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Optimal Risky Portfolios


Optimal Risky Portfolio
When choosing the optimal allocation between a
risk-free asset and a risky portfolio, we have
assumed that we have already selected the optimal
risky portfolio.
In this section, we learn how to determine the
optimal risky portfolio.
We start from two risky assets. Most of the intuition
carries to the case of more than two risky assets.
( ) ( ) ( )
) (1 2 ) (1 +
) (1
AB B A
2
B
2 2
A
2 2
p
+ =
+ =
w w w w
R E w R wE R E
B A P
Portfolio of Two Risky Assets
Suppose you hold a proportion w in asset A
and (1-w) in asset B
The portfolio expected return and risk is given
by
Return and Risk of A Portfolio
Given the expected returns of A and B,
variances of A and B, and the covariance
(correlation) between A and B, we compute
the expected return and variance of the
portfolio for a series of portfolio weights.
Then we plot the expected returns against
variances.
An Example
Suppose you hold two assets in your
portfolio, GE and IBM.
Let the portfolio weight of GE be w, and
then the portfolio weight of IBM be (1-w)
If w =1, you hold only GE,
If w =0, you hold only IBM,
If w =0.5, you have an equally
weighted or naively diversified portfolio.
An Example
Based on data for 1982-2001, we find that
The average monthly return is 1.68%
for GE, and 1.22% for IBM
The standard deviation is 6.49% for GE
and 8.10% for IBM
The correlation between GE and IBM is
0.377
2
Equally weighted portfolio
The expected return of the equally weighted
portfolio is:
0.5*1.68%+0.5*1.22%=1.45%
The standard deviation of this portfolio is
more complicated
Equally weighted portfolio
This portfolio is less risky than either of GE
and IBM!!!
% 07 . 6
00368 . 0
377 . 0 % 10 . 8 % 49 . 6 5 . 0 5 . 0 2
% 10 . 8 5 . 0 % 49 . 6 .5 0
) (1 2 ) (1 +
2 2 2 2
AB B A
2
B
2 2
A
2 2
p
=
=

+ + =
+ =
p
w w w w


Another Portfolio
Calculate the expected return and standard
deviation of the portfolio consisting of 80%
GE and 20% IBM
Diversification Benefit
The portfolio risk is lower than either of the
individual stocks
This is called the benefit of diversification
I repeat the above steps for other portfolio
weights, w=0, 0.1, 0.2, , 0.9, 1.0
I plot the expected return against standard
deviation
Portfolios of GE and IBM
$0 GE, $1000 IBM
$200 GE, $800 IBM
$400 GE, $600 IBM
$600 GE, $400 IBM
$800 GE, $200 IBM
$1,000 GE, $0 IBM
0.01
0.011
0.012
0.013
0.014
0.015
0.016
0.017
0.018
0.05 0.055 0.06 0.065 0.07 0.075 0.08 0.085 0.09 0.095
Expected Return
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
Investment Opportunity Set
13579
1
1
1
3
1
5
1
7
1
9
2
1
2
3
2
5
2
7
2
9
3
1
3
3
3
5
3
7
3
9
4
1
4
3
4
5
4
7
4
9
Variance
Number of Assets
Diversification and Risk
Systematic
Non-
Systematic
3
Feasible Portfolios
With N Risky Assets
Expected
Return E(R)
Std dev
Efficient
frontier
Investment Opportunity Set
or Feasible Set
A
B
C
Efficient Frontier
You can construct the efficient frontier using
one of two equivalent approaches.
For given expected return, find the
minimum variance
For given variance, find the maximum
expected return
You can do this using the Solver in Excel.
Utility Maximization
Expected
Return E(R)
Std dev
A
.
A is the Utility maximizing
risky-asset portfolio
Indifference Curves
B
C
Higher Utility
What if a risk-free asset is
available?
We have covered the capital allocation
problem between a risk-free asset and a risky
asset.
Recall that the capital allocation line is the
straight line through the risk-free asset and
the risky asset.
The Optimal Risky Portfolio
has the Highest Sharpe Ratio
Expected
Return E(R)
Std dev
Riskless
Asset

A
B
CAL
A
CAL
B
C
D
E

Capital Market Line


Optimal Risky
Portfolio
What if a risk-free asset is
available?
The feasible set of portfolios becomes more
attractive
We can identify an optimal risky portfolio
which dominates all other risky portfolios
(irrespective of risk preferences)
The optimal (tangency) portfolio has the
highest Sharpe ratio among all feasible
portfolios
4
Utility Maximization with
a Risk-free Asset
Expected
Return E(R
i
)
Std dev
i
Efficient
frontier
.
.
Optimal Risky
Portfolio
Riskless
Asset
.
.
D
E
Capital
Market Line
Optimal Risky Portfolio is the
Market Portfolio
Everybody holds a combination of risk-free
asset and the optimal risky portfolio
This optimal risky portfolio is the same for
everybody regardless of how risk averse you
are
It must be the market portfolio
If not, then there must be some assets that no
one holds, which cannot be true
Passive Strategy is Efficient
The optimal risky portfolio is the same for
every investor, and is the market portfolio
No need for stock selection
Investors need only to adjust the mix of risk-
free asset and the market portfolio based on
risk aversion
The Optimal Risky Portfolio
Key Question: How do we find the optimal
risky portfolio?
By choosing asset weights w
i
that maximize
the Sharpe Ratio:
( )
p
f p
p
w
R R E
S
i

= Max
The Optimal Risky Portfolio
(with 2 risky assets)
For two risky assets, we know that the
portfolio return and standard deviation are
given by
( ) ( ) ( )
2
B
2
AB
2
A
2
p
) (1 + ) (1 2
) (1
w w w w
R E w R wE R E
B A P
+ =
+ =
The Optimal Risky Portfolio
(with 2 risky assets)
Therefore, we need to maximize the ratio
by choosing w appropriately. This can be
done using Solver in Microsoft Excel.
( ) ( )
2
B
2
AB
2
A
2
) (1 + ) (1 2
) (1
w w w w
R R E w R wE
S
f B A
p
+
+
=
5
The Optimal Risky Portfolio
(with 2 risky assets)
Or, by the following formula which gives the
weights for the optimal portfolio comprised of
only two assets:
( ) ( ) ( ) ( )
( ) [ ] ( ) [ ] ( ) ( ) [ ]
( )
A B
AB f B f A A f B B f A
AB f B B f A
A
W W
R R E R R E R R E R R E
R R E R R E
W
=
+ +

=
1
2 2
2


The Optimal Risky Portfolio
(with N risky assets)
Steps to solve for the optimal risky portfolio
weights using Solver in Microsoft Excel:
Identify all of the risky assets to be
included in the investment universe
Compute return series (from prices) for
each risky asset and the risk-free asset
and determine the average return for each
The Optimal Risky Portfolio
(with N risky assets)
Compute the covariance matrix of the risky
assets
Enter the formula for the Sharpe ratio into
a cell
Set up a column of cells for the portfolio
weights
Use Solver to maximize the Sharpe ratio
by changing the weights, subject to the
constraint that the weights sum to one
Solver
Solver Solver
6
Solver Solver
Solver
Solver
Solver
Solver
7
Solver Solver
Solver Solver