Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
by
Frank K. Reilly & Keith C. Brown

Chapter 7
 Chapter 7 - An Introduction to
Portfolio Management
Questions to be answered:
• What do we mean by risk aversion and what
evidence indicates that investors are generally
risk averse?
• What are the basic assumptions behind the
Markowitz portfolio theory?
• What is meant by risk and what are some of the
alternative measures of risk used in
investments?
 Chapter 7 - An Introduction to
Portfolio Management
• How do you compute the expected rate of
return for an individual risky asset or a
portfolio of assets?
• How do you compute the standard deviation of
rates of return for an individual risky asset?
• What is meant by the covariance between rates
of return and how do you compute covariance?
 Chapter 7 - An Introduction to
Portfolio Management
• What is the relationship between covariance
and correlation?
• What is the formula for the standard deviation
for a portfolio of risky assets and how does it
differ from the standard deviation of an
individual risky asset?
• Given the formula for the standard deviation of
a portfolio, how and why do you diversify a
portfolio?
 Chapter 7 - An Introduction to
Portfolio Management
• What happens to the standard deviation of a
portfolio when you change the correlation
between the assets in the portfolio?
• What is the risk-return efficient frontier?
• Is it reasonable for alternative investors to
select different portfolios from the portfolios on
the efficient frontier?
• What determines which portfolio on the
efficient frontier is selected by an individual
investor?
 why the need of portfolio theory
• you cannot create an optimum investment portfolio by
simply combining numerous individual securities that
have desirable risk–return characteristics.
• an investor must consider the relationship among the
investments to build an optimum portfolio that will meet
investment objectives.
• The recognition of how to create an optimum portfolio
was demonstrated in the derivation of portfolio theory.
 Optimal Portfolio
• an optimal portfolio is one that is a perfect
balance between risk and return.

• The optimal portfolio aims to balance securities

with the greatest potential returns with an
acceptable degree of risk or securities with the
lowest degree of risk for a given level of potential
return.
Background Assumptions
general assumptions of portfolio theory .
• As an investor you want to maximize the
returns,from total set of investments,for a given
level of risk.
1. Your portfolio includes all of your assets and
liabilities (stocks car house art coins etc)
2. The relationship between the returns for assets in
the portfolio is important.
3. A good portfolio is not simply a collection of
individually good investments.
 Risk Aversion
Given a choice between two assets with
equal rates of return, most investors
will select the asset with the lower
level of risk.
Not all investors are risk averse-Risk
preference may have to do with amount of
money involved - risking small amounts,
but insuring large losses
 Definition of Risk
1. Uncertainty of future outcomes
or
2. Probability of an adverse outcome
 Markowitz Portfolio Theory
• Modern portfolio theory (MPT) is a theory on
how risk-averse investors can construct
portfolios to optimize or maximize
expected return based on a given level of
market risk.
• The basic portfolio model was developed by
Harry Markowitz (1952, 1959).
• was awarded a Nobel prize for his work.
 Markowitz Portfolio Theory
• Quantifies risk
• Derives the expected rate of return for a
portfolio of assets and an expected risk measure
• Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
• Derives the formula for computing the variance
of a portfolio, showing how to effectively
diversify a portfolio
 Assumptions of
Markowitz Portfolio Theory
1. Investors consider each investment
alternative as being presented by a
probability distribution of expected returns
over some holding period.
 Assumptions of
Markowitz Portfolio Theory
2. Investors minimize one-period expected utility,
and their utility curves demonstrate diminishing
marginal utility of wealth.
Utility is an economic term used to represent satisfaction
or happiness. Marginal utility is the incremental
increase in utility that results from consumption of one
additional unit.
Diminishing Marginal Utility means that all else equal,
as consumption increases the marginal utility derived
from each additional unit declines. the satisfaction
derived from every additional unit of consumption –
the marginal utility – goes on decreasing.
 example
• assume an individual pays $100 for a
vacuum cleaner. Because he has little value
for a second vacuum cleaner, the same
individual is willing to pay only $20 for a
second vacuum cleaner.
• Consuming one candy bar may satisfy a
person's sweet tooth. If a second candy bar
is consumed, the satisfaction of eating that
second bar will be less than the satisfaction
gained from eating the first.
 Another example
• An individual can purchase a slice of pizza for $2; she
is quite hungry and decides to buy five slices of pizza.
• After doing so, the individual consumes the first slice
of pizza and gains a certain positive utility from eating
the food. Because the individual was hungry and this
is the first food she consumed, the first slice of pizza
has a high benefit.
• Upon consuming the second slice of pizza, the
individual’s appetite is becoming satisfied. She wasn't
as hungry as before, so the second slice of pizza had a
smaller benefit and enjoyment as the first.
• The third slice, as before, holds even less utility as the
individual is now not hungry anymore.
 Assumptions of
Markowitz Portfolio Theory
3. Investors estimate the risk of the portfolio
on the basis of the variability of expected
returns.
 Assumptions of
Markowitz Portfolio Theory
4. Investors base decisions solely on expected
return and risk, so their utility curves are a
function of expected return and the
expected variance (or standard deviation) of
returns only.
 Assumptions of
Markowitz Portfolio Theory
5. For a given risk level, investors prefer
higher returns to lower returns. Similarly,
for a given level of expected returns,
investors prefer less risk to more risk.
 Markowitz Portfolio Theory
Using these five assumptions, a single asset
or portfolio of assets is considered to be
efficient if no other asset or portfolio of
assets offers higher expected return with the
same (or lower) risk, or lower risk with the
same (or higher) expected return.
 Efficient Frontier
• Every investment is the choice between risk &
return.
• efficient frontier is modern portfolio theory tool
that shows investor the best possible return they
can expect from their portfolio, given the level of
risk they are willing to accept.
• Efficient/optimal portfolio lies on the curve.
• Below the curve portfolio are undesirable
• Above the curve portfolio is impossible to
achieve,
 Efficient Frontier

• Every possible combination of assets that exists can be

plotted on a graph, with the portfolio's risk on the X-axis
and the expected return on the Y-axis.
• This plot reveals the most desirable portfolios. For
example, assume Portfolio A has an expected return of
8.5% and a standard deviation of 8%, and that Portfolio B
has an expected return of 8.5% and a standard deviation
of 9.5%. Portfolio A would be deemed more "efficient"
because it has the same expected return but a lower risk.
 Alternative Measures of Risk
1. Variance or standard deviation of expected
return-larger value ,larger dispersion, larger risk
2. Range of returns- a larger range of expected
returns, from the lowest to the highest, means
greater uncertainty regarding future expected
returns
3. Returns below expectations
– Semivariance – a measure that only considers
deviations below the mean
– These measures of risk implicitly assume that
investors want to minimize the damage from returns
less than some target rate
 Expected Rates of Return
• For an individual asset - sum of the
potential returns multiplied with the
corresponding probability of the returns
• For a portfolio of assets - weighted average
of the expected rates of return for the
individual investments in the portfolio
Expected Rates of Return
individual asset
1.6
Expected Rates of Return
portfolio
Computation of Expected Return for an
Individual Risky Investment
Exhibit 7.1
Computation of the Expected Return
for a Portfolio of Risky Assets

Exhibit 7.2
 Variance (Standard Deviation) of
Returns for an Individual Investment
Standard deviation is the square root of the
variance
Variance is a measure of the variation of
possible rates of return Ri, from the
expected rate of return [E(Ri)]
 Variance (Standard Deviation) of
Returns for an Individual Investment

where Pi is the probability of the possible rate

of return, Ri
 Variance (Standard Deviation) of
Returns for an Individual Investment

Standard Deviation
 Variance (Standard Deviation) of
Returns for an Individual Investment
Exhibit 7.3

Variance ( 2
) = .0050
Standard Deviation ( ) = .02236
Variance (Standard Deviation) of
Returns for a Portfolio
1. Covariance of Returns: Covariance is a
measure of the degree to which two
variables move together relative to their
individual mean values over time.
– A positive covariance means that the rates of return for
two investments tend to move in the same direction
relative to their individual means during the same time
period.
– In contrast, a negative covariance indicates that the
rates of return for two investments tend to move in
different directions relative to their means during
specified time intervals over time
 Covariance of Returns
For two assets, i and j, the covariance of rates
of return is defined as:
Covij = {[Ri - E(Ri)][Rj - E(Rj)]}/n-1
 Covariance and Correlation
• The correlation coefficient is obtained by
standardizing (dividing) the covariance by
the product of the individual standard
deviations
• The way to measure whether two investments will
contribute to diversifying a portfolio is to compute the
correlation coefficient between their rates of return over
time.
• Correlation coefficients can range from +1.00 to −1.00.
• A correlation of +1.00 means that the rates of return for
these two investments move exactly together. (would not
help diversify the portfolio because they have identical
rate-of-return patterns over time.)
• In contrast, a correlation coefficient of −1.00 means that
the rates of return for two investments move exactly
opposite to each other.
• When one investment is experiencing above-average rates
of return, the other is suffering through similar below-
average rates of return.
• if you want to diversify your portfolio,
reduce the standard deviation of the
portfolio rates of return and reduce your
risk, you want an investment that has either
low positive correlation
• zero correlation,
• or, ideally, negative correlation
• with the other investments in your portfolio.
 Covariance and Correlation
Correlation coefficient varies from -1 to +1
 Correlation Coefficient
• It can vary only in the range +1 to -1. A
value of +1 would indicate perfect positive
correlation. This means that returns for the
two assets move together in a completely
linear manner. A value of –1 would indicate
perfect correlation. This means that the
returns for two assets have the same
percentage movement, but in opposite
directions
Portfolio Standard Deviation
Formula
 Impact of a New Security in a
Portfolio
• As shown by the formula, we see two effects.
• The first is the asset’s own variance of returns,
• the second is the covariance between the returns of this new asset
and the returns of every other asset that is already in the portfolio.
• The relative weight of these numerous covariances is substantially
greater than the asset’s unique variance; the more assets in the
portfolio, the more this is true.
• This means that the important factor to consider
when adding an investment to a portfolio that
contains a number of other investments is not the new
security’s own variance but the average covariance of
this asset with all other investments in the portfolio.
 Problem 1
• Considering the world economic outlook for the
coming year and estimates of sales and earning for
the pharmaceutical industry, you expect the rate of
return for Lauren Labs common stock to range
between −20 percent and +40 percent with the
following probabilities.
• Compute the expected rate of return E(Ri) for
Lauren Labs.
 Problem 2
• Given the following market values of stocks in
your portfolio and their expected rates of
return, what is the expected rate of return for
your common stock portfolio?
 Problem 3
• The following are the monthly rates of
return for Madison Cookies and for Sophie
Electric during a six-month period.(assume
equal probability)
 Problem 4
• You are considering two assets with the
following characteristics.
• E(R1) = 0:15 E(σ1) = 0:10 w1 = 0:5
• E(R2) = 0:20 E(σ2) = 0:20 w2 = 0:5
• Compute the mean and standard deviation of
two portfolios if r1,2 = 0.40 and −0.60,
respectively.
.
 Problem 5
• Given:
• E(R1) = 0:10
• E(R2) = 0:15
• E(σ1) = 0:03
• E(σ2) = 0:05
• Calculate the expected returns and expected standard deviations of a two-stock
portfolio in which Stock 1 has a weight of 60 percent under the following
conditions.
• a. r1,2 = 1.00
• b. r1,2 = 0.75
• c. r1,2 = 0.25
• d. r1,2 = 0.00
• e. r1,2 = −0.25
• f. r1,2 = −0.75
• g. r1,2 = −1.00
 Portfolio Standard Deviation
Calculation
• Any asset of a portfolio may be described
by two characteristics:
– The expected rate of return
– The expected standard deviations of returns
• The correlation, measured by covariance,
affects the portfolio standard deviation
• Low correlation reduces portfolio risk while
not affecting the expected return
1) Equal Risk and Return—
Changing Correlations
Here, the negative covariance term exactly offsets the
individual variance terms, leaving an overall standard
deviation of the portfolio of zero. This would be a risk-free
portfolio.
 Important point to remember
• Combining assets that are not perfectly
correlated does not affect the expected
return of the portfolio, but it does reduce the
risk of the portfolio (as measured by its
standard deviation).
• When we eventually reach the ultimate
combination of perfect negative correlation,
risk is eliminated.
• Perfect negative correlation gives a mean
combined return for the two securities over time
equal to the mean for each of them, so the returns
for the portfolio show no variability.
• Any returns above and below the mean for each
of the assets are completely offset by the return
for the other asset, so there is no variability in
total returns—that is, no risk—for the portfolio.
Thus, a pair of completely
• negatively correlated assets provides the
maximum benefits of diversification by
completely eliminating variability—i.e., risk.
2-Combining Stocks with Different
Returns and Risk
1 .10 .50 .0049 .07
2 .20 .50 .0100 .10

Case Correlation Coefficient Covariance

a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070
 Combining Stocks with Different
Returns and Risk
• Assets may differ in expected rates of return and
individual standard deviations
• Negative correlation reduces portfolio risk
• Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to zero
only when individual standard deviations are
equal.
 Constant Correlation
with Changing Weights
1 .10 r ij = 0.00

2 .20
 Constant Correlation
with Changing Weights
Portfolio Risk-Return Plots for
Different Weights
E(R) f
g 2
With uncorrelated h
assets it is possible i
to create a two j Rij = +1.00
asset portfolio with
k
lower risk than 1
either single asset Rij = 0.00

Standard Deviation of Return

Portfolio Risk-Return Plots for
Different Weights
E(R) f
g 2
With correlated h
assets it is possible i
to create a two j Rij = +1.00
asset portfolio
k Rij = +0.50
between the first 1
two curves Rij = 0.00

Standard Deviation of Return

Portfolio Risk-Return Plots for
Different Weights
E(R) With Rij = -0.50 f
negatively 2
g
correlated h
assets it is i
possible to j Rij = +1.00
create a two k Rij = +0.50
asset portfolio 1
with much Rij = 0.00
lower risk than
either single
asset

Standard Deviation of Return

Portfolio Risk-Return Plots for
Different Weights Exhibit 7.13

E(R) Rij = -0.50 f

Rij = -1.00 g 2
h
i
j Rij = +1.00
k Rij = +0.50
1
Rij = 0.00
With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk

Standard Deviation of Return