Portfolio Management &

Diversification

Diversification
Statistical Terms

Expected Return ()
Expected Return of a random variable E(R)=
is mean or the average of the sample or the
population.

Diversification
Statistical Terms

Risk ()
Instatisticsandprobability
theory,standard
deviation(represented by the symbol sigma,) shows
how much variation or dispersionexists from the
average (mean), or expected value.
A low standard deviation indicates that the data
points tend to be very close to themean; high
standard deviation indicates that the data points are
spread out over a large range of values.

Significance of &

Diversification
Statistical Terms

Variance (^2)
The
variance
is
also
equivalent
to
the
secondmovementof
the
probability
distribution
forX.
The variance is typically designated as Var(X) simply
2(pronounced "sigmasquared").

Diversification
Statistical Terms

Correlation coefficient (r or Rho)

ris a measure of the linearcorrelation(dependence)
between two variablesXandY, giving a value between
+1 and 1 inclusive.
+1 indicates perfect positive correlation. -1 indicates
perfect negative correlation.
Purely from the diversification point of view lesser the
number or closer to -1 is better.

Diversification
Statistical Terms

Co-variance (r*1*2)
Covarianceis a measure of how much tworandom
variableschange together
The sign of the covariance therefore shows the
tendency in the linear relationship between the
variables. i.e. the variables tend to show similar
behavior, the covariance is positive & vice versa.

Diversification benefits
Statistical Explanation
Consider portfolio of 2 assets
Expected return
E(R) = w11+ w22
Where w1 & w2 are the weightings of the individual securities in
portfolio
Implied Risk
port= square root ( sum (w1^2*1^2+ w2^2*2^2 + 2*w1*w2*
Covariance(1,2))
Where covariance(1,2)= 1*2*r(1,2)
At any r (1,2) less than 1 you will get reduction in risk .i.e. As long as
securities are not perfectly positively correlated you will get
reduction in risk.
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Diversification benefits
Expected Return

Implied Risk

Implied Risk

Diversification benefits
Practical Explanation

It is really unlikely that 2 securities within an asset class

or across the asset classes will be perfectly correlated.

E.g. Dollar appreciation will be positive for most IT

companies but it will be negative for auto companies.

Having said that degree of positivity & negativity will be

different for different companies within the sector as
well.

So more than likely that Infosys-TCS , M&M Tata motors

will be positively correlated but coefficient of correlation
between them wont be exactly 1.

Simple explanation being there will be similar companies

but not exactly same company.
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Modern Portfolio Theory

Modern Portfolio Theory (MPT)

Assumptions
1.
Rational Investors
2.
Asset Returns are normally distributed.
3.
Investors are risk averse
4.
All the Investors have same information
5.
No transaction cost is involved
6.
Expected returns by different investors are same.
7.
Investors can borrow or lend money at risk free rate (Rfr)
8.
No investor is large enough to influence the market price.
In real world none of these assumptions are true but still MPT has lot of
explanation towards way risk-return trade off happens in real world.
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Modern Portfolio Theory (MPT)

Harry Markowitzintroduced MPT in a 1952
Explanation of MPT
. MPT is an investment theory whose purpose is to maximize a
portfoliosexpected
returnby
altering
and
selecting
the
proportions of the various assets in the portfolio.
. MPT explains how to find the best possiblediversification.
. If investors are presented with two portfolios of equal value that
offer the same expected return, MPT explains how the investor
will prefer and should select the less risky one.
. Investors assume additional risk only when faced with the
prospect of additional return.
. In brief, MPT explains how investors can reduce overall risk by
holding a diversified portfolio of assets.
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Efficient Frontier

One
of
the
most
important and widely
used
concept
of
Modern
Portfolio
Theory

Every
possible
combination of assets
plotted on graph.

Plots return % vs Risk

% (Standard Deviation)

Optimal portfolio lies

on the efficient frontier
curve (parabola)
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Capital Market Line (CML)

Capital Market Line (CML)

X- axis is Risk or Standard
deviation()
Y- axis is Expected Return or
E(r)
CML is the tangent line
drawn from the point of the
risk-free
asset
to
thefeasible regionfor risky
assets.
The
tangency
point
M
represents
themarket
portfolio, so named since
allrational
investors(minimum variance
criterion) should hold their
risky assets in the same
proportions as their weights
in the market portfolio.

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CML Equation

Where,
E(r) Expected Return from the stock/ Portfolio
E(rM)- Expected Return from the market or the index
rf or Rfr Risk free Rate
Standard deviation of the stock/Portfolio
M Standard deviation of the market

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CML and Sharpe Ratio

Mathematically,
All portfolios on CML satisfy Sharpe Ratio as stated below in
equation (2)
E(r) Expected Return from the stock
E(rM)- Expected Return from the market or the index
rf or Rfr Risk free Rate
Standard deviation of the stock
M Standard deviation of the market

Equation (2)

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Significance of CML and Sharpe Ratio

Astock pickingrule of thumb is to buy assets whose Sharpe
ratio will be above the CML and sell those whose Sharpe ratio
will be below CML.
i.e. Invest in portfolio which offer higher returns for given risk
and sell those portfolios which offer lesser returns for given
risk.
However as per efficient market hypothesisit follows that it's
impossible to beat the market and such underperforming or
outperforming portfolios should not exist.
If there are any such outperforming stocks/portfolios
investors would buy them increasing their prices and reducing
their future excess returns and bring them back on CML.
Conversely,
If
there
are
any
such
underperforming
stocks/portfolios investors would sell them reducing their
prices and increasing their future excess returns and bring
them back on CML.
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Security Market Line (SML)

Security Market Line (SML)

X- axis is Systematic
Risk or Beta()
Y- axis is Expected
Return or E(r)
SML
is
representation
theCapital
pricing model.

the
of
asset

It
displays
the
expected
rate
of
return of an individual
security as a function
of
systematic,nondiversifiable risk

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SML Equation

Where,
E(Ri) Expected Return from the stock
E(rM)- Expected Return from the market or the index
rf or Rf Risk free Rate
non-diversifiable or systematic risk

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 (Beta) and its significance

A measure of the volatility, or systematic risk, of a security or a portfolio in
comparison to the market as a whole.
Beta is used in the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on its beta and expected
market returns.
Statistically, Beta is calculated using regression analysis. It is the slope of
the line in case of a linear regression.
A beta of 1 indicates that the security's price will move in line with the
market. E.g. If market goes up by 10% stock will go up by 10% and vice
versa.
A beta of more than 1 indicates that the security's price will be more
volatile than the market. E.g. If market goes up by 10% stock will go up by
more than 10% and vice versa. Typically stocks from sectors such as
metals, capital goods, automobiles, real estate, banking etc will have beta
of more than 1.
A beta of less than 1 indicates that the security's price will be less volatile
than the market. E.g. If market goes up by 10% stock will go up by less
than 10% and vice versa. Typically stocks from sectors such as FMCG,
Pharmacy, IT etc will have beta of less than 1.
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SML and Treynor Ratio

Mathematically,
All portfolios on SML satisfy Treynor Ratio as stated below in equation
(2)
Where,
E(Ri) Expected Return from the stock
E(rM)- Expected Return from the market or the index
rf or Rf Risk free Rate
i non-diversifiable or systematic risk
M systematic risk for market is equal to 1.

Equation (2)

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Significance of SML and Treynor Ratio

Astock pickingrule of thumb is to buy shares whose Treynor
ratio will be above the SML and sell those whose Treynor
ratio will be below SML.
i.e. Invest in shares which offer higher returns for given
systematic risk and sell those shares which offer lesser
returns for given systematic risk.
However as per efficient market hypothesisit follows that it's
impossible to beat the market and such underperforming or
outperforming shares should not exist.
If there are any such outperforming stocks investors would
buy them increasing their prices and reducing their future
excess returns and bring them back on SML.
Conversely, If there are any such underperforming stocks
investors would sell them reducing their prices and
increasing their future excess returns and bring them back
on SML.
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Capital Asset Pricing Model

(CAPM)

History of CAPM Model

The CAPM was introduced byJack
1962),William
Sharpe(1964),John
andJan Mossin (1966) independently.

Treynor(1961,
Lintner(1965)

This was done with building on the earlier work

ofHarry
Markowitzondiversificationandmodern
portfolio
theory.
Sharpe,
Markowitz
andMerton
Millerjointly received the 1990Nobel Memorial Prize in
Economicsfor this contribution to the field of financial
economics.
Fischer Black(1972) developed another version of
CAPM, called Black CAPM or zero-beta CAPM, that does
not assume the existence of a riskless asset.
This version was more robust against empirical testing
and was influential in the widespread adoption of the
CAPM.
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CAPM Equation

Where,
E(Ri) Expected Return from the stock
E(rM)- Expected Return from the market or the index
rf or Rf Risk free Rate
i non-diversifiable or systematic risk

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Significance of CAPM Model

CAPM is used to determine a theoretically
appropriate requiredrate of return of anasset for
the given systematic risk.
The model takes into account the asset's sensitivity
to non-diversifiable risk (also known assystematic
riskormarket risk), often represented by the
quantitybeta() in the financial industry, as well as
theexpected returnof the market and the expected
return of a theoreticalrisk-free asset.
CAPM suggests that an investors cost of equity
capital is determined by beta. Higher the beta
higher is the cost of equity and vice versa.

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