Portfolio Selection

Portfolio Selection
A widely used approach to portfolio selection has been
suggested by Markowitz.
Under this approach, portfolios are evaluated on the basis of
their expected return and risk (measured by standard
deviation of returns)
A large number of possible portfolios can be built from a given
set of securities.
All of these portfolios comprise the portfolio opportunity set.
The shape of the portfolio opportunity set depends on the
correlation among returns of securities comprised in the
portfolio

Portfolio Opportunity Set- Two
Securities
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07
E
x
p
e
c
t
e
d

R
e
t
u
r
n

Standard Deviation
Portfolio Opportunity Set-Perfect Positive
Correlation
A
B
Portfolio Opportunity Set- Two
Securities
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0 0.01 0.02 0.03 0.04 0.05 0.06 0.07
E
x
p
.

R
e
t
u
r
n

Standard Deviation
Portfolio Opportunity Set-Perfect Negative
Correlation
B
A
Portfolio Opportunity Set- Two
Securities
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.0000 0.0100 0.0200 0.0300 0.0400 0.0500 0.0600 0.0700
E
x
p
e
c
t
e
d

R
e
t
u
r
n

Standard Deviation
Portfolio Opportunity Set-Zero Correlation

A
B
Portfolio Opportunity Set- Two
Securities
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.0000 0.0100 0.0200 0.0300 0.0400 0.0500 0.0600 0.0700
E
x
p
e
c
t
e
d

R
e
t
u
r
n

Standard Deviation
Portfolio Opportunity Set -Intermediate
Correlation (0.5)
A
B
Portfolio Opportunity Set- Two
Securities
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.0000 0.0100 0.0200 0.0300 0.0400 0.0500 0.0600 0.0700
R
e
t
u
r
n

Standard Deviation
Portfolio Opportunity Sets with different levels of
correlation
Correlation 0
Correlation +1
Correlation -1
Correlation 0.5
B
A
Diversification Properties

Diversification results due to correlation between
securities less than one.

In case the correlation is one, the opportunity set is given
by a straight line.

With lower correlation, the opportunity set curve
becomes backward bending.

With higher correlation, the backward bend in the curve
goes away.


Diversification Properties

The diversification effect is given by the distance
between the straight line and the curved line.

With higher correlation between returns, the
diversification effect is lower and the distance of the
curved line from the straight line is reduced.

The portfolio depicted farthest to the left is the
minimum variance portfolio.




Diversification Properties
As long as the correlation coefficient is less than ratio
of smallest standard deviation to the largest standard
deviation i.e.



Some combination of the two stocks will give a
smaller standard deviation of return than either
security taken alone.



x
xy
y
o

o
<
Portfolio Opportunity Set-Multiple
Security Portfolios
The possible combinations of securities do not lie on
a single line but within a large area.






The number of combinations increase geometrically
with the number of securities available.

Minimum-Variance Frontier
The risk-averse investor need not evaluate all of these
portfolios in the portfolio opportunity set.

He would be interested only in efficient portfolios.

An efficient portfolio has the smallest risk for a given level of
expected return or the largest expected return for a given
level of risk.

Using the expected returns, variances and covariances, he can
calculate the portfolio with the smallest variance or risk for a
given level of expected return.
Minimum-Variance Frontier
These minimum variance portfolios can be
plotted to form the minimum-variance
frontier.

The portfolio that has the minimum variance
among the portfolios on the minimum-
variance frontier is called the global minimum-
variance portfolio.

Minimum Variance Portfolio-Two
Security Case
When correlation between two securities A and B is
-1, the weight of A that will minimize the variance
can be found out by using the formula:


In any other case:



W
B
= 1-W
A




B
A
A B
W
o
o o
=
+

2
2 2
.
2 .
B
A
A B
Cov AB
W
Cov AB
o
o o

=
+
Efficient Frontier
The segment of the minimum-variance frontier
above the global minimum-variance portfolio, is
called the efficient frontier of portfolios.

This efficient frontier is determined by the principle
of dominance.

A portfolio X dominates another portfolio Y, if it has
the same level of risk but a larger expected return
than Y or the same expected return but a lower risk.

Efficient Frontier
Building the Efficient Frontier
The solution to Markowitz model revolves around
the portfolio weights.

The expected returns, standard deviations, and
correlation coefficients for the securities being
considered are inputs in the Markowitz analysis.

The portfolio weights are the only variable that can
be manipulated to solve the portfolio problem of
determining efficient portfolios.

The Efficient Frontier with Short Sales

The efficient frontier is a concave function in
expected return standard deviation space that
extends from the minimum variance portfolio
to the maximum return portfolio.

In case short sales are allowed, the efficient
frontier has no finite upper bound.

Selection of Optimal Portfolio from
the Efficient Frontier
The investor will select that portfolio on the efficient frontier
that maximizes his utility. The utility derived by the investor
will depend on his risk aversion index A.
The utility provided by the portfolios can be found through
the equation U=E(r
p
)-0.5 A
Assuming that there are two risky assets, a debt fund D and
an equity fund E in the portfolio, the optimal investment
proportions are given by:


W
E
=1-W
D




2
p
o
2
2 2
( ) ( ) ( )
( 2 )
D E E D E DE
D
D E D E DE
E r E r A
W
A
o o o
o o o o
+
=
+
Selection of Optimal Portfolio from
the Efficient Frontier
Indifference curves that provide equal utility
can also be drawn.

The tangency point of the highest indifference
curve with the efficient frontier gives the
optimal risky portfolio.

Selecting an Optimal Risky Portfolio

) E(
port
o
) E(R
port
X
Y
U
3

U
2

U
1

U
3

U
2

U
1


Efficient Frontier with Riskless
Lending and Borrowing

Introduction of a riskless asset into the portfolio
considerably simplifies the analysis.

Lending at a riskless rate means investing in an asset with
a certain outcome (e.g. a short-term government bill or
savings account).

Borrowing can be considered as selling such a security
short.

The rate of return on a riskless asset is R
F
. The standard
deviation is zero as the return is certain.


Efficient Frontier with Riskless
Lending and Borrowing

The investor invests in a risky portfolio P and either lends
or borrows.
The weight of P can be more than 1.0 as the investor can
borrow at riskless rate and invest more than his initial
funds.
All combinations of riskless lending or borrowing with
portfolio P lie on a straight line in the expected return
standard deviation space.
The intercept of the line is R
F
and the slope is

The line passes through the point (
p
, ). This line is
called the capital allocation line (CAL)

( )
/
P F p
R R o
P
R
Capital Allocation Line
To the left of P, we have combinations of lending and portfolio
P and to the right of P, we have combinations of borrowing
and portfolio P.

CAL for Different Lending and
Borrowing Rate
Optimal Risky Portfolio
For the case of riskless lending and borrowing, identification
of portfolio P constitutes a solution to the portfolio problem.

The efficient frontier is the entire length of the ray extending
through R
F
and P.

The ray R
F
P can be identified by maximizing the slope of the
ray given by


The portfolio with the highest reward to variability ratio
constitutes the optimal risky portfolio.

P F
p
R R
o

Optimal Risky Portfolio

Optimal Risky Portfolio
The optimal risky portfolio P lies at the tangency point of the
CAL and the efficient frontier.

Capital Market Line
The line from the risk free rate that is tangent to the
efficient frontier is called the Capital Market Line (CML).
An investor would always prefer a portfolio on the CML
to that on the efficient frontier as he gets a higher return
for the same risk.
All investors who believed they faced the efficient
frontier and riskless lending and borrowing rates would
hold the same portfolio of risky assets (Portfolio P) and
combine it with borrowing or lending in risk-free asset.
Separation Property
The separation property tells us that the portfolio
choice problem may be separated into two
independent tasks
Determination of the optimal risky portfolio is
purely technical
Allocation of the complete portfolio to T-bills
versus the risky portfolio depends on personal
preference

Separation Property
Very risk-averse would select a portfolio along the
segment R
F
P and place some of their money in a
riskless asset and some in portfolio P.

Others who are much more tolerant of risk would
hold portfolios along the segment going beyond P,
borrowing funds and placing their original capital plus
borrowed funds in risky portfolio P.

Still other investors would just place the total of their
original funds in risky portfolio P.

Optimal Complete Portfolio
The risky portfolio when combined with a risk free
asset forms a complete portfolio.
The optimal complete portfolio will depend on the
risk-aversion index (A) of the investor.
The weight of the risky portfolio in such a complete
optimal portfolio will be y such that:


(Note: When returns and variances are expressed in
percentages rather than decimals, use 0.01 A instead
of A in the above equation.)



2
( )
p F
p
E r r
y
Ao

=
Optimal Complete Portfolio
Graphically, this portfolio represents the point at which
the indifference curve is tangent to CML.

The rate of return on the complete portfolio C , r
c
is
given by


The standard deviation of the complete portfolio is given
by:


because the risk free asset has a zero risk.


(1 )
c p F
r y r y r = +

C p
y o o =
Optimal Complete Portfolio
Optimal Weights of Risky Assets
For a risky portfolio comprising of two risky assets: a debt
fund D and an equity fund E, the optimal weights of the risky
assets in the risky portfolio are given by:




W
E
=1-W
D


To construct optimal risky portfolios of more than two risky
assets, a spreadsheet or other computer program is required.


| | | |
| | | | | |
2
2 2
( ) ( ) ( , )
( ) ( ) ( ) ( ) ( , )
D F E E F D E
D
D F E E F D D F E F D E
E r r E r r Cov r r
W
E r r E r r E r r E r r Cov r r
o
o o

=
+ +