Topic 3:

Portfolio
Management
“
What is Portfolio Management??
The art and science of making decisions about
investment mix and policy, matching
investments to objectives, asset allocation
(diversification) for individuals and institutions,
and balancing risk against performance.
To optimize the risk/return tradeoff!

Question:
How do you design/construct your portfolio of
securities?
 Main concept of portfolio: Diversification – to
reduce risk!
 By adding different financial assets to the
portfolio, investor benefits from
diversification. He is avoiding excessive
exposure to any one source of risk. Eg. If one
stock falls, he has other stocks to rely on and
does not lose everything.
 The benefit of diversification is that the unique
risk of all the assets in the portfolio can be
eliminated, leaving only the market risk.
 It has been shown from actual financial data,
that a portfolio of 10 to 30 stocks is enough to
eliminate almost all of the unique risk. This is
why it is called diversifiable risk.
 The market risk is non-diversifiable.

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Nondiversifiable risk
 Portfolio Returns- two
Asset Portfolio
 The expected return of the portfolio is
simply the weighted average of the returns
on the individual assets:
E(rP) = wXE(rX) + wYE(rY)
where wX and wY are the weights of the
assets.
 The portfolio return will always be between
the two individual returns.
 Example: Suppose E(rX) = 12% and E(rY) =
20%.
 If you want a portfolio with 25% in asset X
and 75% in asset Y, the expected return on
the portfolio would be:
 E(RP) = 0.25(0.12) + 0.75(0.2) = 0.18 = 18%
How to Calculate Portfolio Risk ?
Covariance

The risk of the portfolio is not as simple.

You CANNOT simply find the weighted
average of the individual risks.
The covariance must be considered.
This is a measure of the degree to which
the two assets move together
(relationship). A positive covariance
means that asset returns move together.
A negative covariance means that asset
returns vary inversely.
Cov(X,Y) = Σ p [rX–E(rX)][rY–E(rY)]
The calculation is incorporating the
variability of returns of both assets at
each probability.
 Example
The returns of two (X and Y) assets are given under 3 scenarios:
Excellent Good Poor
Probability 0.2 0.7 0.1
Asset X 35% 10% 8%
Asset Y 12% 5% 20%

E(rX) = (0.2)(0.35)+(0.7)(0.1)+(0.1)(0.08) = 0.148 = 14.8%

E(rY) = (0.2)(0.12)+(0.7)(0.05)+(0.1)(0.2) = 0.079 = 7.9%
Cov(X,Y) = (0.2)(0.35-0.148)(0.12-0.079)

+ (0.7)(0.1-0.148)(0.05-0.079)

+ (0.1)(0.08-0.148)(0.2-0.079) = 0.001808
 Corelation
The correlation is a standardized measure of
covariance. The symbol for correlation is ρ (rho).

The correlation values are always between -1 and

+1.

σX = 0.1012
σY = 0.0489
ρXY = 0.001808 /(0.1012)(0.0489) = 0.366

The positive correlation tells us that the two assets

move together (just as the positive covariance).
 Degrees of Correlation

 A perfect negative correlation (ρ = -1) is where the asset movements are

exactly opposite to each other. The risk of the portfolio will be completely
eliminated.
 A negative correlation (-1<ρ<0) is where the assets move opposite to
each other. This is the type of relationship that an investor should look for
to get a good diversification benefit. The closer ρ is to -1, the more
diversification.
 A Zero correlation (ρ = 0) is where the asset movements are not related
to each other in any way. The portfolio will still benefit from diversification.
 A positive correlation (0<ρ<1) is where the assets move together. There
will still be a diversification benefit but the closer ρ gets to 1, the less
diversification is attained.
 A perfect positive correlation (ρ = +1) is where the asset movements are
exactly equal to each other. This is the only correlation that will not result
in any diversification benefit.
Portfolio risk (using standard deviation)
 To calculate the portfolio risk, the variances
of the assets as well as the covariance
between them are used:
 If you decide on buying 70% in X and 30%
in Y:
σX = 0.1012; σY = 0.0489

σP = 0.0774 = 7.74%
 The risks of the individual assets were σX =
10.12% and σY = 4.89% but the risk of the
combined portfolio is to 7.74%.
 The expected return on the portfolio is:
0.7(0.148) + 0.3(0.079) = 12.73%
“
The Importance of
Diversification – Why should I
diversify risk?
● In order to reduce risk one just need to
be very conservative,
● risk-averse investor, you decide to
invest all of your money in a bond
mutual fund. Very conservative,
indeed?
Uh, is this decision a wise one?

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Should I add
on HIGHER
risky
securities in
my portfolio
even if I am
risk averse?
Consider
For simplicity, let’s consider 2 fund portfolios.

Stocks
Bonds
Expected Return 12% 6%
Standard Deviation 15% 10%

How to optimize your risk/return tradeoff?

“
Think About It…
Is it possible to
construct the “best”
portfolio for an investor
based on his/her
expected risk/return
trade-off preference?

If yes, how to do it?

 Mean-variance analysis

 P2 wX2  X2  wY2 Y2  2wX wY  X  Y  XY

17

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2 low correlated (or –ve correlated) assets
 Markowitz Model
“Father of the Modern Portfolio Theory”

 We can extend the analysis of the two-asset

portfolio to a combination of as many assets as we
like.
 The calculations for identifying the portfolio
opportunity set would be very complicated because
of the many covariances that would have to be
considered. We could use computer software to
help us do this.
 We will consider these risk-return opportunities to
be identified for us as the minimum-variance frontier
of risky assets. It represents all the possible risky
portfolios that can be chosen.
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Correlation and Diversification
 In Efficient frontier, the various combinations of risk and return
available all fall on a smooth curve.
 This curve is called an investment opportunity set, because it
shows the possible combinations of risk and return available
from portfolios of these two assets.
 A portfolio that offers the highest return for its level of risk is
said to be an efficient portfolio.
 The undesirable portfolios are said to be dominated or
inefficient.
 The magnitude of diversification benefit depends on the
degree of correlation.

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 Asset Allocation (investing in different asset classes – easier to find low
or –ve correlation between assets from different asset classes)
We can illustrate the importance of asset allocation with 3 assets.
How? Suppose we invest in three mutual funds:
 One that contains Foreign Stocks, F
 One that contains U.S. Stocks, S
 One that contains U.S. Bonds, B

Expected Return Standard Deviation

Foreign Stocks, F 18% 35%

U.S. Stocks, S 12% 22%

U.S. Bonds, B 8% 14%

The next slide shows the results of calculating various expected

returns and portfolio standard deviations with these three assets.

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Risk & Return With Multiple Assets
 Asset Allocation or Security
Selection?
 Is asset allocation or security selection more
important to the success of a portfolio?

 Most people are inclined to think security selection is

more important element for successful investing.

 Research shows that asset allocation is more

important.
 About 90% of portfolio performance stems from
asset allocation.
 So, only 10% of portfolio performance comes
from security selection.

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 Asset Allocation
Empirical evidence suggests that we can reduce the risk on portfolios by
combining several different asset classes than to just rely on a single asset
class.
Traditionally, can be a basket of:

Equities: Bonds: Cash

Global, regional, local, Global, regional, high Short term
blue chips, growth. yield, low yield

Or you can just invest into mutual funds in that asset class.

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Portfolio Return Attributors
 Next Question is...
Which combination is the
best for (all of) you in the
investment opportunity set
(regardless of individual
investor’s risk profile?
Sharpe
Ratio
Sharpe Ratio

The Sharpe ratio compares the return of

an investment with its risk. It's a
( rP  rf ) mathematical expression of the insight
that excess returns over a period of time
P may signify more volatility and risk, rather
than investing skill.

William F. Sharpe

rp = Average return on the portfolio

rf = Average risk free rate

p = Standard deviation of portfolio
return
1) Getting Started with Portfolio
Optimization (4.12 min)

2) Optimal portfolios with Excel

Solver (6.22 min)

3) Investing Basics- The Efficient

Frontier (3.58 min)

4) Explained: Modern Portfolio

Theory (3 min)

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Capital Allocation Line
The investor can allocate his investment between the risk-free
asset and P.

The points along the capital allocation line represent ALL

possible risk-return combinations available to the investor.
It is the different possible combinations between the risky
assets and non-risky assets

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 The optimal risky portfolio, P
• The steeper the CAL, the better. You get more return
for the given risk – invest in more diverse assets
• The CAL that just touches the opportunity set
indicates the optimal P at the point of tangency.
• Any other CAL that cuts the curve would have a
lower slope, meaning that there is less return. This is
not optimal.
• At point P
– E(r) = 11%
– σ = 14.20%
 Capital Market Line
 The capital market line (CML) is similar to the
capital allocation line (CAL) that we just analysed.
 The two components of the CAL are rf and P.
 When we substitute
 the return on a 30-day T-bill as the risk-free
rate
 the market portfolio as the risky portfolio
 the CAL is transformed into the CML.
 The market portfolio, M, is a broad index
represents the stocks in the market.
 The CML is seen as representing a passive
strategy
“
Next Week
Topic 4 –
Investment & Risk
Management