp 217 – 219 (217 – 221; 230 – 234) TR
 Risk pooling
 Merging uncorrelated, risky projects as a means to
reduce risk
 It increases the scale of the risky investment by
adding additional uncorrelated assets
 Insurance principle
 Risk increases less than proportionally to number of
policies when policies are uncorrelated
 Sharpe ratio increases

40
 Risk Pooling and the Insurance
Principle pp 217 – 219 (217 – 221; 230 – 234) TR
 As risky assets are added to portfolio, a portion of pool is
sold to maintain a risky portfolio of fixed size
 Risk sharing combined with risk pooling is key to
insurance industry
 True diversification means spreading a portfolio of fixed
size across many assets, not merely adding more risky
bets to an ever-growing risky portfolio

41
 Investment for the Long Run
pp 219 – 219 (217 – 221; 230 – 234) TR

Long-Term Strategy Short-Term Strategy

 Invest in risky portfolio for  Invest in risky portfolio

2 years for 1 year and in risk-
free asset for second
 Long-term strategy
year
riskier
 Risk reduced by selling
some of risky assets in
year 2
 “Time diversification” is
not true diversification
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 Preparation for next session
 Make sure you understand what we have covered in Chapter
7.
 Moodle quiz on Study unit 5, Chapter 7, opens on 1
September at 09:00 and closes on 14 September at 17:00
 Prepare Study Unit 6, Chapters 11 and 12, for your lecture on
14 September 2023
 Homework 1 due on 31 August 2023 – due today
 Homework 2 due on 14 September 2023 – submit in class
before commencement of lecture
 Semester test 2 – 14 October 2023 (SUs 4 to 7)

 JSE sector report and presentation due on 20 October at

23:00
 Enrolment key EBMG4022023 43