Optimal Risky Portfolios

CHAPTER 7: Part 2

INVESTMENTS | BODIE, KANE, MARCUS

McGraw-Hill/Irwin Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Starting Point
Recall from last lecture:
We are trying to build an optimal portfolio We have access to only two assets: a bond mutual fund and a stock mutual fund D: debt (bond mutual fund), E: equity (stock mutual fund) Our question is: what is the optimal portfolio, given the investors preferences (i.e. the utility function)

Optimal Risky Portfolio (no riskfree asset available)

e* is the fraction in stocks
2 E{Re} E{Rd } Cov(d ,e) e* 2 d2 2 2 2Cov(d ,e)] d e 2Cov(d ,e) A[ e d

2 Cov(d ,e) d emin var 2 2 e d 2Cov(d ,e)

Minimum variance component

Relative riskadjusted return component

E{Re} E{Rd } eRelReturn 2 2 2Cov(d ,e)] A[ e d

Capital Allocation Among Risky and Risk Free Assets

Suppose now we have access to two risky assets (equity and bonds) and a risk-free asset Consider two possible risky portfolios, A (the minimum variance portfolio) and B. Each one has associated "Capital Allocation Line," CALA and CALB CALB dominates CALA

E{r}

At S, you can experience the same risk on B as A But expected return is higher on CALB Capital Allocation Lines B A CALB

CALA

.rf

Standard deviation

Capital Allocation Among Risky and Risk Free Assets

Suppose two risky assets (equity and bonds) and a risk-free asset Consider two possible risky portfolios, A and B CALC dominates all other CAL's

The best CAL must be tangent to the efficient frontier

Slope.of .CAL

E{rp}rf

Key observation: best/tangent CAL has highest possible slope

CALC Capital Allocation Lines B A CALB Efficient Frontier

E{r}

CALA

.rf

Standard deviation

The Sharpe Ratio

Maximize the slope of the CAL for any possible portfolio, P. The objective function is the slope:

SP

E (rP ) rf

The slope is also the Sharpe ratio.

The Opportunity Set of the Debt and Equity Funds

Determination of the Optimal Overall Portfolio

Capital Allocation Among Risky and Risk Free Assets

With two risky assets, equities and bonds, allocation to bonds in risky portfolio: d* = [E{rd} - rf]2e - [E{re} - rf]Cov(d,e) [E{re} - rf]2d+ [E{rd} - rf]2e- [(E{re} - rf ) + (E{rd} - rf )]Cov(d,e) .

What a mess! However, it makes sense:

If E{rd} = E{re}, 2e = 2d, and corr(d,e) < 1, then d* =

For identical but imperfectly correlated assets, only goal is risk minimization: Split portfolio evenly

If E{rd} = E{re}, but 2e > 2d, and corr(d,e) < 1, then d* >
For imperfectly correlated assets with identical returns but differing risk, only goal is risk minimization: Invest more than half in the asset with lower risk

If E{rd} < E{re}, but 2e = 2d, and corr(d,e) < 1, then d* <
For imperfectly correlated assets with identical risk but differing returns, there's now a risk-return trade-off: Invest less than half in the asset with lower returns

If E{rd} < E{re}, but 2e = 2d, and corr(d,e) 1, then d* = 0

For perfectly correlated assets with identical risk but differing returns, there is no riskreturn trade-off: Invest none in the asset with lower returns

Capital Allocation Among Risky and Risk Free Assets

Optimal share of bonds in portfolio of risky assets, d*:

d* = d* = 0.40 =

[E{rd} - rf]2e - [E{re} - rf]Cov(d,e) [8 - 5]*202 - [13 - 5]*72 )

[E{re} - rf]2d + [E{rd} - rf]2e- [(E{re} - rf ) + (E{rd} - rf )]Cov(d,e)

[13 - 5]*122 + [8 - 5]*202 - [(13- 5 ) + (8 -5 )]*72 Properties of optimal portfolio of risky assets:

E{rp(d*)} = 11% = 0.4* 8 + 0.6 * 13

p (d*) = 14.2% = [0.42 122 + 0.62 202 + 2*0.4*0.6*72]1/2

Slope of Capital Allocation Line = [E{rp(d*)}-rf]/p(d*) = [11 - 5]/14.2 = 0.42

Capital Allocation Among Risky and Risk Free Assets

An Example:

Bonds

Equities

Risk Free

Expected return
Standard Deviation Correlation

8%
12 0.30

13%
20

5%
0

Which portfolio of risky assets defines the (one and only) Capital Allocation Line?

At the minimum variance portfolio, share stocks= 0.20, E{RP} = 0.09, Stdev(RP) = 0.12, Slope = 0.349
At optimum portfolio, share stocks= 0.60, E{RP} = 0.11, Stdev(P) = 0.14, Slope = 0.423
Capital Allocation Line at Minimum Risk Portfolio? No.
15%

The Right Capital Allocation Line

15%

Expected Return

13% 11% 9% 7% 5% 3% 0% 5% 10% 15% 20% 25%

Expected Return

13% 11% 9% 7% 5% 3% 0% 5% 10% 15% 20% 25%

Standard Deviation

Standard Deviation

Figure 7.9 The Proportions of the Optimal Overall Portfolio

Risk-free rate = 5%; A = 4 y*= (0.11-0.05)/(4*0.142^2)

y* = 0.7439 e* = 0.6*0.7439 = 44.63% d* = 0.4*0.7439 = 29.76% T-bills = 1-y = 0.2561

Markowitz Portfolio Selection Model

Security Selection The first step is to determine the riskreturn opportunities available. All portfolios that lie on the minimumvariance frontier from the global minimum-variance portfolio and upward provide the best risk-return combinations: efficient frontier

The Minimum-Variance Frontier of Risky Assets

Markowitz Portfolio Selection Model

We now search for the CAL with the highest reward-to-variability ratio

Slope.of .CAL

E{rp}rf

Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL

Markowitz Portfolio Selection Model

Everyone invests in P, regardless of their degree of risk aversion. P must be the market portfolio.
More risk averse investors put more in the risk-free asset. Less risk averse investors put more in P.

Capital Allocation and the Separation Property

The separation property tells us that the portfolio choice problem may be separated into two independent tasks Determination of the optimal risky portfolio is purely technical. Allocation of the complete portfolio to Tbills versus the risky portfolio depends on personal preference.

The Power of Diversification

Remember: 2 P
i 1 n

w w Cov(r , r )
j 1 i j i j

Consider an equally-weighted portfolio. If we define the average variance and average covariance of the securities as:
1 n 2 i n i 1
2 n 1 Cov n(n 1) j 1 j i

Cov(r , r )
i 1 i j

The Power of Diversification

We can then express portfolio variance as: 1 2 n 1 2 P Cov n n
If all risk is firm-specific, the average covariance is 0 and as n becomes large, the portfolio variance converges to zero. If there is non-diversifiable risk, the covariance term is not zero, and the portfolio variance does not converge to zero even as we add more and more securities.

Table 7.4 Risk Reduction of Equally Weighted Portfolios in Correlated and Uncorrelated Universes

Optimal Portfolios and Nonnormal Returns

Fat-tailed distributions can result in extreme values of VaR (value at risk) and ES (expected shortfall) and encourage smaller allocations to the risky portfolio.
If other portfolios provide sufficiently better VaR and ES values than the mean-variance efficient portfolio, we may prefer these when faced with fat-tailed distributions.