Lecture 4

Markowitz portfolio theory

Learning outcomes
After this lecture you should:
Be familiar with the concepts of preferences and utility
Understand how preferences are represented by utility functions in
economic theory
Know how and when to apply the mean-variance criterion to rank a
set of portfolios
Have refreshed your statistical knowledge and be ready to calculate
the first two moments of stochastic portfolio returns as functions of
the constituent assets
In particular you should be able to set up a covariance matrix for those assets
and use it to calculate the portfolio variance
These statistical techniques will be important for the coming two lectures as
well

Understand why diversification is central to portfolio theory

Know how to, in principle, construct an optimal portfolio given an
investment opportunity set and some mean-variance preferences

Preferences
If an individual prefers an apple to a banana, we
say that she has a preference for the apple over
the banana
As economists, we are interested in satisfying as
many such preferences as possible
To be able to work with preferences
mathematically, we use utility functions
A utility function assigns a value to each outcome
so that preferred outcomes get higher values

Utility
In practice it is cumbersome to assign values
to every outcome
We argue that that the more money an
individual has, the more outcomes are
achievable
We model utility as depending only on wealth
We are particularly interested in modeling
insatiation and risk aversion

Risk aversion
This is a central concept in finance
It means that we prefer certain outcomes to
stochastic ones
To induce risk averse investors to nevertheless
take on risk, we need to give them an
incentive a risk premium
The liquidity premium we discussed in lecture
2 is an example of a risk premium

Log utility
A common specification of the utility function is
U(W) = ln(W)
The concavity ensures risk aversion. Compare this to
the convexity concept we discussed in lecture 3.
4.5
4
3.5

Utility

3
2.5
2
1.5
1
0.5
0
1

11

21

31
Wealth

41

Our utility function

Log utility is obviously a simplification of actual preferences
Well make an even simpler assumption:

U E r

U is the utility value we assign to a portfolio with a given risk,

2, and expected return, E(r). A is a measure of our risk
aversion.
In this context we are only interested in risk and return
For a risk free portfolio, U = r
U can be interpreted as the certainty equivalent return

Mean-Variance criterion
Our utility function basically expresses the
idea that we like high expected returns and
dislike high risk (return uncertainty)
This sometimes allows us to easily rank some
portfolios, e.g. whenever one portfolio has
both higher E(r) and lower 2 then some other
portfolio
When this happens we say that the former
portfolio dominates the latter

Portfolios
A portfolio is a group of assets that we hold at the same
time. Recall the bond portfolios from lecture 3.
The portfolio return, rP, is a weighted average of the returns
of the assets that make up the portfolio:
N

rP w1r1 w2 r2 ... wN rN wi ri
i 1

The weight of asset i is the fraction of portfolio value made

up by asset i. We call this the portfolio weight of asset i, wi.
The portfolio expected return and risk are the expected
value and variance of rP, and hence depends crucially on
the weights, expected return and risk of the portfolio
assets.

Expectations
Since returns are generally stochastic we deal
with expected returns
We form expectations by multiplying each
possible return with its associated probability:
E ri ps ri s
s

If a stock has a 75 % chance of giving a 20 %

return and a 25 % chance of giving a -10 %
return, our expected return would be:
E ri ps ri s 0.75 0.2 0.25 0.1 12.5%
s

Expectations
Since expectations are basically weighted
averages, some useful rules apply to them:
E X Y E X E Y
E X E X

X and Y above are stochastic variables, e.g.

returns, and is a constant, e.g. a portfolio
weight
We can use these rules to see that the expected
return of a portfolio is a weighted average of the
expected returns of its assets:
N
N
N
E rP E wi ri E wi r i wi E ri
i 1
i 1
i 1

Risk
By risk we mean the variance, 2, or standard
deviation, , of returns
Variances are easier to manipulate and we
typically use them in calculations
We typically express our answers as standard
deviations, as they are easier to interpret
Of course, we can easily go from one to the
other by squaring or taking the square root

Covariance
The covariance of two variables express their tendency
to be higher or lower than their respective mean
values at the same time:
Cov( X , Y ) E X EX Y EY
The variance of a variable is simply its covariance with
itself :
2
Var ( X ) E X E X
Of course, a variable is always on the same side of its
mean as itself. The variance only expresses how large
the expected deviation is.
It will be useful in the following to remember that the
variance is a special case of a covariance

Some rules for covariances

Var ( X ) Cov( X , X )
Cov( X , Y ) Cov(Y , X )
Cov( X , Y ) X Y
Cov(X , Y ) Cov( X , Y )
Var (X ) 2Var ( X )
Cov( X Y , P Q) Cov( X , P) Cov( X , Q) Cov(Y , P) Cov(Y , Q)
Var ( X Y ) Var ( X ) Var (Y ) 2Cov( X , Y )

The summation rule can get a tad messy, especially for

many terms. It is useful to express it as a covariance
matrix:
P
+
Q
X
+

Cov(X,P)

Cov(X,Q)

Cov(Y,P)

Cov(Y,Q)

We typically dont write out the plus signs

The covariance matrix

The covariance matrix gives the components
of the covariance, i.e. the different parts of
the total covariance
If we sum up the parts we get the total
covariance. In our example:
P

Cov(X,P)

Cov(X,Q)

Cov(Y,P)

Cov(Y,Q)

Cov( X Y , P Q) Cov( X , P) Cov(Y , P) Cov( X , Q) Cov(Y , Q)

The covariance matrix

This is very useful, since we are interested in
the variance of a sum, i.e. r w r w r ... w r w r
Recall that the variance of a variable is its
covariance with itself. So we are interested in:
N

1 1

2 2

N N

i 1

N
N

Var rP Cov wi ri , wi ri
i 1
i 1

We can easily set up the variance covariance

matrix for this expression and figure out the
correct formula

i i

The covariance matrix for two assets

Suppose we have formed a portfolio with some
fraction wA invested in asset A and some fraction wB
= (1-wA) invested in asset B
Our (stochastic) portfolio return is rP wArA wB rB
We are interested in Var r Covr , r Covw r w r , w r w r
Lets set up the corresponding variance covariance
matrix
P

w Ar A

wBrB

w Ar A

Cov(wArA,wArA)

Cov(wArA,wBrB)

wBrB

Cov(wBrB,wArA)

Cov(wBrB,wBrB)

A A

B B

A A

B B

The covariance matrix for two assets

w Ar A

wBrB

w Ar A

Cov(wArA,wArA)

Cov(wArA,wBrB)

wBrB

Cov(wBrB,wArA)

Cov(wBrB,wBrB)

w Ar A

wBrB

w Ar A

Var(wArA)

Cov(wArA,wBrB)

wBrB

Cov(wArA,wBrB)

Var(wBrB)

Var rP P2 CovwA rA , wA rA CovwB rB , wA rA CovwA rA , wB rB CovwB rB , wB rB

P2 Var wA rA 2CovwB rB , wA rA Var wB rB

P2 wA2 A2 wB2 B2 2wA wB CovrA , rB
P2 wA2 A2 wB2 B2 2wA wB A B
P wA2 A2 wB2 B2 2wA wB A B

The covariance matrix

We can use the same approach for portfolios with
an arbitrary number of assets
We simply get a larger matrix, with N2 elements
for N assets
The approach is also useful for calculating
covariances between two portfolios, e,g.:
rP1 wA rA wB rB
rP 2 wC rC wD rD wE rE

Wed get a 2 X 3 matrix of covariance terms to

sum up

Numerical example
Consider two portfolios (1 and 2) with the
following portfolio weights:
w1A 0.25

wA2 0

w1B 0.5

wB2 0

w1X 0.25

wX2 1

The return of the assets (A, B and X) have the

following properties:

Find Cov(rP1,rP2)

A 20%
B 25%
X 25%

A, B 0.75
A, X 0.5
B , X 0.6

Numerical example
Set up the covariance matrix:
rX

wArA

wBrB

wXrX

Cov(wArA,rX)

Cov(wBrB,rX)

Cov(wXrX,rX)

Calculate each element:

CovwA rA , rX wACovrA , rX wA A, X A X 0.25 0.5 20 25 62.5
CovwB rB , rX wB CovrB , rX wB B , X B X 0.5 0.6 25 25 187.5
CovwX rX , rX wX CovrX , rX wX X2 0.25 252 156.25

Finally, we sum up the elements of the

covariance matrix to get the entire covariance:
CovrP1 , rP 2 CovwA rA , rX CovwB rB , rX CovwX rX , rX
CovrP1 , rP 2 62.5 187.5 156.25 406.25

Diversification
Recall the portfolio variance for a two-asset
portfolio:
P2 wA2 A2 wB2 B2 2wA wB A B

If the correlation coefficient is one, = 1, we have

P2 wA2 A2 wB2 B2 2wA wB A B wA A wB B 2
P wA A wB B

That is the standard deviation of the portfolio is a

weighted average of the standard deviations of
its assets. Just as its expected return is.

These are linear combinations

We have:
P wA A wB B 1 wB A wB B A wB B A

E rP wA E rA wB E rB 1 wB E rA wB E rB E rA wB E rB E rA

So wB determines what fraction of the distance

between portfolios A and B is covered in both
dimensions
When wB = 0 we are in portfolio A. When wB = 0.5 we
are halfway between A and B in E(r) and halfway
between A and B in . When wB = 1 we are in
portfolio B.

Diversification
If we plot this in risk-return space, we get a
straight line:
E(r)

Diversification
For lower values of the portfolio standard
deviation must be lower.
E(r)

Diversification
The combination of two or more less than
perfectly correlated assets in one portfolio is
called diversification, and the risk reduction is
called a diversification benefit
This concept is at the heart of portfolio theory
We typically want to combine many assets
with low correlations to maximize the
diversification benefits

Diversification
Diversification works by letting some of the risks
in the portfolio cancel each other out
If the asset returns have low correlations, they
are unlikely to realize below their respective
means at the same time
If the correlations are negative, they will even
work as insurance for each other
Diversification is a slightly more sophisticated
version of the idea of not putting all your eggs in
one basket

So what portfolio should we pick?

Imagine an investment universe with assets
characterized by their risk-return profile. We
can plot it:
E(r)

So what portfolio should we pick?

By combining the assets in different
proportions we can construct portfolios with
new risk-return profiles below the red line:
E(r)

So what portfolio should we pick?

By our mean-variance criteria we can see that
some portfolios dominate others, e.g. any
portfolios in the green squares
E(r)

The efficient frontier

Since it would make no sense to pick a dominated
portfolio, we focus on the undominated portfolios.
These make up the efficient frontier.
E(r)

The efficient frontier

In practice we construct the efficient frontier
by minimizing the standard deviation for each
given expected return, e.g. for all E(rP) we find
the set of weights that minimize P.

So what portfolio should we pick?

Once we have excluded dominated portfolios,
our choice depends on our utility function, i.e.
on our preferences
We can illustrate our preferences by
indifference curves, i.e. curves in risk-return
space that connect points giving equal utility
We pick the portfolio that is on the highest
utility curve

The optimal portfolio

The portfolio marked by the star gives the highest
possible utility. We refer to this as the optimal
portfolio.
E(r)