PORTFOLIO THEORY

LESSON 4 & 5
Introduction to Portfolio Theory
• Portfolio Theory is a framework for constructing and managing a collection of investments
(a portfolio) to maximize returns for a given level of risk or minimize risk for a given level
of expected return.
• It is a cornerstone of modern investment management and forms the basis for many
investment strategies.
• This is the theory that states that assets should be chosen on the basis of how they
interact with one another rather than how they perform in isolation.
• According to this theory, an optimal combination would secure for the investor the highest
possible return for a given level of risk or the least possible risk for a given level of return.
• Although individual investors can use some of the ideas of portfolio theory in putting
together a group of investments, the theory and the literature relating to it are so complex
and mathematically sophisticated that the theory is applied primarily by market
professionals.
 Key Concepts of Portfolio Theory

• Diversification: Diversification is the practice of investing in a variety of assets to reduce risk. Portfolio theory
emphasizes that holding a mix of different assets can lower the portfolio’s overall risk, as the performance of one
investment may offset the poor performance of another.
• Example: Combining stocks, bonds, and commodities in a portfolio reduces exposure to any single asset class or
industry.
• Risk and Return: Every investment has an associated risk and expected return. Portfolio theory seeks to balance these
two factors to achieve an optimal trade-off:
• Risk: The variability of returns (measured by standard deviation).
• Return: The expected profit or gain from an investment.Investors are assumed to prefer higher returns for lower
levels of risk.
• Efficient Frontier: The efficient frontier is a graphical representation of the optimal portfolios that offer the highest
return for a given level of risk. Portfolios below the efficient frontier are considered suboptimal because they do not
provide sufficient return for the risk taken. Objective is to Construct a portfolio that lies on the efficient frontier.
• Correlation: Correlation measures how two assets move in relation to one another. Portfolio theory emphasizes
combining assets with low or negative correlations to reduce overall portfolio risk.
• Positive correlation: Assets move in the same direction.
• Negative correlation: Assets move in opposite directions.
• Example: Combining stocks (which may rise during economic growth) with bonds (which may perform well during
downturns) can reduce risk.
• Risk-Return Trade-off:Investors must decide how much risk they are willing to take to achieve a desired level of return.
Portfolio theory assumes that investors are risk-averse, meaning they prefer lower risk for a given level of return.
 A Portfolio
• A portfolio is a group of assets e.g. projects, investments or securities
held by an investor with the objective of maximizing return for a given
level of risk. A company is normally faced with two types of risks
namely:-
• a) Financial risk – This results from the use of debt in the company’s
capital structure. This is due to the fixed financial charges in form of
interest due from the company’s gearing level. Financial risk is normally
measured using the financial gearing ratio. Gearing Ratio=
• b) Business / Operating / Total risk – This refers to the fluctuations of
the company’s expected earnings due to the nature of the industry is in
which the company operates. Business risk is also known as total risk
because it is a combination of systematic risk and unsystematic risk.
Systematic risk
• i) Systematic risk
• This refers to variations in returns of securities due to factors which systematically
affects all firms adversely. These factors include war, inflation, recession, high
interest rates etc. All securities tend to be negatively affected by these factors and
for this reason, systematic risk can not be eliminated by diversification.
ii) Unsystematic
This refers to variations in returns of a company or a security due to factors which
are unique to the specific company. These are factors such as legal suits, strikes,
successful / unsuccessful marketing programs, losing or winning a major contract
etc. Since these events are essentially random, then their effects on a portfolio can
be eliminated by diversification where bad events in one firm can be offset by good
events in another.
Factors influencing the efficiency of
a portfolio.
• There are normally two factors which influence the efficiency of the
portfolio. These are;
• The number of securities forming the portfolio
• The nature of the relationship between the returns of the securities
forming the portfolio
Number of securities forming the portfolio
• It has been established that between 15 to 20 well-selected securities
will form an efficient portfolio.
• A portfolio with more than 20 securities is likely to malfunction because
of management problems. The relationship between the number of
securities forming the portfolio and the risk of that portfolio can be
represented diagrammatically as shown below:
Nature of relationships between the
security returns forming a portfolio
• The possible relationship between the security returns forming the portfolio will be either positive or
negative.
• For risk diversification purposes a negative relationship is recommended. Security returns are assumed
to have a negative relationship if a given economic factor affects their performance in the opposite
direction.
• A negative relationship occurs when a given economic factor affects the performance of the two
securities in the opposite direction.
• Example: Consider firm A, an ice cream manufacturing company, and firm B, a raincoat manufacturing
company. The risk being minimized in this case is weather conditions. Let’s suppose that it is rainy and
humid most of the time. Demand for products of firm B will be higher than those of firm A. This negative
relationship will favour risk diversification because the effect of such weather conditions will easily be
averaged out.\
• On the other hand a positive relationship occurs if a given economic factor affects performance of the
companies in the same direction. E.g. two companies are manufacturing gumboots and another
manufacturing rain coats. If it is sunny and dry most of the time then the demand for these products will
decrease and vice versa if it’s rainy most o f the time
Measuring the relationship between
the returns of securities
• To measure the relationship between the returns of securities, we use
covariance. Covariance between A and B can be given by:

• Covariance will be negative for negative correlation (association) and

positive for positive correlation.
Measuring the strength of
correlation
• To measure the strength of the association between the returns, a
standardized statistical measure called the correlation coefficient
denoted (ρ) read as (rho) is used.
 PORTFOLIO RETURN
• The portfolios expected return is equal to a weighted average of the
returns of the individual assets in the portfolio, the weights being the
proportions of each asset in the portfolio.
PORTFOLIO RISK
• Risk of a portfolio is also measured by its standard deviation or by its
variance. Risk of a portfolio depends on:
• i) Correlation or covariance between the returns of the two
securities.
• ii) The risk of the constituent (individual) investments in isolation
as measured by standard deviation.
• iii) The weights or proportions of the individual investments in the
portfolio.
• Generally for a two asset case the following formula is used to
calculate risk of a portfolio:
Summary
• Standard deviations is the favored measure of risk of a portfolio
Illustration
• Consider the returns of two securities A & B which depend on the states of nature with
the following probabilities.
Solution
• To obtain the correlation coefficient between the two securities returns. We first need
the covariance between the two:

This is a perfect positive correlation. Where returns are perfect positively collected it is meaningless
to construct such a portfolio since it will not eliminate any risk. This implies that there will be 0% risk
reduction through diversification
Risk of portfolio – 2 asset A and B

•Since the correlation coefficient between the two securities is +1, it is not possible to
form a portfolio of A and B that will minimize risk.
•Now assume that the correlation coefficient between A and B is -1.
Conclusion:

• 1. When ρ = -1 standard deviation of a portfolio is a weighted

difference and its possible to reduce risk significantly by forming a
portfolio.
• 2. When = ρ +1, standard deviation is a weighted average and its
not possible to reduce risk through portfolio formation.
• 3. When ρ is between -1 and +1, use formular
to determine risk and it may be possible to reduce risk to some extent.
 Example
Consider the returns of two securities A & B which depend on the states of nature with the
following probabilities.

a) Compute the expected returns of A and B

b) Compute the standard deviation of returns of the individual securities
c) Compute the correlation coefficient between the two securities returns and comment.
d) Compute portfolios expected return for a portfolio consisting of 60% of A and 40% of B.
e) Compute the risk of the portfolio in (d) above.
ASSIGNMENT 1