Chapter 5

Modern Portfolio
Concepts

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Modern Portfolio Concepts

Learning Goals
1. Understand portfolio objectives and the procedures used to
calculate portfolio return and standard deviation.

2. Discuss the concepts of correlation and diversification, and

the key aspects of international diversification.
3. Describe the components of risk and the use of beta to
measure risk.

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Modern Portfolio Concepts

Learning Goals (contd)
4. Explain the capital asset pricing model (CAPM)
conceptually, mathematically, and graphically.
5. Review the traditional and modern approaches to
portfolio management.
6. Describe portfolio betas, the risk-return tradeoff, and
reconciliation of the two approaches to portfolio
management.

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What is a Portfolio?
Portfolio is a collection of investments
assembled to meet one or more investment
goals.
Growth-Oriented Portfolio: primary objective is
long-term price appreciation
Income-Oriented Portfolio: primary objective is
to produce regular dividend and interest income

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The Ultimate Goal:

An Efficient Portfolio
Efficient portfolio
A portfolio that provides the highest return for a given
level of risk
Requires search for investment alternatives to get the
best combinations of risk and return

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Portfolio Return and Risk Measures

The return on a portfolio is simply the weighted
average of the individual assets returns in the
portfolio
The standard deviation of a portfolios returns is
more complicated, and is a function of the
portfolios individual assets weights, standard
deviations, and correlations with all other assets

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Return on Portfolio

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Correlation:
Why Diversification Works!
Correlation is a statistical measure of the relationship
between two series of numbers representing data
Positively Correlated items tend to move in the same
direction
Negatively Correlated items tend to move in opposite
directions
Correlation Coefficient is a measure of the degree of
correlation between two series of numbers representing
data

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Correlation Coefficients
Perfectly Positively Correlated describes two
positively correlated series having a correlation
coefficient of +1
Perfectly Negatively Correlated describes two
negatively correlated series having a correlation
coefficient of -1

Uncorrelated describes two series that lack any

relationship and have a correlation coefficient of
nearly zero
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Figure 5.1 The Correlation Between Series M, N,

and P

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Correlation:
Why Diversification Works!
Assets that are less than perfectly positively
correlated tend to offset each others movements,
thus reducing the overall risk in a portfolio

The lower the correlation the more the overall

risk in a portfolio is reduced
Assets with +1 correlation eliminate no risk
Assets with less than +1 correlation eliminate some risk
Assets with less than 0 correlation eliminate more risk
Assets with -1 correlation eliminate all risk

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Figure 5.2 Combining Negatively Correlated Assets

to Diversify Risk

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Figure 5.3 Portfolios of ExxonMobil and Panera

Bread

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Figure 5.4 Risk and Return for Combinations of Two Assets

with Various Correlation Coefficients

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Why Use International Diversification?

Offers more diverse investment alternatives than U.S.only based investing
Foreign economic cycles may move independently from
U.S. economic cycle
Foreign markets may not be as efficient as U.S.
markets, allowing true gains from superior research
Study done between 1984 and 1994 suggests that
portfolio 70% S&P 500 and 30% EAFE would reduce risk
5% and increase return 7% over a 100% S&P 500
portfolio

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International Diversification
Advantages of International Diversification
Broader investment choices
Potentially greater returns than in U.S.
Reduction of overall portfolio risk

Disadvantages of International Diversification

Currency exchange risk

Less convenient to invest than U.S. stocks
More expensive to invest
Riskier than investing in U.S.

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Methods of
International Diversification
Foreign company stocks listed on U.S. stock
exchanges

Yankee Bonds
American Depository Shares (ADSs)
Mutual funds investing in foreign stocks
U.S. multinational companies (typically not considered
a true international investment for diversification
purposes)

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Components of Risk
Diversifiable (Unsystematic) Risk
Results from uncontrollable or random events that are
firm-specific
Can be eliminated through diversification
Examples: labor strikes, lawsuits

Nondiversifiable (Systematic) Risk

Attributable to forces that affect all similar investments
Cannot be eliminated through diversification
Examples: war, inflation, political events

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Components of Risk

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Beta: A Popular Measure of Risk

A measure of nondiversifiable risk

Indicates how the price of a security responds to market forces
Compares historical return of an investment to the market return (the S&P
500 Index)
The beta for the market is 1.00
Stocks may have positive or negative betas. Nearly all are positive.
Stocks with betas greater than 1.00 are more risky than the overall market.
Stocks with betas less than 1.00 are less risky than the overall market.

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Beta: A Popular Measure of Risk

Table 5.4 Selected Betas and Associated Interpretations

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Interpreting Beta
Higher stock betas should result in higher expected returns
due to greater risk
If the market is expected to increase 10%, a stock with a
beta of 1.50 is expected to increase 15%

If the market went down 8%, then a stock with a beta of

0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained from Value
Line reports or online websites such as yahoo.com

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Interpreting Beta

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Capital Asset Pricing Model (CAPM)

Model that links the notions of risk and return

Helps investors define the required return on an

investment
As beta increases, the required return for a given
investment increases

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Capital Asset
Pricing Model (CAPM) (contd)
Uses beta, the risk-free rate and the market
return to define the required return on an
investment

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Capital Asset
Pricing Model (CAPM) (contd)
CAPM can also be shown as a graph

Security Market Line (SML) is the picture of the

CAPM
Find the SML by calculating the required return
for a number of betas, then plotting them on a
graph

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Figure 5.6 The Security Market Line (SML)

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Two Approaches to Constructing Portfolios

Traditional Approach
versus
Modern Portfolio Theory

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Traditional Approach
Emphasizes balancing the portfolio using a
wide variety of stocks and/or bonds
Uses a broad range of industries to diversify the
portfolio

Tends to focus on well-known companies

Perceived as less risky
Stocks are more liquid and available
Familiarity provides higher comfort levels for
investors

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Modern Portfolio Theory (MPT)

Emphasizes statistical measures to develop a
portfolio plan
Focus is on:
Expected returns
Standard deviation of returns
Correlation between returns

Combines securities that have negative (or lowpositive) correlations between each others rates
of return

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Key Aspects of MPT:

Efficient Frontier
Efficient Frontier
The leftmost boundary of the feasible set of portfolios
that include all efficient portfolios: those providing the
best attainable tradeoff between risk and return
Portfolios that fall to the right of the efficient frontier
are not desirable because their risk return tradeoffs
are inferior

Portfolios that fall to the left of the efficient frontier are

not available for investments

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Figure 5.7 The Feasible or Attainable Set and the

Efficient Frontier

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Key Aspects of MPT:

Portfolio Betas
Portfolio Beta
The beta of a portfolio; calculated as the weighted
average of the betas of the individual assets the
portfolio includes
To earn more return, one must bear more risk
Only nondiversifiable risk (relevant risk) provides a
positive risk-return relationship

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Figure 5.8 Portfolio Risk and Diversification

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Key Aspects of MPT: Portfolio Betas

Table 5.6 Austin Funds Portfolios V and W

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Interpreting Portfolio Betas

Portfolio betas are interpreted exactly the same way as
individual stock betas.
Portfolio beta of 1.00 will experience a 10% increase when the
market increase is 10%
Portfolio beta of 0.75 will experience a 7.5% increase when the
market increase is 10%
Portfolio beta of 1.25 will experience a 12.5% increase when the
market increase is 10%

Low-beta portfolios are less responsive and less risky than

high-beta portfolios.
A portfolio containing low-beta assets will have a low beta,
and vice versa.
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Interpreting Portfolio Betas

Table 5.7 Portfolio Betas and Associated Changes in Returns

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Reconciling the Traditional

Approach and MPT
Recommended portfolio management policy uses aspects
of both approaches:
Determine how much risk you are willing to bear
Seek diversification between different types of securities and
industry lines
Pay attention to correlation of return between securities
Use beta to keep portfolio at acceptable level of risk
Evaluate alternative portfolios to select highest return for the given
level of acceptable risk

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Figure 5.9 The Portfolio Risk-Return Tradeoff

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Chapter 5 Review

Learning Goals
1. Understand portfolio objectives and the
procedures used to calculate portfolio return and
standard deviation.
2. Discuss the concepts of correlation and
diversification, and the key aspects of international
diversification.

3. Describe the components of risk nd the use of

beta to measure risk.

Copyright 2011 Pearson Prentice Hall. All rights reserved.

5-41

Chapter 5 Review (contd)

Learning Goals (contd)
4. Explain the capital asset pricing model (CAPM)
conceptually, mathematically, and graphically.
5. Review the traditional and modern approaches to
portfolio management.
6. Describe portfolio betas, the risk-return tradeoff, and
reconciliation of the two approaches to portfolio
management.

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5-42

Chapter 5

Additional
Chapter Art

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Table 5.1 Individual and Portfolio Returns and Standard Deviation of Returns for
ExxonMobil (XOM) and Panera Bread (PNRA)

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Table 5.2 Portfolio Returns and Standard Deviations for ExxonMobil

(XOM) and Panera Bread (PNRA)

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Table 5.3 Expected Returns, Average Returns, and Standard Deviations

for Assets X, Y, and Z and Portfolios XY and XZ

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Table 5.5 The Growth Fund of America, November

1, 2008

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