Chapter 6: Efficient Diversification (Portfolio Theory)

Outline:
I.
II.
III.
IV.

Diversification and Portfolio Risk

Markowitz Portfolio Theory without the Risk-Free Asset
When the Risk-Free Asset Is Available
A Single-Factor Asset Market

Motivation:
- Do not put all of your eggs in one basket. Why?
- The benefits of diversification.
I. Diversification and Portfolio Risk
(Total) risk can be defined as:
1. The uncertainty of future payoffs.
- Typically measured by variance or standard deviation.
2. The uncertainty of adverse outcomes.
- Possible measures: range of returns, lower partial movements (e.g., semivariance).
Figure 6.1, p. 170
The total risk of a risky portfolio can be reduced to a certain degree even by randomly
selecting a large number (40-50) of stocks.
Systematic (market) risk: risk factors common to the whole economy.
Idiosyncratic (firm-specific) risk: risk that can be eliminated by diversification.
II. Markowitz Portfolio Theory without the Risk-Free Asset
Two Basic Assumptions:
1. The investor maximizes the returns from her investments (including all of her assets
and liabilities, e.g., stocks, bonds, car, house, etc.) for a given level of risk.
2. The investor is risk averse, meaning that, given a choice between two assets
(portfolios) with equal rates of return, they will select the asset with the lower level of
risk.
- Implication: a positive relationship between expected return and expected risk.
Measure of Return: expected rate of return on a portfolio
E(RP) = expected rate of return on a portfolio =
E(R2) +
where, xi = portfolio weight
= market valuei/market valuep

( x E ( R )) = x1 E(R1) + x2
i

E(Ri) = expected rate of return on an asset

(Pr ob

Ri , s ) = Prob1 Ri, 1 +

Prob2 Ri, 2 +
Measure of Risk: variance of portfolio returns

2
{Pr
ob
s

[
R
p
,
s

E
(
R
p
)]
}
var(RP) =
s

= Prob1 [Rp, 1 E(Rp)]2 + Prob2 [Rp, 2

E(Rp)]2 +
where, Rp, s =

(x R
i

i, s

) = x1 R1, s + x2 R2, s

+
Aside:

2
{Pr
ob
s

[
R
i
,
s

E
(
R
i
)]
}
var(Ri) =
s

= Prob1 [Ri, 1 E(Ri)]2 + Prob2 [Ri, 2

E(Ri)]2 +
Question:
Suppose that we live in an economy consisted with only two securities. Both provide the
same expected rate of return. Suppose that you find one of two securities, called CCC
Inc., providing a lower variance. Can you benefit by adding the other security, say DDD
Inc., which has the same expected rate of return, but a higher variance, into your
portfolio?
Example:
State of U.S.
Economy
S1: +1%
S2: +2%
S3: +3%
Recall that:

Probabilities of
States, Probs
25%
50%
25%

% Return in CCC,
RCCC,s
-5%
15%
35%

% Return in DDD,
RDDD,s
45%
15%
-15%

E(Ri) = expected rate of return on a security

= (Probs Ri, s)
s

= Prob1 Ri, 1 + Prob2 Ri, 2 +

Then for CCC:
E(RCCC) = Prob1 RCCC, 1 + Prob2 RCCC, 2 + Prob3
RCCC, 3
= 25% -5% + 50% 15% + 25% 35%
= 15%
Similarly, you can use the same formula to calculate the expected rates of return for
DDD. The answer is 15% (25% 45% + 50% 15% + 25% -15%). CCC and DDD
have the same expected rate of return.
Also recall that:

2
{Pr
ob
s

[
R
i
,
s

E
(
R
i
)]
}
var(Ri) =
s

= Prob1 [Ri, 1 E(Ri)]2 + Prob2 [Ri, 2

E(Ri)]2 +
So, for CCC:
var(RCCC) = Prob1 [RCCC, 1 E(RCCC)]2
+ Prob2 [RCCC, 2 E(RCCC)]2
+ Prob3 [RCCC, 3 E(RCCC)]2
= 0.25 [-0.05 0.15]2
+ 0.50 [0.15 0.15]2
+ 0.25 [0.35 0.15]2
= 0.02
(RCCC) = standard deviation of CCC = var(RCCC)1/2 =

0.02

= 14.14%

Similarly, var(RDDD) = 0.045, and (RDDD) = 21.21%. DDD is far more volatile than
CCC.
If an investor only holds CCC, she will have an expected return of 15% and a variance of
0.02.
On the other hand, if she invests 50% in CCC and 50% in DDD, she will have the same
expected return, 15%, but a much lower variance, 0.00125 (vs. 0.02).

E(RP) =

( x E ( R ))
i

= xCCC E(RCCC) + xDDD E(RDDD)

= 50% 15% + 50% 15% = 15%
Rp, s =

(x R
i

i, s

) = xCCC RCCC, s + xDDD RDDD, s

For 1st state,

Rp, 1 = xCCC RCCC, 1 + xDDD RDDD, 1
= 50% -5% + 50% 45% = 20%.
For 2nd state,
Rp, 2 = xCCC RCCC, 2 + xDDD RDDD, 2
= 50% 15% + 50% 15% = 15%.
For 3rd state,
Rp, 3 = xCCC RCCC, 3 + xDDD RDDD, 3
= 50% 35% + 50% -15% = 10%.

2
{Pr
ob
s

[
R
p
,
s

E
(
R
p
)]
}
var(RP) =
s

= Prob1 [Rp, 1 E(Rp)]2 + Prob2 [Rp, 2 E(Rp)]2

+ Prob3 [Rp, 3 E(Rp)]2
= 25% [20% 15%]2 + 50% [15% 15%]2 + 25% [10% 15%]2 = 0.00125
(RP) =

0.00125

= 3.54%

Lesson:
Holding a portfolio is better off as long as the correlation among securities are low. The
lower the correlation among securities, the greater the benefit of diversification. So, go
find a different animal.
CFA Which of the following statements about the standard deviation is/are true? A
standard deviation:
I. Is the square root of the variance.
II. Is denominated in the same units as the original data.
III. Can be a positive or a negative number.
Answer: I and II.
Covariance (covi,j): an absolute measure of the extent to which the return numbers of two
assets, i and j, move together.

Correlation (ri,j): a relative measure of the extent to which the return numbers of two
assets, i and j, move together.
S

covi,j =

[Pr ob ( R
s

i, s

E ( Ri )) ( Rj , s E ( Rj ))]

s 1

covCCC,DDD =

[Pr ob ( R
s

CCC , s

E ( RCCC )) ( RDDD , s E ( RDDD ))]

s 1

= [25% (-5% 15%) (45% 15%) + 50% (15% 15%) (15% 15%) + 25%
(35% 15%) (-15% 15%)]
= -0.03
ri,j =

cov i ,

ij

rCCC,DDD = -0.03/(0.1414 0.2121) = -1

Correlation coefficient ranges from 1 to +1. A value of 1 indicates a perfect negative
linear relationship between the two securities. A value of +1 would indicate a perfect
positive linear relationship. A value of zero indicates no systematic relationship.
CFA An investor is considering adding another investment to a portfolio. To achieve
the maximum diversification benefits, the investor should add, if possible, an investment
that has which of the following correlation coefficients with the other investments in the
portfolio?
a. 1.0.
b. 0.5.
c. 0.0.
d. +1.0.
Answer: a.
Different Weighting Schemes:
It has been shown that the portfolio of 50% CCC-50% DDD has an expected rate of
return of 15% and standard deviation of 3.54%. The calculation of portfolio standard
deviation, in fact, can be simplified if we know individual securities variances (standard
deviations) and their covariance):
(RP) =

xi 2i 2 xj 2j 2 2 xixj cov i ,

(For a portfolio consisted of more than two securities, please refer to the formula in p.
268.)

For the 50% CCC-50% DDD portfolio,

(RP) =

xCCC 2CCC 2 xDDD 2DDD 2 2 xCCCxDDD cov CCC , DDD

= (0.5) (0.02) (0.5) (0.045) 2(0.5)(0.5)(0.03)

2

= 3.54%
This formula can also be applied to portfolios with different weighting schemes between
CCC and DDD. These portfolios will have different levels of portfolio standard
deviation. On the other hand, because the two securities have the same expected rate of
return, the portfolio expected rate of return is always 15% regardless of the weighting
scheme.
For example, a 60% CCC-40% DDD portfolio has the following attributes:
E(RP) = xCCC E(RCCC) + xDDD E(RDDD)
= 60% 15% + 40% 15% = 15%
(RP) =

xCool 2Cool 2 xDido 2Dido 2 2 xCoolxDido cov Cool , Dido

= (0.6) (0.02) (0.4) (0.045) 2(0.6)(0.4)(0.03)

2

= 0%
Because 0% is the lowest possible value of portfolio standard deviation, while the
portfolio expected rate of return is the same for all possible portfolios consisted with
CCC and DDD, the 60% CCC-40% DDD portfolio will be selected by all risk-averse
investors, according to assumption #2. The 60%-40% DDD portfolio is considered to be
efficient: if no other asset or portfolio of assets offers higher expected return with the
same (or lower) variance, or lower variance with the same (or higher) expected return.
The above two-security example can be extended to an economy with many risky
securities. Please see Fig. 6.10, p. 190.
Efficient frontier: the set of portfolios that has the maximum rate of return for every given
level of variance, or the minimum variance for every level of return.
Here, a technical issue needs to be noted. The slope of the efficient frontier decreases
steadily as you move upward; the marginal benefit of increase in return is decreasing.
That is, the efficient frontier is concave.
Estimation Issues:

The previous discussion and calculations are based on a probability distribution as if we

could observe the distribution. However, the reality is that we cannot see the actual
probability distribution that generates the returns.
In practice, we typically use historical data to infer the parameters that we are interested
in. That is, we have a sample of historical data. Our job is to estimate some variables in
a statistically sensible manner.
Consequently, the formulas that we use to estimate portfolio variance (standard deviation)
and portfolio expected return are slightly different.
Lets begin with a return sample with the time period T = 10:

1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

CCC

DDD

10%
8%
6%
9%
12%
16%
20%
21%
18%
17%

20%
25%
20%
15%
20%
15%
13%
12%
10%
8%

You can get an estimate of the expected return of the underlying distribution by taking the
sample mean of the sample returns:
T

Ri

i, t

t 1

For CCC, the sample mean is:

T

RCCC

CCC , t

t 1

10% 8% ... 17%

10

= 13.70%
Similarly, we can obtain the sample mean returns on DDD, which is 15.8%. Please
verify it.
These mean values give us unbiased estimates of expected returns if the underlying return
distribution does not change its shape over the time.

Remember it is just an estimate. This means that it is not 100% accurate.

Estimation risk: the potential source of error that arises from estimations
(approximations).
We can also use this return sample to estimate variance and covariance. The usual
formula to calculate variance and covariance is:
T

cov(Ri, Rj) =

[( R

i, t

Ri )( Rj , t Rj )]

t 1

T 1
Note that variance is just a special case of covariance in which i and j have the same
value. For example, the variance on CCC is:
cov(RCCC, RCCC) = CCC2 =
= 0.0029

(0.10 0.137) 2 ... (0.17 0.137) 2

10 1

Similarly, the variance on DDD is 0.0028, and the covariance between CCC and DDD is
0.0022. You should verify it.
Once the estimates of expected returns and covariances (variances and therefore standard
deviations) are obtained, we can then use the same sets of formulas to estimate portfolio
expected returns and portfolio variances (standard deviations):
E(Rp) =
ri,j =

( x E ( R )) ,
i

cov i ,

ij

(RP) =
CFA
Asset
X
Y
Z

, and

xi 2i 2 xj 2j 2 2 xixj cov i ,

A three-asset portfolio has the following characteristics:

Expected Return

Standard Deviation

15%
10%
6%

22%
8%
3%

What is the expected return on this three-asset portfolio?

Weight
0.5
0.4
0.1

E(Rp) = 0.5 15% + 0.4 10% + 0.1 6%

= 12.1%
III. When the Risk-Free Asset Is Available
Adding the risk-free asset into your portfolio is always no worse off. Why?
Capital allocation line (CAL): plot of risk (standard deviation)-return combinations
available by varying portfolio allocation between a risk-free asset and a risky portfolio.
Reward-to-variability ratio: the slope of the CAL; ratio of risk premium to standard
deviation.
Because adding the risk-free asset into an investment is always a good idea, the investor
chooses the appropriate mix between the optimal risky portfolio and the risk-free asset
according to her risk tolerance.
A portfolio manager will offer the same risky portfolio to all clients, no matter what their
degrees of risk aversion. Risk aversion comes into play only when clients select their
desired point on the CAL.
Separation property: implies that portfolio choice can be separated into independent
tasks: (1) the determination of the optimal risky portfolio, and (2) the personal choice of
the best mixture of the risky portfolio and the risk-free asset.
IV. A Single-Factor Asset Market
Risk can be systematic or idiosyncratic. Because systematic risk cannot be diversified
away, they have influences even on well-diversified portfolios. How can one measure
systematic risk? The most popular method is by using a single-factor model of running a
LS regression of individual excess returns on market (S&P 500) excess returns, Fig. 6.11,
p. 195.
This regression line is called the security characteristic line (SCL). The slope of this line
is also called beta. On average, the slope of this line is one. A security may have a
negative beta. Can you think of an example?
End-of-chapter problem sets: #1, #2, #6, #14, #18