CHAPTER 5

CHAPTER 5
VALUATION CONCEPTS PART III PORTFOLIO THEORY Learning outcome After studying this chapter, you should be able to understand the following: Introduction to risk management Portfolios and portfolio theory Portfolio risk and diversification Determination of an optimum portfolio International Portfolio Diversification Limitations of Portfolio Analysis Investors preferences Investors indifference curve! "orrelation of Investments #fficient frontier of risky investments "apital $arket Line Information and the efficiency of capital markets
5.0
INTRODUCTION TO RISK MANAGEMENT
The reality of life is that Businesses do not operate in a perfect world where there is no risk. Risk in business, or any activity of life for that matter, is something everyone who undertakes to do business must be ready to encounter. Risk is a concept that denotes a potential negative impact to an asset or some characteristic of value that may arise from some present process or future event. In everyday usage, "risk" is often used synonymously with the probability of a loss or threat. Risk is defined in Webster s dictionary as a !ha"ard# a peril# e$posure to loss or in%ury.& Thus risk refers to the chance that some unfavourable event will occur. In professional risk assessments, risk combines the probability of an event occurring with the impact that event would have and with its different circumstances. Risk does not always only refer to the avoidance of negative outcomes. In finance, risk is only a measure of the variance of possible outcomes. Insurance is a classic e$ample of an investment that reduces risk ' the buyer pays a guaranteed amount, and is protected from a potential large loss. (ambling is a risk increasing investment, wherein money on hand is risked for a possible large return, but also the possibility of losing it all. By this
112 Chapter 5 Portfolio Theory
definition, purchasing a lottery ticket such as )ick * lot, is an e$tremely risky investment +a high chance of no return, but a small chance of a huge return,, while putting money in a bank at a defined rate of interest is a risk'averse course of action +a guaranteed return of a small gain,. (enerally speaking, %isk $anagement is the process of measuring, or assessing risk and developing strategies to manage it. -trategies include transferring the risk to another party, avoiding the risk, reducing the negative effect of the risk, and accepting some or all of the conse.uences of a particular risk. Traditional risk management focuses on risks stemming from physical or legal causes +e.g. natural disasters or fires, accidents, death, and lawsuits,. /inancial risk management, on the other hand, focuses on risks that can be managed using traded financial instruments. In ideal risk management, a prioriti"ation process is followed whereby the risks with the greatest loss and the greatest probability of occurring are handled first, and risks with lower probability of occurrence and lower loss are handled later. In practice the process can be very difficult, and balancing between risks with a high probability of occurrence but lower loss versus a risk with high loss but lower probability of occurrence can often be mishandled. Intangible risk management identifies a new type of risk ' a risk that has a 0112 probability of occurring but is ignored by the organi"ation due to a lack of identification ability. /or e$ample, knowledge risk occurs when deficient knowledge is applied. Relationship risk occurs when collaboration ineffectiveness occurs. )rocess'engagement risk occurs when operational ineffectiveness occurs. These risks directly reduce the productivity of knowledge workers, decrease cost effectiveness, profitability, service, .uality, reputation, brand value, and earnings .uality. Intangible risk management allows risk management to create immediate value from the identification and reduction of risks that reduce productivity. Risk management also faces difficulties allocating resources. This is the idea of opportunity cost. Resources spent on risk management could have been spent on more profitable activities. *gain, ideal risk management minimi"es spending while ma$imi"ing the reduction of the negative effects of risks. 5.0.1 THE DIFFERENCE BETWEEN RISK AND UNCERTAINTY In his seminal work "Risk, 3ncertainty, and )rofit", /rank 4night +0560, established the distinction between risk and uncertainty.
7 &ncertainty must be taken in a sense radically distinct from the familiar notion of %isk, from which it has never been properly separated' ( )he essential fact is that *risk* means in some cases a +uantity susceptible of measurement, while at other times it is something distinctly not of this character, and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating' ( It will appear that a measurable uncertainty, or *risk* proper, as we shall use the term, is so far different from an un-measurable one that it is not in effect an uncertainty at all'
5.0.2
Ris
F!"" I#$"s%&"#%s
(overnment bonds are certainly low risk, but they are not risk'free. There has to be a government there willing to repay them on maturity. If the revolution comes, or the national debt has to be repaid and deposited funds are re.uisitioned, or a period of hyper'inflation occur, they will have little value. 8conomies do collapse and governments do fall. 9o country is immune.
5.0.' E("&"#%s )* T)%+( Ris

Whether it is investing, driving, or %ust walking down the street, everyone e$poses themselves to risk. :our personality and lifestyle play a big deal on how much risk you are comfortably able to take on. If you invest in stocks and have trouble sleeping at nights because of your investments you are probably taking on too much risk. The chance of financial loss, i.e. assets having greater chances of loss are viewed as more risky than those with lesser chances of loss. Investors are risk averse. This means that given two assets that offer the same return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated by higher e$pected returns. ;onversely, an investor who wants higher returns must accept more risk. The e$act trade'off will differ by investor. The implication is that a rational investor will not invest in a portfolio if a second portfolio e$ists with a more favourable risk'return profile ' i.e. if for that level of risk an alternative portfolio e$ists which has better e$pected returns.
B,si#"ss Ris
Business risk arises from the nature of the environment in which a company operates. It is primarily determined by the general economic conditions to which the firm is e$posed and the type of industry in which a company is involved. (eneral economic conditions refer to variables such as inflation, political stability and government regulations. These factors affect all companies within a country. Industry factors are variables that affect specific sectors of the economy, for e$ample, the price of copper has a ma%or impact on the copper mining sector, but relatively little influence on the sugar producing industry. It is important to note that the management of the firm has very little control over the business risk of a firm.
O-"!+%i#. Ris
<perating risk arises from the nature of the operating activities of the firm. The type of industry often determines the general cost structure of a firm +proportions of fi$ed and variable costs, capital' or labour' intensive production processes, and=or the pattern of sales revenue. The total costs of production are usually divided into fi$ed and variable costs and the measurement of operating risks are based on the proportion of fi$ed costs to total production costs. /i$ed costs can act as a "lever", whereby a small change in sales revenue can be magnified into a larger change in profits. The financial manager of a company can
use methods such as ;ost'>olume')rofit +;>), analysis to assess the operating risk of the firm. ?owever, a comparison between companies in the same industry on the basis of ;>) analysis shows that differences e$ist. This indicates that management has some degree of control over the cost structure of the company.
Fi#+#/i+( Ris
/inancial risk arises from the e$tent to which a firm relies on debt to finance its operations. When a firm borrows, it is liable for the interest payments of debt. Whilst operating risk refers to the proportions of the firm@s fi$ed total production costs, financial risk is essentially illustrated by the proportion of debt capital to the total capital of the firm. Interest payments can be thought of as the firm@s fi$ed cost of finance. /inancial risk is entirely under the control of the firm@s management.
C!"0i% )! D"*+,(% Ris

This is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bond@s within their portfolio. (overnment bonds, especially those issued by the /ederal government, have the least amount of default risk and least amount of returns while corporate bonds tend to have the highest amount of default risk but also the higher interest rates. Bonds with lower chances of default are considered to be !investment grade,& and bonds with higher chances are considered to be %unk bonds.
C),#%!1 Ris
This refers to the risk that a country won@t be able to honor its financial commitments. When a country defaults it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. ;ountry risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit.
F)!"i.# E2/3+#." Ris

When investing in foreign countries you must consider the fact that currency e$change rates can change the price of the asset as well. /oreign e$change risk applies to all financial instruments that are in a currency other than your domestic currency. *s an e$ample, if you are a resident of Aambia and invest in some ;anadian stock in ;anadian dollars, even if the share value appreciates, you may lose money if the ;anadian dollar depreciates in relation to the 4wachas.
I#%"!"s% R+%" Ris

* rise in interest rates during the term of your debt securities hurts the performance of stocks and bonds.
P)(i%i/+( Ris
This represents the financial risk that a country@s government will suddenly change its policies. This is a ma%or reason that second and third world countries lack foreign investment.
M+! "% Ris

This is the most familiar of all risks. It@s the day to day fluctuations in a stocks price. *lso referred to as volatility. Barket risk applies mainly to stocks and options. *s a whole, stocks tend to perform well during a bull market and poorly during a bear marketCvolatility is not so much a cause but an effect of certain market forces. >olatility is a measure of risk because it refers to the behavior, or !temperament,& of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance it can go dramatically either way.
T)%+( Ris
The total risk of a company is a combination of business, operating and financial risks. ;ontrolling the degree of total risk is an important corporate function. The financial risk is the one variable that a firm can influence. ?owever, business risk is determined by the economic environment and is not sub%ect to corporate control whilst operating risk is determined by the nature of the firm@s business activities# hence it is hard to control. )ractical e$perience shows that companies with a high degree of business and operating risks usually have a low degree of financial risk, while companies with a low degree of business and operating risk have more scope for using debt capital. <ne of the most important uses of assessing operating and financial risks is the analysis of the firms@ characteristics relative to other firms in the same industry and the analysis of changes in risk and its components over time. ;omparison with other firms allows the assessment of both the risk inherent in an industry and the risk specific to each firm. *nalysing changes in risk components and total risk over time illustrates the firm@s performance over time and gives an indication of changes in the cost and financial structures that occur within a company. The e$istence of any firm depends on the availability of capital, which the firm employs in order to achieve its strategic ob%ectives. The .uestion of capital availability re.uires that financial managers are aware not only of the different sources of capital, but also of where such capital can be obtained. 3nsystematic risk or specific risk represents the portion of an asset@s risk that is associated with random causes that can be eliminated through diversification. It is attributable to firm'specific events, such as strikes, lawsuits, regulatory actions, and loss of a key account. 9on'diversifiable risk +also called systematic risk! is attributable to market factors that affect all firms# it cannot be eliminated through diversification. /actors such as war, inflation, international incidents, and political events account for non' diversifiable risk. Because any investor can create a portfolio of assets that will eliminate virtually all diversifiable risk, the only relevant risk is nondiversifiable risk' *ny investor or firm therefore must be concerned solely with
non'diversifiable risk. The measurement of non'diversifiable risk is thus of primary importance in selecting assets with the most desired risk'return characteristics.
5.1
PORTFOLIOS AND PORTFOLIO THEORY
8very financial manager of a business will consider the total risk of the business carefully and attempt to manage the risk in such a way that shareholders receive the best advantage. /rom an investment analysis point of view, investors consider the most effective way of investing funds. It is well known that placing all one@s funds in one investment only is more risky than spreading the funds. This is known as diversification and the different investments, into which one diversifies is known as a portfolio of investments. In the early 05D1@s there was considerable interest in portfolio theory as an investment strategy. This theory has been developed further in recent years. The theory holds that rational investors all hold a portfolio rather than investing in a single investment. The effect of this is that risk is reduced through holding a portfolio. )ortfolio theory identifies two types of riskE systematic and unsystematic risk. -ystematic +market, non diversifiable, non specific, risk relates to the economy and the stock market as a whole. -hare prices generally are sub%ect to fluctuations. *ny investor who invests in these markets must thus be sub%ect to this risk as it cannot be eliminated through diversification. 3nsystematic +specific, diversifiable, risk relates to specific investments. This risk can be eliminated through investing in a portfolio. Fuite simply, it is based on the principle that some companies will perform well when others do badly and vice versa. The differences between company risks can be eliminated but the overall market risk cannot and everyone has to dance to its tune, at least in the short run period. Get us consider what happens to the risk of a portfolio consisting of a single security +asset,, to which we add securities randomly selected from, say the population of all actively traded securities. 3sing the standard deviation of return, to measure the total portfolio risk, the diagram depicts the behaviour of the total portfolio risk . - A$is, as more securities are added /- A$is,. With the addition of securities, the total portfolio risk declines, as a result of the effects of diversification, and tends to approach a lower limit. Research has shown that, on average, most of the risk'reduction benefits of diversification can be gained by forming portfolios containing 0H to 61 randomly selected securities. )he total risk of a security can be viewed as consisting of two parts: )otal security risk 0 1on diversifiable risk 2 Diversifiable risk
5.1.1
P)!%*)(i) Ris +#0 M"+s,!"&"#%
The risk in an investment, or in a portfolio of investment, is that the actual return will not be the same as the e$pected return. The actual return may be higher, but it may be lower as well. * prudent investor will want to avoid too much risk, and will hope that the actual returns from his portfolio are much the same as what he e$pected them to be.
The risk of a security, and the risk of a portfolio, can be measured as the standard deviation of e$pected of returns, given estimated probabilities of actual returns. The standard deviation of returns. The standard deviation measures the dispersion around the e$pected value. The larger the standard deviation, the higher the risk of an investment is considered to be, as a higher standard deviation infers that there is a greater probability of returns below the e$pected return. ;onsider the normal distributions for the returns of two different assets * and B illustrated in the figure. Both have been constructed using 011 data readings of past returns. It is apparent from the summary statistics and from the graphical representation that asset * carries more risk as there is a higher chance of earning below the e$pected return of 0H2. *sset B has much tighter distribution, with a standard deviation of only I2 and a much lower chance of earning below 062. *sset * has a greater risk because it has a higher standard deviation. What is also apparent is that asset * offers an average return of 0H2 while asset B only offers an average return of 062. This is not by chance. Investors demand a higher return on an asset, which carries risk. This accord with intuition and market forces ensures that this relationship is maintained. *ssume for e$ample that both assets had the same e$pected return, but that asset * has greater risk as measured by the standard deviation. Rational investors will sell shares in asset * in preference for shares in asset B. This will result in a decline in the share price of asset * +and resultant higher returns for investors who purchase at the lower price, and an increase in the share price of asset B +and resultant lower returns for investors who purchase at the higher price,.
TRESPHORD CHAMA EXAMPLE !
)resphord e3pects that the return from an investment has the following probability distribution' %eturn /4 5 86 87 8; Probability P 6'7 6'7 6': 6'8 #3pected %eturn P/ 8'9 7'6 9'6 8'; ----88'6 000
Re"uire#$
"alculate the <tandard Deviation of )resphords investment'
ANSWER4
The e$pected return is 002, and the standard deviation of the e$pected return is calculated as followsE the symbol : refers to the e$pected value of the return, 002. Return 56 J 01 06 0K 5Y 'I '0 0 I P 1.6 1.6 1.H 1.0 >ariance P75 Y82 0.J 1.6 1.H 1.5 I.K
-tandard deviation L M I.K L 0.JK2
%&%'SA ( CHA%&SHA EXAMPLE )
<uppose =ibusa and "habisha have e3perienced the following returns for the last four years' Scenario %ecession 1ormal =oom Re"uire#$ "alculate the following: )he e3pected return, variance and standard deviation for investments in either =ibusa or "habisha stocks, or an e+ually weighted portfolio of both' Pro*a*ility 7:4 ;64 ?:4 764 %i*u+a -;4 54 -;4 >4 ;4 Cha*i+ha
ANSWER Bi9,s+ S%)/ s

R"%,!# 5 'K J 61 P!)9+9i(i%1 P 1.6H 1.K1 1.IH P5 '0.11 I.11 D.11 :.20 E2-"/%"0 R"%,!#
-tandard NeviationE Return 5 'K J 61 5;Y '0I.6 '0.61 01.J P 1.6H 1.K1 1.IH P75;Y82 01.J5 1.6I 0K.65 25.<1
-tandard Neviation L M 6H.K0 L H.1K
C3+9is3+ S%)/ s
R"%,!# 5 5 K 'K P!)9+9i(i%1 P 1.6H 1.K1 1.IH P5 6.6H 0.O1 '0.K1 2.<5 E2-"/%"0 R"%,!#
-tandard NeviationE 5 5 K 'K 5;Y O.HH 0.HH 'O.KH P 1.6H 1.K1 1.IH P75;Y82 6.OJ 1.IJ H.15 =.15
-tandard Neviation L M J.0H L 6.JH
E>,+((1 W"i.3%"0 P)!%*)(i)

8$pected return L +1.H $ 5.62, P +1.H $ 6.KH2, L H.JI2 >ariance L 1.6H +'K2 P 52, $ H, Q H.JI2,6 P 1.K +J2 P K2, $ H, Q H.JI2,6 P1 .IH +612 ' K2, $ H, Q H.JI2,6 L 6.DD P .10 P 0.OH L K.KI -tandard deviation L +K.KI,6 L 6.02 ,OTE$ )hat the standard deviation of the portfolio is considerably less than that of either =ibusa <tocks or "habisha <tock'
T?) Ass"% P)!%*)(i)s

The standard deviation of the returns from a portfolio of two investments can be calculated using the following formulaE
-p . / -a ) X) 0 -)* 1! X2) 0 )X 1! X2 Pa* -a -* 3here$ -p . &+ the +tan#ar# #e4iation of a portfolio of t5o in4e+tment+6 A an# % -a . &+ the +tan#ar# #e4iation of the return+ from in4e+tment A -* . &+ the +tan#ar# #e4iation of the return+ from in4e+tment % -a) 6 -)* . Are the 4ariance+ of return+ from in4e+tment A an# % 1The +"uare+ of the +tan#ar# #e4iation+2 X . &+ the 5eighting or proportion of in4e+tment A in the portfolio Pa* . &+ the correlation coefficient of return+ in4e+tment A an# % that i+$ . Co4ariance of in4e+tment+ A an# % 7 -a 8 -* from
EXAMPLE S'SA, 9'M3E,DA PLC

<usan @umwenda Plc wishes to buy @8 million of shares in each of two companies from a choice of three companies that it might wish to ac+uire at some future date' )he companies are in different industries' Aistoric five year data on the risk and returns of the three companies are shown below'
Company
=walya Boods $ulenga "ommunications @oDile Printers
A4erage annual return+

884 764 8;4
Stan#ar# #e4iation of return+

8C4 7>4 784
Company
=walya Boods $ulenga "ommunications @oDile Printers
Correlation coefficient *et5een return+

6'66 6';6 6'97
$r' "hisanga, an adviser to <usan @umwenda Plc has suggested that the decision about which shares to buy should be based upon selecting the most efficient portfolio of the two shares'
Re"uire#$
#stimate which of the possible portfolios is the most efficient'
ANSWER4 M)s% "**i/i"#% -)!%*)(i)

The method that should be used is to measure risk, as represented by standard deviation, and e$pected return of each of the possible two asset portfolios. The formula to be used to calculate the standard deviation is the one indicated above for two asset portfolios. The e$pected return of each portfolio can be calculated usingE R- @ R+ 2 A R9 71;28 WhereE Rp L 8$pected return of the portfolio Ra L 8$pected return from investment * Rb L 8$pected return from investment B R L The proportion of investment * in the portfolio. The Risk and return for each portfolio can now be calculatedE
B?+(1+ F))0s +#0 M,("#.+ C)&&,#i/+%i)#s4

Fp L M +0D6 S 1.H6, P +656 S 1.H6, P +6S 1.HS1.HS1.1S0DS65, Fp L 0O.J0 Rp L +1.HS00, P +1.HS61, L 0H.H2
B?+(1+ F))0s +#0 K)Bi(" P!i#%"!s M (172 *0.52) + (212 *0.52) + (2*0.5*0.5*0.62*17*21)
Fp L 0D.06 Rp L +1.HS00, P +1.HS0K, L 06.H2
M,("#.+ C)&&,#i/+%i)#s +#0 K)Bi(" P!i#%"!s

Fp L M +656 S1.H6, P +606 S1.H6, P +6S1.HS1.H S1.K S65 S60, Fp L 60.1I
Rp L +1.HS61, P +1.HS0K, L 0D2. It is clear that the portfolio containing Bwalya foods and 4o"ile )rinters is less efficient than that containing of Bwalya and Bulenga since it has both a lower e$pected return of 06.H2 and a higher level of risk of 0D.06. ?owever, it is not possible to say which of the other two portfolios is the most efficient since the Bwalya and 4o"ile has both a lower risk and a lower return than the Bulenga and 4o"ile portfolio. The differences between the levels of risk and return for the two portfolios are broadly similar, and hence it is not possible even to guess at which may be the most efficient.
5.1.2
P)!%*)(i) Ris +#0 Di$"!si*i/+%i)#
?ow many times have you heard someone say, "Non@t put all your eggs in one basket"T When it comes to investing, that@s very good advice. -uccessful investors know that diversifying their investments can help reduce the impact that a single, poorly performing investment can make on their overall portfolio, or mi$ of investments. Niversification means having different kinds of investments, such as stocks, bonds, and mutual funds. It also means having a mi$ of investments in different sectors or industries. * well'diversified portfolio might include bonds, money market funds, and stocks of small, medium, and large companies in a variety of industries and countries. International stocks, for e$ample, may rise at the same time domestic stocks are falling, softening the blow to your overall portfolio. 8ven if your risk tolerance is low, you can still consider diversifying into riskier investments as long as you keep the overall risk of your portfolio low. *n important first step in building a well'diversified investment portfolio is deciding how to divide your money among various investments ' a process called asset allocation. These types of investments can include individual stocks and bonds, mutual funds that invest in stocks or bonds, or bank accounts or money market mutual funds. /inancial professionals such as stockbrokers, financial planners, or insurance agents can help you analy"e your financial needs and ob%ectives and recommend a mi$ of appropriate investments. To help an investor determine the mi$ of investment options that may be appropriate for his investment goals, he should probably be asking the following .uestionsE What are my investment goalsT ?ow much time do I have to reach these goalsT ?ow much can I afford to invest regularlyT ?ow much do my assets need to grow to reach my goalsT ?ow much investment risk am I willing to take to reach my goalsT
Niversification is essential for successful investors who have multiple goals with different time hori"ons. /or e$ample, a I1'year'old unmarried investor is likely to need a different investment mi$ than a H1'year'old with two children heading off to college in the ne$t few years. If you are retired, protecting your principal becomes increasingly important as opposed to growing your investments. Niversification is akin to *not putting all your eggs in one basket'* /or e$ample, if an investor s portfolio only consisted of stocks of technology companies, it would likely face a substantial loss in value if a ma%or event adversely affected the technology industry. There are different ways to diversify a portfolio whose holdings are concentrated in one industry. ?e might invest in the stocks of companies belonging to other industry groups. ?e might want to allocate his portfolio among different categories of stocks, such as growth, value, or income stock. Niversification re.uires an investor to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree to which returns of two securities are related. /or e$ample, two stocks whose returns move in lockstep have a coefficient of P0.1. Two stocks whose returns move in e$actly the opposite direction have a correlation of '0.1. To effectively diversify, an investor should aim to find investments that have a low or negative correlation.
S+&-(" A..!"ssi$" Ass"% A(()/+%i)#
*n aggressive asset allocation is most suitable for investors with a long'term investment hori"on +for e$ample, 61 years or longer,, who tolerate risk well, and whose primary goal is growing their investments.
S+&-(" M)0"!+%" Ass"% A(()/+%i)#
* moderate asset allocation is most suitable for investors with a medium' term investment hori"on +for e$ample, 01 years or longer,, who tolerate risk moderately well, and whose primary investment goal is a moderate level of growth.
S+&-(" C)#s"!$+%i$" Ass"% A(()/+%i)#
* conservative asset allocation is most suitable for investors with a short' term investment hori"on +for e$ample, less than 01 years,, whose risk tolerance is low, and whose primary investment goals are generating income and protecting against inflation. It@s a good idea for an investor to periodically review his investment plan. Because different investments grow at different rates, his original allocation of money among stocks, bonds, and mutual funds will change over time. If this happens with his investments, the investor will probably need to redistribute some money to bring his investment mi$ back into line with his original plan. In addition to the annual review, whenever he makes a ma%or life change, it@s time to reassess his overall financial situation. -ome common e$amples of such changes include switching careers, retiring, getting married or divorced, having a child, starting his own business, taking care of an elderly parent, and returning to school or paying tuition for a child. Bost of these events are likely to affect his ability to invest, his time hori"on, and his investment goals, both short'term and long'term. It@s never easy to find the time to review his investment plan when he is in the midst of any of these life changes. But it@s worth making the effort. ?e would not want to enter a new phase of his life with a financial plan that was designed for different circumstances. In the end, staying on course with a diversified investment mi$ will help make sure that the performance and risk levels of his overall portfolio reflect his goals and e$pectations. The benefits of diversification are indisputable. Niversification is essential for economic survival and prosperityU )articularly in today@s volatile stock market environment, an investor@s greatest risk is not having a properly balanced, diversified portfolio. If an investor s portfolio primarily consist of stocks,
bonds, mutual funds, and other correlated investments that generally move in the same direction, it is advisable to diversify.
5.2
DETERMINATION OF OPTIMUM PORTFOLIOS
*n investor might choose to invest a proportion of his or her wealth in a portfolio of risky assets with the remainder in cash ' earning interest at the risk free rate +or indeed may borrow money to fund his or her purchase of risky assets in which case there is negative cash weighting,. ?ere, the ratio of risky assets to risk free asset determines overall return ' this relationship is clearly linear. It is thus possible to achieve a particular return in one of two waysE By investing all of one s wealth in a risky portfolio# and <r by investing a proportion in a risky portfolio and the remainder in cash +either borrowed or invested,.
/or a given level of return, however, only one of these portfolios will be optimal +in the sense of lowest risk,. -ince the risk free asset is, by definition, uncorrelated with any other asset, option 6, will generally have the lower variance and hence be the more efficient of the two. This relationship also holds for portfolios along the efficient frontierE a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. /or a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio. Tobin@s -eparation Theorem says you can separate the problem into first finding that optimal combination of risky securities and then deciding whether to lend or borrow, depending on your attitude toward risk. It then showed that if there@s only one portfolio plus borrowing and lending, it@s got to be the market portfolio. The reasoning behind this is easy to understand from the following diagramE
*s usual we are trying to build an optimal portfolio for your risk tolerance# and as before, it will lie somewhere on the straight line %oining the cash rate
R* to some optimal mi$ on the efficient frontier. We@re specifically assuming what -harpe said, that high risk investors can and will buy on margin, with money borrowed at the low rate R*. That@s why there is %ust one straight line in the picture and one uni.ue optimal mi$ on the efficient frontier# so the problem of building an optimal portfolio is "separated" into somehow finding the optimal mi$ and then combining it with cash to give you your desired risk tolerance. 9ow for the part that@s really interesting. *ssume that everybody is facing the same efficient frontier that you are, and that the market is efficient in the specific sense that it behaves in the aggregate as if everybody is trying to build an efficient portfolio this way. That means it behaves as if everybody is on your straight line, with the same optimal mi$ as you. -o the mi$ that the market is holding ' the inde3 ' is guaranteed to be your own personal optimal mi$.
5.'
INTERNATIONAL PORTFOLIO DIVERSIFICATION
It has been estimated that about D2 of total world e.uities has been estimated to comprise cross'border holdings. 8ven so, it is arguable that there remains a domestic bias among many types of investor, which can be attributed to a number of barriers to international investment, including the followingE Gegal restrictions e$ist in some markets, limiting ownership of securities by foreign investors. /oreign e$change regulation may prohibit international investment or may make it more e$pensive. Nouble ta$ation of income from foreign investment may deter investors There are likely to be higher information and transaction costs associated with investing in foreign securities -ome types of investor may have a parochial home bias for domestic investment.
There are a number of arguments in favour of international portfolio diversification.
Di$"!si*i/+%i)# )* !is
* portfolio which is diversified internationally should in theory be less risky than a purely domestic portfolio. This is of advantage to any risk' averse investor. *s with a purely domestic portfolio, the e$tent to which risk is reduced by international diversification will depend upon the degree of correlation between individual securities in the portfolio. The lower the
degree of correlation between returns on the securities, the more risk can be avoided by diversification. * few years ago, few investors .uestioned the value of investing internationally. *llocating some portion of one@s portfolio to non ' Aambian e.uities had clearly delivered on the promise of providing better risk'ad%usted returns than a portfolio of Aambian assets alone. In fact, the case for international investing was so compelling that most of the research during the last decade focused not on whether to invest internationally, but how much to invest.
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The idea behind international diversification is that by adding non' Aambian assets to a Aambian portfolio, investors reduce portfolio'level volatility and, thereby, generate better risk'ad%usted returns. In any given period, portfolio returns in international markets may be higher or lower than returns generated in an investor@s domestic market. ?owever, over long holding periods international diversification has delivered on the promise of reducing portfolio volatility and enhancing risk'ad%usted returns.
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*nnual Return Risk +-td. deviation, -harpe ratio Source$ :actSet
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/or instance, in the 3-*, from 05D1'6110, an internationally diversified portfolio reali"ed both of these benefits. While higher returns and lower risk need not occur simultaneously for successful international diversification, many investors have come to e$pect both. This is perhaps one source of frustration for investors whose portfolio returns had fallen short of 3.- only portfolios, even as portfolio risk levels declined.
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While long'term data confirm the benefits of investing internationally, investors are wary of the recent upward trend in correlations between global markets. Noes this trend diminish the benefits of international investing or perhaps signal the demise of international diversification all togetherT Both the magnitude and duration of any increase in correlation will determine the answer. <ver the past I0 years, correlation between 3.-. and international markets averaged 1.H, however, the figure actually ranged from 1.0 to 1.J.
8ric Brandhorst, a Nirector of Research for (lobal -tructured )roducts in a 3-* firm, observes that while correlations between 3.-. and non'3.-. markets have moved higher in recent years, this is not the first time they have reached high levels. )revious spikes came in the early and mid D1s, as well as in the late J1s. * significant drop has followed each spike in correlation. *s recently as the mid'51s, the correlation between 8*/8 e$'Vapan and the 3.-. was as low as 1.H, dropping from a high of 1.J in 05J5. -imilarly, the correlation between Vapan and the 3.-. has varied over time with a long'term average of %ust 1.I. <nly recently has the correlation between the 3.-. and non'3.-. markets moved materially higher than the long'term average. Barkets often move more closely together in times of unusual market activity such as the05JD crash, the (ulf War, the 055J *sian financial crisis and the 0555'6111 technology bubble. While any increase in correlation lessens the effectiveness of diversification, the temporary nature of periods of unusual activity suggests that investors should avoid overstating the decline in long' term diversification benefits. /or e$ample, the recent rise in correlations is in part a reflection of the unwinding of global e$cesses in technology, telecom and internet shares. Investors can, therefore, e$pect correlations to settle in at levels more reflective of long'term averages. Ten'year correlation
averages offer a more appropriate measure of the e$tent to which markets are becoming more connected.
-ome investors argue that the recent increase in correlations reflects a new economic environment where firms are more global and economies are more integrated. They suggest that these correlation levels will persist and conse.uently reduce the effectiveness of international diversification. If correlations reflect these trends, one would e$pect the correlation of fundamental measures, such as earnings growth, to have increased. In our view, an increase in the correlation of underlying cash flow growth signals that, in fact, economies are becoming more integrated and firms more global. ?owever, while changes in )=8 ratios across markets have become more correlated in recent years +what we call "valuation correlation",, the same cannot be said for the correlation between cash'flow growth rates across countries. This suggests that the recent increase in the correlation of returns is a more temporary reflection of changing views of global risk, rather than a permanent increase in correlation reflecting higher levels of economic integration. )ut another way, we do not believe that an increase in "valuation correlation" can persist if there is little evidence of "fundamental correlation". ?ow can markets that are e$periencing truly different cash flow growth have such consistently similar views of changing risksT
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/igure 6 illustrates that the correlation between cash earnings'per'share growth for ma%or markets does not appear to be particularly correlated. 9either does the correlation appear to be trending upward. )=8 changes are reflecting much higher levels of correlation than underlying fundamentals
would suggest. Gong'term correlations may be on the rise, but a more sustainable level is probably between 1.O and 1.OH. /urthermore, even at increased correlation levels, diversification benefits still e$ist which significantly improve the risk=return profile of a global portfolio.
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/igure I illustrates the percentage improvement in the -harpe ratio of a portfolio comprising J12 3.-. e.uities and 612 non'3.-. e.uities for different levels of correlation.
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*dding non'3.-. assets to a 3.-. portfolio improves the risk=return trade'off of the portfolio across all different levels of correlation. *s one might e$pect, the lower the correlation between assets, the bigger the improvement in the portfolio@s -harpe ratio. /or e$ample, a portfolio comprised of assets with a correlation of 1.H offers a 5.02 improvement in the -harpe ratio while only a I.K2 improvement e$ists in the portfolio with a correlation level of 1.J. 8ven if long'term correlations are creeping upward, say to a new level of 1.OH, significant improvements +O2'D2, in the risk=return tradeoff of the portfolio can still be achieved by adding non'3.-. assets to the mi$. It is also important to put the diversification benefit of international e.uity into perspective relative to other potential portfolio diversifiers. 8ven if one assumes a permanent decrease in diversification benefit of international e.uity as a reflection of a more integrated global economy, the benefits are still significant relative to many other asset classes. <ur analysis suggests
that for a 3.-. large'cap e.uity investor, the benefits of international diversification lie somewhere between the benefits offered by diversifying into small'cap e.uities and bonds.
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;orrelations aside, many investors simply feel more comfortable investing in 3.-. assets due to the return advantage the 3.-. market has en%oyed versus other developed markets over the last 0H years. -ome argue that the fle$ibility and entrepreneurial mindset of 3.-. corporations, sound monetary and fiscal policy, and the level of regulation in the 3.-. combine to create a more fertile ground for earnings growth and e.uity return. The e$traordinary market gains e$perienced by 3.-. e.uities over the past decade have only reinforced that idea. Those who were invested internationally during the 0551s were left feeling as though they had "diversified away" opportunities for e$ceptional returns. ?owever, it is naWve and potentially very harmful to e$trapolate historical returns, particularly following a long period of superior performance by one asset. /orecasting relative returns between markets is notoriously difficult, and runs counter to the fundamental idea of diversification. *ccepting diversification as an important ob%ective means that investors believe that over time, markets will price assets to reflect the return and risk associated with the investment opportunity ' even if the reali"ation of return can differ .uite significantly from e$pectations. While we believe in the pure benefits of diversification, some historical perspective on the valuation, capitali"ation, and return characteristics of international investments relative to the 3.-. is helpful to investors who .uestion the role of international e.uity in portfolios.
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The increase in wealth over time for the 3.-., Vapan and 8*/8 e$'Vapan markets has essentially been the same for the I0'year period beginning in 05D1 and ending in 6110. While the end'point was the same for each asset, the paths to that end'point diverged significantly along the way, as illustrated in /igure K. 9onetheless, historically the 3.-. market has not out'shined other developed markets, and in fact the superior 3.-. performance since 05JJ is largely a reversal of superior performance by international markets from 05D1 to 05JJ, as seen in /igure H.
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While the three asset classes e$perienced nearly identical annuali"ed returns since 05D1, many investors didn@t make their first foray into international e.uities until the late J1s or early 51s, the e$act period during which Vapan began its precipitous fall from grace. This unfortunate timing may be the cause for much of the current an$iety over international investing. Those investors who eagerly anticipated the rewards of international investing 01 or 0H years ago are in some cases considering %umping ship today. * long'term observer might remark that the timing of this potential e$odus couldn@t be worse. 9ot only do the returns indicate that international assets may be poised for improved relative performance, but various valuation measures also suggest that the 3.-. e.uity market may be e$pensive relative to other e.uity markets. In summary, we can safely say that International diversification works. <ver the past I1 years, portfolios comprising both 3.-. and non'3.- e.uities have e$perienced higher returns and lower levels of overall risk and this trend can be said to be true about Aambian portfolios that are mi$ed with non Aambian portfolios. Risk reduction is usually the dominant effect for those who invest
internationally and if you are still struggling to grasp this concept, %ust think about why most *frican )residents consider investing abroad rather than their home countries. *nd the simple reason is that the risk of holding only domestic portfolios is so high that they risk being stripped of those portfolios after leaving office. While the reali"ed correlation of returns between countries has risen in recent years, there is little evidence that changes in underlying cash'flows have become more correlated across countries. While the changes in valuation ratios across countries have become more correlated, it is possible to .uestion the e$tent to which elevated @valuation correlation@ can persist in the face of fundamental cash'flow growth diversification. *lthough it is prudent to be hesitant to endorse international e.uities from a relative return standpoint, it is true that capitali"ation, reali"ed return and valuation data suggest that international e.uities are at least as attractive as one country s e.uities ' if not more so.
5.<
LIMITATIONS OF PORTFOLIO ANALYSIS
)ortfolio analysis is useful for diversifying through the firm s investment decisions. *pplied to selection of investment proposals, portfolio theory has a number of limitations. )robabilities of different outcomes must be estimatedE fairly easy for +e.g., machine replacement# more difficult for +e.g., new product development. -hareholder preferences between risk and return may be difficult to know and personal ta$es may impact. )ortfolio theory is based on the idea of managers assessing the relevant probabilities and deciding the combination of activities for the business. Banagers have their %ob security to consider, while the shareholder can easily buy and sell securities. Banagers may therefore be more risk averse than shareholders, and this may distort managers investment decisions. )ro%ects may be of such a si"e that they are not easy to divide in accordance with recommended diversification principles. The theory assumes that there are constant returns to scale, in other words that the percentage returns provided by a pro%ect are the same however much is invested in it. In practice, there are may be economies of scale gained from making a larger investment in a single pro%ect. <ther aspects of risk not covered by the theory may need to be considered, e.g. Bankruptcy costs.
5.5
INVESTORSG PREFERENCES
Investors must choose a portfolio which gives them a satisfactory balance betweenE
The e$pected returns from a portfolio# and The risk that actual returns from the portfolio will be higher or lower than e$pected. -ome portfolios will be more risky than others.
Traditional investment theory suggests that rational investors wish to ma$imi"e return and minimi"e risk. Thus, if two portfolios have the same element of risk, the investor will choose the one yielding the higher return. -imilarly, if two portfolios offer the same return the investor will select the portfolio with the lesser risk.
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Bean'variance theory provides a neat separation between Investor preferences and capital market opportunities. The latter are summari"ed in the feasible mean'variance opportunity set and its efficient frontier. The former can be shown with a set of Investor indifference curves The diagram below shows portions of a map of the preferences of a specific Investor
?ere are some answers obtained when this Investor was asked to choose between various pairs of mean'variance combinationsE C3))s" 9"%?""# W and : > and : R and : W and A > and R A and : A#s?"! W : Non@t care W R Non@t care
These responses can be written using algebraic notation, with X meaning "is preferred to" +more properlyE "would be chosen over",, Y the converse, and L meaning "is e.ually desirable as" +more properly, "would let someone else choose" or "flip a coin",. ThusE WX: :X>
RL: WXA RX> AL: If the Investor has transitive preferences, we can combine all these responses, using the rules of algebraE WXRL:LAX> Thus if we know that W is preferred to : and : is preferred to >, we assume that if asked to choose between W and >, the Investor would pick W. This may seem obvious, but people often fail to make choices that are "rational" in this sense. Worse yet, when the preferences represent the results of choices made by a committee voting by ma%ority rule, instances of intransitivity are common. In such cases the order in which votes are presented can easily affect the outcome. Thus W might win over : in a first vote, and : over > in a second vote, even though in an initial contest between W and >, the victory might have gone to >. The *nalyst who works with Investment ;ommittees must be aware of such possibilitiesE a difficult task indeed. -uch is the world of practice. In the world of theory no such dangers lurk. The Investor is assumed to have transitive preferences which can, in principle, be graphed as a series of indifference curves of the type shown in the figure. The Investor is indifferent among all combinations of e$pected return and risk plotting on a single indifference curve +for e$ample, R,: and A,. ?e or she prefers any combination on a curve that cuts the e$pected return a$is at a higher point to any combination that cuts it at a lower point. Thus W is preferred to R +or : or A or >,, and R +or : or A, is preferred to >. The %oint task of the Investor and the *nalyst is to put the former on the highest possible indifference curve. This is shown below, with the red curve plotting the risk and return combinations available with efficient portfolios.
In this case, point : is optimal. 9ote that point 80 is inferior. 8ven though it represents an efficient mean'variance combination, it puts the Investor on the lowest curve shown, points on which are inferior to points on the middle curve, given his or her preferences. <f course, this Investor would prefer to be on the highest curve shown, but this is impossible, given current resources and capital market opportunities. It would be convenient if each Investor would present an *nalyst with a complete map of his or her indifference curves. The *nalyst could then recommend an asset mi$ virtually instantaneously. But the task is never this simple. *s we will see, indifference curves are a useful construct, but in practice the *nalyst generally focuses on only one portion of an Investor@s entire indifference map.
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The points marked on the efficient frontier correspond to the positions of three different investors, each of whom prefers the level of return and risk associated with the chosen point to any other on the frontier. 8ach investor has a series of indifference curves, and will choose to be situated on the highest indifference curve that is tangential to the best available investment opportunities. The average investor is risk averse, and so will only support more risky undertakings if the reward for doing so is at a suitably high level, hence the slope of these indifference curves. The most advantageous result an investor can obtain would therefore be where one of his indifference curves is tangential to the efficient frontier, for at that point all specific risk would have been removed, and no greater utility could be derived from moving to any other position. 9o investor would wish to remain in a position to the right, or below, the efficient frontier as in that case specific risk would still e$ist. 9o opportunities currently e$ist to the left, or above, the frontier. ,ote$ the efficient frontier is a curve, because the e3tra return for accepting e3tra risk is not constant - eventually no additional return will be on offer, no matter what the risk, so the curve flattens'
The "AP$, which we will e$plore in more detail in the ne$t chapter, assumes that the risk'return profile of a portfolio can be optimi"ed ' an optimal portfolio displays the lowest possible level of risk for its level of return. *dditionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, +assuming no trading costs, with each asset value'weighted to achieve the above +assuming that any asset is infinitely divisible,. *ll such optimal portfolios, i.e., one for each level of return, comprise the efficient frontier. *n important property of the efficient frontier is that it@s curved, not straight. This is actually significant ' in fact, it@s the key to how diversification lets you improve your reward'to'risk ratio. To see why, imagine a H1=H1 allocation between %ust two securities. *ssuming that the year'to'year performance of these two securities is not perfectly in sync ' that is, assuming that the great years and the lousy years for -ecurity 0 don@t correspond perfectly to the great years and lousy years for -ecurity 6, but that their cycles are at least a little off ' then the standard deviation of the H1=H1 allocation will be less than the average of the standard deviations of the two securities separately. (raphically, this stretches the possible allocations to the left of the straight line %oining the two securities. In statistical terms, this effect is due to lack of covariance. The smaller the covariance between the two securities ' the more out of sync they are ' the smaller the standard deviation of a portfolio that combines them. The ultimate would be to find two securities with negative covariance +very out of syncE the best years of one happen during the worst years of the other, and vice versa,.
5.H
CORRELATION AND COVARIANCE OF INVESTMENTS
There is little doubt that the correlation coefficient in its many forms has become the workhorse of .uantitative research and analysis. *nd well it
should be, for our empirical knowledge is fundamentally of co'varying things. We come to discern relationships among things in terms of whether they change together or separately# we come to impute causes on the basis of phenomena co'occurring# and we come to classify as a result of independent variation. When we perceive two things that covary, what do we seeT When we see one thing vary, we perceive it changing in some regard, as the sun setting, the price of goods increasing, or the alternation of green and red lights at an intersection in ;airo Road. Therefore, when two things covary there are two possibilities. <ne is that the change in a thing is concomitant with the change in another, as the change in a child@s age covaries with his height. The older, the taller. When higher magnitudes on one thing occur along with higher magnitudes on another and the lower magnitudes on both also co'occur, then the things vary together positively, and we denote this situation as positive covariation or positive correlation' The second possibility is that two things vary inversely or oppositely. That is, the higher magnitudes of one thing go along with the lower magnitudes of the other and vice versa. Then, we denote this situation as negative covariation or negative correlation' This seems clear enough, but in order to be more systematic about correlation more definition is needed. )erceived covariation must be covariation across some cases. * case is a component of variation in a thing. /or e$ample, the change in the speed of traffic with the presence or absence of a traffic policeman +a negative correlation, is a change across time periods. Nifferent time periods are the cases. Nifferent levels of (9) that go along with different amounts of energy consumption may be perceived across nations. 9ations are the cases, and the correlation is positive, meaning that a nation +case, with high (9) has high energy consumption# and one with low (9) has low energy consumption. The degree to which a regime is democratic is inversely correlated with the intensity of its foreign violence. The cases here are different political regimes. To be more specific, consider the magnitudes shown in Table 0. The two things we perceive varying together, the variables, are 05HH (9) per capita and trade. The cases across which these vary are the fourteen nations shown. *lthough it is not easy to observe because of the many different magnitudes, the correlation is positive, since for more nations than not, high (9) per capita co'occurs with high trade, and low (9) per capita with low trade.
T+9(" 1 ; T!+0"
NATIONS Bra"il Burma ;hina ;uba 8gypt India Indonesia Israel Vordan 9etherland s )oland 3--R 34 3-*
GNP PER CAPITA 50 H0 HJ IH5 0IK D1 065 H0H D1 D1D KOJ DK5 55J 6,IIK
TRADE 7US KG Mi((i)#s8 6,D65 K15 IK5 0,0O5 56I 6,OJ5 0,O10 K0H JI H,I5H 0,JH6 O,HI1 0J,ODD 6O,JIO
1Source$ Rummel 1!;<)2 Data for !;552

We can summari"e this covariation in terms of a four'fold table, as in Table 6. Get us define high as above the means +averages, of 4KJ0 for (9) per capita in Table 0 and 4K,5DH millions for trade, and low at or below these means. Then we get the positive correlation shown in Table 6. The numbers that appear in the cells of the table are the number of nations that have the indicated %oint magnitudes. /or e$ample, there are nine nations which have both low (9) per capita and low trade.
T+9(" 2
Gow Gow
GNP P"! C+-i%+
?igh
5 1
0 K
Tr ad e
?igh
8 :rom ta*le ! = High an# lo5 are #i4i#e# at the a4erage

/rom the table, we can now clearly see that the correlation between the two variables is positive, since with only one e$ception +in the upper right cell, high magnitudes are observed together, as are low magnitudes. If the correlation were negative, then most cases would be counted in the lower left and upper right cells. What if there were about an e.ual number of cases in all the cells of the fourfold tableT Then, there would be little correlationE the two variables would not covary. In other words, sometimes high magnitudes on one variable would occur as often with low as with high magnitudes on the other. But all this is still imprecise. The four'fold table gives us a way of looking at correlation, but %ust considering correlation as covarying high or low magnitudes is .uite a loss of information, since we are not measuring how high or low the figures are. Boreover, if we are at all going to be precise about a correlation, we should determine some coefficient of correlation ' some one number that in itself e$presses the correlation between variables. To be a useful coefficient, however, this must be more than a number uni.ue to a pair of variables. It must be a number comparable between pairs of variables. We must be able to compare correlations, so that we can determine, for e$ample, which variables are more or less correlated, or whether variables change correlation with change in cases. /inally, we want a correlation that indicates whether the correlation is positive or negative. Investment *dvisers often repeat this line ' always diversify your investments. This is also the common wisdom repeated by the finance te$tbooks, including this one. -o how do we construct an investment portfolio and what does the above really meanT -ome have attempted to put it simply, going back to historical guidance of not putting all your eggs in one basket# conventional wisdom states that if you were to buy a variety of investments, then the failure of one would not cause your entire portfolio to collapse. ?owever, the reverse is also true, that
the stellar performance of any one investment would not reap you ama"ing returns. The construction of a diversified portfolio builds on the above, but on slightly more technical aspects. /irstly, one should diversify amongst the different asset classes# investors commonly select e.uities, bonds, cash and some alternative investments such as hedge funds, property or commodities. These asset classes are chosen, as their returns have historically not been correlated to one another. What this means for e$ample is that when e.uities make positive returns, it has been shown that bonds make neutral or negative returns. *sset classes with low correlation to each other are good choices for the diversified portfolio as each can perform independently of one another. In recent years, the performance of the metals, energy and soft commodities markets have shown themselves to be able to provide formidable returns, independently of the returns of e$isting asset classes. The proportion of each asset class in the portfolio is determined by the risk tolerance of the investor ' an investor with a higher risk tolerance can accept greater volatility and hence can incorporate a larger proportion of the asset class with a higher volatility. The significance of volatility in this case is the fluctuation of the asset class@ returns about its mean ' an asset with higher volatility can rise higher, but can also suffer sharper falls. ?aving decided the proportion of different asset classes in the portfolio, the investor now has to select the components of each asset class. In e.uities, the famed efficient portfolio model and ;apital *sset )ricing Bodel describe theoretically how to construct an investment portfolio. In the hedge fund world, funds of hedge funds attempt to take advantage of the neutral correlations of the various strategies to build a diversified hedge fund portfolio. *n e$ample of the composition of a fund of hedge funds would be buying into a global macro fund, managed futures, a convertible arbitrage fund and a long'short manager. The investment community sells the concept of diversification as a way to minimi"e risk and ma$imi"e returns. ?owever, the devil is in the details and in some cases over'diversification has shown to provide the opposite result ' giving the investor mediocre returns when the general market has given far better returns, as can easily happen in an e.uities bull market. What this means is, that the investor has to form an understanding of his or her risk appetite in deciding the level of diversification and the composition of the investment portfolio. When you put together a grouping of investments through the term asset allocation, you attempt to use those investments that are slightly dissimilar in character and therefore don@t always move the same amount at the same time for the same reasons. This is the key reason for the use of foreign investments. ?owever, as the world has gotten smaller due to the ability to
communicate almost instantaneously. *ccording to a /inancial World article, -outh 4orea, India and Taiwan had e$tremely low correlations of '1.16, 1.1K and 1.1D between 0550 to 055K as compared to the 3.-. market. +)erfect correlation is 0.1,. )ortugal was 1.K0 as was Bra"il. 9ow that doesn@t mean the markets will go up as is evidenced by some *sian countries that have not done that well recently. But, along with growth records, correlation is a ma%or focal point for investing.
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The correlation coefficient, a concept from statistics, is a measure of how well trends in the predicted values follow trends in past actual values. It is a measure of how well the predicted values from a forecast model "fit" with the real'life data. The correlation coefficient is a number between 1 and 0. If there is no relationship between the predicted values and the actual values the correlation coefficient is 1 or very low +the predicted values are no better than random numbers,. *s the strength of the relationship between the predicted values and actual values increases, so does the correlation coefficient. * perfect fit gives a coefficient of 0.1. Thus the higher the correlation coefficient the better.
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This is a relatively "simple" concept but absolutely mandatory in the use of investments. It basically refers to whether or not "different" investments will move at the same time for the same reason and in the same direction. If true, they have a correlation of plus 0. If, on the other hand, they were to move in e$actly opposite direction they would have a negative correlation of minus 0. Rarely do portfolios have e$actly either' most of the investments have correlations greater than 1 but less than 0.1. In another words, there is some movement of one investment based on the movement of the other+s,. * more specific note is the use of stocks and bonds. (oing back 61P years ago, stocks and bonds were effectively negatively correlated. That@s why most investors were told to use some of each ' or one instead of the other depending on economic conditions ' mostly the movement of interest rates. But as the inflation rate and the interest rates have dropped, the correlations between these two is now maybe 1.J. That@s a pretty strong positive correlation. Therefore the old O1 2 stocks and K1 2 bonds'used in a number of supposedly low'risk portfolios' effectively will not provide the diversification that one might e$pect. /oreign stocks might provide some of
this reduced correlation, but even here one needs to be careful since, if a foreign investment has a negative correlation and also a negative return, there has been little gained. :ou also have the increased risk of currency devaluation. * correlation coefficient is, therefore, %ust a number between '0 and 0 which measures the degree to which two variables are linearly related. If there is perfect linear relationship with positive slope between the two variables, we have a correlation coefficient of 0# if there is positive correlation, whenever one variable has a high +low, value, so does the other. If there is a perfect linear relationship with negative slope between the two variables, we have a correlation coefficient of '0# if there is negative correlation, whenever one variable has a high +low, value# the other has a low +high, value. * correlation coefficient of 1 means that there is no linear relationship between the variables.
I#%"!#+%i)#+( /)!!"(+%i)# )* i#$"s%&"#%s

We find that international e.uity correlations change dramatically through time, with peaks in the late 05th century, the (reat Nepression and the late 61th ;entury. Thus, the diversification benefits to global investing are not constant. )erhaps most important to the investor of the early 60st ;entury is that the international diversification potential today is very low compared to the rest of capital market history. <ne important .uestion to ask of this data is whether diversification works when it is most needed. This issue has been of interest in recent years due to the high correlations in global markets conditional upon negative shocks. 8vidence from capital market history suggests that periods of poor market performance, most notably the (reat Nepression, were associated with high correlations, rather than low correlations. Wars were associated with high benefits to diversification, however these are precisely the periods in which international ownership claims may be abrogated, and international investing in general may be difficult. Indeed, investors in the past who have apparently relied upon diversification to protect them against e$treme swings of the market have been occasionally disappointed. We find that roughly half the benefits of diversification available today to the international investor are due to the increasing number of world markets and available to the investor, and half is due to lower average correlation among the available markets.
C)$+!i+#/" 156 Chapter 5 Portfolio Theory
Intuitively, covariance is the measure of how much two variables vary together. That is to say, the covariance becomes more positive for each pair of values which differ from their mean in the same direction, and becomes more negative with each pair of values which differ from their mean in opposite directions. In this way, the more often they differ in the same direction, the more positive the covariance, and the more often they differ in opposite directions, the more negative the covariance.
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8very investor knows that there is a tradeoff between risk and rewardE To obtain greater e$pected returns on investments, one must be willing to take on greater risk. In solving the )ortfolio selection problem, we aim to use .uantitative measures of risk and reward to obtain a balance between these two factors that suits the individual investor. 9o one combination of securities is optimal for all investors. The best portfolio for any one investor depends on their own tolerance for risk. 8ach investment instrument has its own e$pected monthly return, and its own propensity for these returns to fluctuate from month to month. ?owever, the returns from different instruments are not in general independent. In some cases they tend to move "in sync#" for instance the stocks of gold mining companies tend to follow the price of gold. In other cases they tend to move in opposite directions from each other. These %oint tendencies are .uantified by covariances. 8very investor knows that there is a risk'return tradeoff. In order to obtain greater returns on investments, the investor must be willing to take on greater risk. The only investments that are considered to be risk'free are (RA Treasury bills, notes, and bonds. These investments yield a risk'free rate of return, r. +9ote that r depends on the time to maturity of the investment., *ssuming riskless arbitrage opportunities do not e$ist, one cannot e$pect to have a return greater than the risk'free rate without taking on some risk. )ortfolio theory assumes that for a given level of risk, investors prefer higher returns to lower returns. -imilarly, for a given level of e$pected return, investors prefer less risk to more risk. It is standard to measure risk in terms of the variance, or standard deviation of return. We measure return as the average annual continuously compounded rate. Therefore, we can assume that investors would like to invest in an efficient portfolio, that is, one in which there is no other portfolio that offers a greater return with the same or less risk, or less risk with the same or greater e$pected return.
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*n Investor must choose between two portfolios. The end'of'period value of each one is normally distributed. )ortfolio * has an e$pected value of
401,111 and a standard deviation of 40H,111. )ortfolio B has an e$pected return of 40K,111 and a standard deviation of 40H,111. Which will provide the greatest e$pected utilityT The answer is not difficult to obtain. *s long as the Investor@s utility increases with wealth and does not depend on the state of the world in which the wealth is obtained, portfolio B is better. This can be seen in the plot of the cumulative distributions, shown belowE
Take any possible outcome, for e$ample, 4H,111. This is +H,111' 01,111,=0H,111 standard deviations from the e$pected value of portfolio *. The probability that the actual outcome will fall short of this amount is +H,111 '01,111,=0H,111 or 1.IO5K. <n the other hand, this outcome is +H,111' 0K,111,=0H,111 standard deviations from the e$pected value of portfolio B. The probability that the actual outcome will fall short of this amount is +H,111 '0K,111, =0H,111 or 1.6DKI. ;learly, it is better to have a smaller chance of a shortfall below 4H,111# in this respect, B is preferred to *. But the result will be the same for every possible outcome, as the figure shows. )ortfolio B thus dominates portfolio * for any Investor who prefers more wealth to less and who has a state'independent utility function. /ormally, this is termed a case of firstdegree stochastic dominance. Bore simply putE mean'variance theory assumes that among portfolios with the same standard deviation, the one with the greatest e$pected value is the best. 9ow e$amine the figure below in which each circle plots the e$pected value and standard deviation of a different portfolio.
;onsider the portfolios shown by the black circles in the figure that plot on curve R"":A. 8ach provides the ma$imum e$pected value for a given level of standard deviation. If all the portfolio returns are normally distributed, then any Investor for whom more wealth is better than less and for whom only wealth matters should choose from among the portfolios on this curve. What about the portfolios on the section of the curve from : to AT The one plotting at point : provides a greater e$pected value and a smaller standard deviation than any of the portfolios between : and A. Boreover, for every portfolio on the section between : and A there are alternatives with the same e$pected return but lower standard deviations. /or e$ample, portfolio "" offers the same e$pected return as A but a lower standard deviation +indeed, the lowest possible, in this case,. The figure below plots the cumulative distributions for these two portfolios.
)ortfolio "" dominates A over the lower half of the range of possible outcomes, but A provides larger chances of obtaining higher values. To deal with such a case, Barkowit" proposed that Investors be assumed to be riskaverse ' more precisely, each Investor@s marginal utility of wealth is assumed to decline with wealth. In this case, an Investor with decreasing marginal utility of wealth will prefer "" to A, since moving from A to "" will improve bad outcomes symmetrically with reductions in good outcomes, and the gain in utility from each of the former reductions will e$ceed the loss in utility from the corresponding latter reduction. /ormally, this is a case of second-degree stochastic dominance. Bean'variance theory assumes that Investors prefer +0, higher e$pected
returns for a given level of standard deviation and +6, lower standard deviations for a given a level of e$pected return. )ortfolios that provide the ma$imum e$pected return for a given standard deviation and the minimum standard deviation for a given e$pected return are termed efficient portfolios. *ll others are inefficient. In practice the curve plotting the ma$imum e$pected value for each level of risk will usually be upward'sloping throughout the range of feasible values. -ections such as :A are rare. Thus it generally suffices to assume only that Investors prefer greater e$pected return for given risk, placing a considerably smaller burden on the *nalyst who advocates a focus on only efficient portfolios. The figure below provides an illustration, with e$pected returns e$pressed in terms of e$cess returns over and above a riskless rate of interest.
In this figure each point represents a portfolio. (iven the Investor@s budget and the %oint distribution of security and portfolio values, there are many such points, only a few of which are shown in the figure. The set of all such points make up a feasible region of mean'variance +or mean'standard deviation, combinations. 8fficient portfolios plot on the upper left'hand border of this region, shown as a red curved line in this case. /or obvious reasons this border is often termed the efficient frontier.
5.D
CAPITAL MARKET LINE
The capital market line is the tangent line to the efficient frontier that passes through the risk'free rate on the e$pected return a$is. * tangent line, called the capital mar>et line is drawn to the efficient frontier passing through the risk'free rate. The point of tangency corresponds to a portfolio on the efficient frontier. That portfolio is called the +uper efficient portfolio' 3sing the risk'free asset, investors who hold the super'efficient portfolio mayE
leverage their position by shorting the risk'free asset and investing the proceeds in additional holdings in the super'efficient portfolio, or Ne'leverage their position by selling some of their holdings in the super' efficient portfolio and investing the proceeds in the risk'free asset.
The resulting portfolios have risk'reward profiles which all fall on the capital market line. *ccordingly, portfolios which combine the risk free asset with the super'efficient portfolio are superior from a risk'reward standpoint to the portfolios on the efficient frontier.
The Capital Mar>et Line
The ;BG is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the e$pected return e.uals the risk'free rate of return. The ;BG is considered to be superior to the efficient frontier since it takes into account the inclusion of a risk'free asset in the portfolio. The capital asset pricing model +;*)B, demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually through the security market line +-BG,. )ortfolio R is the efficient portfolio which will appeal to the investor most, ignoring risk free investments. )ortfolios along the ;GB are a mi$ture of the investments in portfolio R and risk free investments. Investors will prefer portfolios along the ;GB to portfolios along the efficient frontier because a higher return is obtained for the same level of risk. It therefore, goes without saying, that the only portfolio consisting entirely of risky investments a rational investor should want to hold is portfolio R. *ll other risky portfolios are inefficient because they are below the ;GB.
<f course the problem is that there is another effect that works in the opposite directionE if you limit yourself to low'risk securities, you@ll be limiting yourself to investments that tend to have low rates of return. -o what you really want to do is include some higher growth, higher risk securities in your portfolio, but combines them in a smart way, so that some of their fluctuations cancel each other out. +In statistical terms, you@re looking for a combined standard deviation that@s low, relative to the standard deviations of the individual securities., The result should give you a high average rate of return, with less of the harmful fluctuations.
5.=
INFORMATION AND THE EFFICIENCY OF CAPITAL MARKETS
The efficient market theory is a good first appro$imation for characteri"ing how free markets react to the disclosure of information. The fact that information is impounded .uickly in stock prices and that windows of investment opportunity are fleeting is one of the best arguments for keeping the markets free of e$cessive trading costs, and for removing the penalties for honest speculation. -peculators keep market prices close to economic values, and this is good, not bad. *ctive investors search for opportunities to e$ploit arbitrage in e$pectations, they will not allow securities to plot far from the security market line +or plane,. Thus, the security market line must be appro$imately correct, for if it were not, the opportunities to make money would be huge. <pportunities for e$ploiting this "*rbitrage in 8$pectations" are likely to be fairy rare. ?owever, when they arise, or are discovered through research, investors will seek to e$ploit them. 8normous potential rewards to arbitrage in e$pectations will motivate firms to do research about e$pected returns, and research about betas. This research will include analysis about cash flows and discount rates, as well as idiosyncratic information such as the health of the ;8<, the relative merits of the product and so on. *rbitrageurs will seek out any information that will change their e$pectations about future returns sufficiently to allow profitable e$ploitation through buying or shorting the security. When such opportunities arise, there is a powerful motivation to sei"e the chance .uickly. There is no telling how fast other arbitrageurs can find out what you have when they start buying, the price of an under priced asset will rise, and the chance to make money will go away ' at least in theory. The issue we address in this chapter is "?ow well does this arbitrage work, and how .uickly do mispricings go awayT"
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-o far, arbitrageurs sound like vultures waiting to swoop in for the kill. They take risks to e$ploit new information at the e$pense of the less informed. The costs seem to be rewarding opportunism at the e$pense of other investors. *re there any benefits to having a market operate efficientlyT *rguments in
favour of efficient capital markets areE +0, the market price will not stray too far from the true economic price if you allow arbitrageurs to e$ploit deviations. This will avoid sudden, nasty crashes in the future. +6, *n efficient market increases li.uidity, because people believe the price incorporates all public information, and thus they are less concerned about paying way too much. If only the market for television sets were as efficient as the market for stocksU * lot less comparison shopping would be needed. +I, *rbitrageurs provide li.uidity to investors who need to sell or buy securities for purposes other than "betting" on changes in e$pected returns. /or instance, ;hina has been seeking to limit access to global financial information in -hanghai +site of its ma%or stock e$change,. The government wishes to keep certain kinds of information from market participants. Is this desirableT Will this be possibleT
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Barket efficiency has implications for corporate managers as well as for investors. This takes a lot of the "gamesmanship" out of corporate management. If a market is efficient, it is difficult to fool the public for long and by very much. /or instance, only genuine "news" can move the stock price. It is hard to pump'up the stock price by claims that are not verifiable by investors. "/ake" news will not move the price or if it does, the price will .uickly revert to the pre'announcement value when the news proves hollow. )ublicly available information is probably impounded in the price already. This is hard for some managers to believe. *n e$ample is -ears@ attempt to sell the -ears Tower in ;hicago in the late 05J1@s. The company believed that, since it carried the property on its balance sheet at greatly depreciated values, the public did not credit the company with the full market price of the building and thus -ears stock was under priced. This proved to be false, in fact, it seems that -ears was overestimating the value of the building and the stock price was relatively efficientU
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What kind of information is impounded in the stock priceT It turns out that there are lots of different levels of market efficiency, depending upon the source or the information being impounded. The best way to illustrate this is by e$ample. -uppose you had a hyper'efficient market that impounded all private information. This means that even a personal note passed between the ;8< and the ;/< regarding a ma%or financial decision would suddenly impact the stock priceU If so, this is called Strong :orm Efficiency. /ew people believe that the market is strong'form efficient, but it is nice to have this benchmarkU ?ow about all public informationT That is, all information available in annual reports, news clippings, gossip columns and so onT If the market price impounds all of this information the market is called Semi Strong :orm Efficient. Bost people believe that the Aambian e.uity markets by and large reflect publicly available information. But consider this, is information one
puts on the Internet pu*licE *re government files available under the freedom of information *ct publicT There must be subtle shades of semi' strong market efficiency, but they are not typically differentiated. 8ach new piece of information an analyst gathers should be carefully considered with regard to whether it is already impounded in the stock price. The easier it was to get, the more likely it is to have already been traded upon. The final form of market efficiency is 3ea> :orm Efficiency? * weak'form efficient market is one in which past security prices are impounded into current prices. -ince past prices are deemed public information, weak form efficiency implies semi'strong form efficiency and semi'strong form efficiency implies strong form efficiency. Weak form efficiency implies that you can@t make e$cess profits by trading on past trends. /unny, a lot of people do %ust that. They are called technical analysts, or chartists. What would you do if you noticed that every time the market went up by 02, the ne$t day on average, it went up again by 0=6 2T What would you do if you noticed that every time the market went down by 02, the ne$t day on average, it went down again by 0=6 2T If your answer is that you would buy on an up day and sell on a down day, you have the makings of an active T8;?9I;*G TR*N8RU *cademics have been testing trading rules like this for over forty years, and traders have been e$ploiting them for even longer.
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* simple test for Strong :orm Efficiency is based upon price changes close to an event. *cts of nature may move prices, but if private information release does not, then we know that the information is already in the stock price. /or e$ample, consider a merger between two firms. 9ormally, a merger or an ac.uisition is known about by an "inner circle" of lawyers and investment bankers and firm managers before the public release of the information. When these insiders violate the G*W by trading on this private information, they may make money.
3nfortunately, stock prices typically move up before a merger, indicating that someone is acting dishonestly. The early move indicates that the market has a tendency towards strong'form efficiency, i.e. even private information is incorporated into prices. ?owever, the public announcement of a merger is typically met with a large price response, suggesting that the market is not strong'form efficient. Geakage, even if illegal, does occur, but it is not fully impounded in stock price. By the way, insider trading is surprisingly legal in some countries.
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The most obvious indication that the market is not always and everywhere semi'strong form efficient is that money managers fre.uently use public information to take positions in stocks. While there is no evidence that they beat the market on a risk'ad%usted basis, it is hard to believe that an entire industry of information production and analysis is for naught. It seems likely that there is value to publicly available information# however there are probably degrees to which information really is public knowledge. What is surprising is that recent studies have shown some evidence that e$cess returns can be made by trading upon $"!1 public information. These tests usually take the form of *back testing* trading strategies. The assumption of semi'strong form efficiency is a good first appro$imation for a market with as many sharp traders and with as much publicly available information as the Aambian e.uity market.
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Weak form efficiency should be the simplest type of efficiency to prove, and for a time it was widely accepted that the Aambian stock market was at least
weak form efficient. Recall that weak form efficiency only re.uires that you cannot make money using past price history of a stock +or inde$, to make e$cess profits. Recall the intuition that, if people know the price will rise tomorrow, then they will bid the price up today in order to capture the profit. Researchers around the world have been testing weak form efficiency using daily information since the 05H1@s and typically they have found some daily price patterns, e.g. momentum. ?owever, it appears difficult to e$ploit these short'term patterns to make money. Interestingly, as you increase the horiDon of the return, there seems to be evidence of profits through trading. Buying stocks that went down over the last two weeks and shorting those that went up appears to have been profitable. When you really increase the hori"ons, stock returns look even more predictable.
5.:
E5AMINATION STANDARD JUESTION WITH ANSWER
9alukui )lc has two separate portfolios of shares in diverse industries. The company is proposing to li.uidate one of these two portfolio investments in order to raise funds for a new venture, but the directors are unsure about which one to hold and which one to li.uidate.
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>anessa Bulenga, the /inance Nirector of the company wishes to assess which portfolio has performed better, on the basis of the capital asset pricing
model +;*)B,. *t a meeting, 9alukui s Banaging Nirector suggests that portfolio theory would provide the most appropriate and useful measure of risk for evaluating the performance of the two portfolios. The ;hairman says that she does not understand what the argument is about since both ;*)B, and the portfolio theory on which it is based, provide the same measure of risk. The Bank of Aambia treasury bills rate of return is H.H2 and the market risk premium in the financial market is currently estimated at J2. Re"uire#$ +a, 8$plain the principle of portfolio diversification, and its relevance in developing the capital asset pricing model. What does the Zbeta of a share represent, and how is it determinedT +b, Niscuss the ;hairman s view that ;*)B and portfolio theory provide the same measure of risk. +c, 3sing the capital asset pricing model identify which of the two portfolios has performed better, and comment briefly on the validity of your conclusions.
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;ombining stocks in a portfolio results in reduction of portfolio risk. *fter the addition of about 0H to 61 stocks to a portfolio, the risk reduction effect begins to taper off. The degree of correlation between the returns on the different investments in the portfolio affects the amount of risk reduction. The greatest risk reduction occurs when correlation is negative. Bost securities tend to be positively correlated, limiting the scope for risk reduction. The total risk of a security held in isolation is more than that of the same security held as part of a portfolio ' the risk that is removed through portfolio diversification is the security s specific risk, caused by random events affecting the company. The effects of such random events are reduced or eliminated by diversification, so specific risk is also called diversifiable risk. The technical term for this risk is unsystematic risk. -ystematic risk affects all the securities in the market, and is associated with factors such as economic conditions, political events and general market sentiment. -ystematic risk is also called market risk or undiversifiable risk. Niversified investors are concerned about the systematic risk of a security Q not the specific risk, which can be diversified away.
The Zmarket portfolio refers to a hypothetical portfolio of all the shares in the market, weighted according to market capitalisation This is the most efficient portfolio, containing only systematic risk Q all unsystematic risk has been diversified away. The beta of a share is the slope of a regression line of the historical returns on the share against the returns on the market portfolio. It therefore measures the change in the share s return that is Ze$plained by change in the return on the market portfolio, and thus provides a measure of the share s systematic risk. (iven the return on the market portfolio and the risk' free return, the e$pected return on any share can be estimated with reference to the share s beta.
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)ortfolio theory uses the standard deviation of a portfolio s return to provide a measure of the total risk of the portfolio Q both systematic and unsystematic risk. ;*)B uses the beta to provide a measure of the systematic risk only. )ortfolio theory and ;*)B would only give the same portfolio risk measure if the portfolio were so well diversified that all unsystematic risk has been eliminated.
7/8 CAPM
3sing ;*)B to assess portfolio performance the weighted average systematic risk of each portfolio can be calculated and, using ;*)B, the e$pected return of each portfolio can be estimated.
P)!%*)(i) 14
)ortfolio beta L +0.6 $ 1.IKJ, P +1 $ 1.6D6, P +1.J $ 1.0DO, P +0.H $ 1.61K, L 1.JOKK 8$pected return L H.H P +J $ 1.JOKK, L 06.K62 The actual return of the portfolio over the last year wasE +0K $ J.D=6H, P +O $ O.J=6H, P +00 $ K.K=6H, P +0H $ H.0=6H, L 00.H12 )ortfolio 0 has therefore under'performed.
P)!%*)(i) 24
)ortfolio beta L +1.5 $ 1.6J1, P +1.I $ 1.0KK, P +0.D $ 1.IK1, P +1.0 $ 1.6IO, L 1.J5OJ 8$pected return L H.H P +J $ 1.J5OJ, L 06.OD2 The actual return of the portfolio over the last year wasE +06 $ D=6H, P +5 $ I.O=6H, P +05 $ J.H=6H, P +J $ H.5=6H, L 0I.112 Therefore )ortfolio 6 has over'performed. 3sing ;*)B, it is possible to recommend )ortfolio 6, which has a positive abnormal return. ?owever, a portfolio of only four investments cannot be said to be well diversified, so Ba$ima would be e$posed to unsystematic risk as well. *lternative portfolios with a greater degree of diversification should be considered. The perfect market assumptions on which the ;*)B is based are limitations that should also be kept in mind when drawing conclusions. >arious researchers have .uestioned other aspects of ;*)B, notablyE Betas calculated on the basis of historical returns do not necessarily remain stable. ;*)B oversimplifies reality by relating e$pected return to a single factor, i.e. the return on the market portfolio# and Indices used as market pro$ies in ;*)B calculations do not e$actly represent the whole market.
SSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSSS

CHAPTER 5 - Portfolio Theory

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CHAPTER 5 - Portfolio Theory

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INTRODUCTION TO RISK MANAGEMENT

112 Chapter 5 Portfolio Theory

113 Chapter 5 Portfolio Theory

114 Chapter 5 Portfolio Theory

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PORTFOLIOS AND PORTFOLIO THEORY

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TRESPHORD CHAMA EXAMPLE !

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"alculate the <tandard Deviation of )resphords investment'

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-tandard Neviation L M J.0H L 6.JH

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EXAMPLE S'SA, 9'M3E,DA PLC

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DETERMINATION OF OPTIMUM PORTFOLIOS

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INTERNATIONAL PORTFOLIO DIVERSIFICATION

There are a number of arguments in favour of international portfolio diversification.

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