Portfolio Theory

RAVI

Expected Return of a
Portfolio

Expected Return
Say you have $1,000 and you plan on investing it into
different assets. Asset A is expected to provide a 5% return
and asset B is also expect to provide a 5% return. If you
invested half of your money, that is $500 into asset A and the
other $500 into asset B you know that the expected return of
the total portfolio would be 5%.
But it isnt as easy as this if you invest a different amount into
each asset or if each asset provides a different expected
return.
What do we mean when we say expected return? Say an
assets expected return is 5%. Also assume that you have
$100 to invest. You are expected to earn $5 on this invested,
but you may actually earn $6 or you may only earn $4.
Expected return is only an estimate.

Expected Return
The higher the return an investor
expects to make the higher the risk.
The lower the return an investor is
expected to make the lower the risk,
i.e. risk and return are directly related.

Example 2 Expected Return

Example 3 Expected Return

Investors Attitude Towards

Risk
Investors attitude towards risk varies. Some
investors are willing to take on greater risk in
the hope for greater returns while other
investors are less willing to take on risk.
Investors can therefore be classified into three
categories.
1. Risk adverse Most investors are risk adverse,
that is, they do not like risk. For any amount of
risk a risk adverse investor takes on they must
be compensated for bearing such risk with high
returns.

Investors Attitude Towards

Risk
If an investor has the choice between two
investments with the same expected
return but different levels of risk, they will
choose the investment with the lowest risk.
If an investor has the choice between an
investment with different expected returns
and the same level of risk, they will choose
the investment with the highest expected
return.

Investors Attitude towards

Risk
What happens if the two investments
have differing returns and differing
risk?
It will depend how risk adverse the
investor is. If an investor is really
risk adverse then they are going to
choose the investment with the
lowest risk.

Risk Natural or Neutral

2. Risk natural A risk natural investor
does not concern themselves with risk.
They will seek the highest expected
return regardless of the risk involved.
If a risk natural investor has the choice
between two investments, one with a
higher risk and return than the other,
they will always choose the investment
with the highest return.

3. Risk seeker/lover
3. Risk seeker/lover Hence as the name suggests, a
risk seeking investor will always choose the
investment with the highest risk regardless of
return.
If an investor has the choice between two
investments, investment one has an expected
return of 6 and a risk of 4 and the second
investment has an expected return of 5 and a risk
of 7 they will choose the second investment, i.e.
the investment with the highest risk. Risk seekers
actively seek out risky investments.

Investors attitude towards

risk
Since most investors are risk
adverse, financial markets behave as
if, collectively, they are risk-averse.
This makes sense as investor control
the financial markets, and if the
majority of them as a whole are risk
adverse then financial markets are
expected to act the same way

Covariance

Covariance
Covariance is a measure of how two risky assets interact with each other.
A positive covariance indicates that two risky assets move together.
A negative covariance indicates that two risky assets move in the
opposite direction. That is, if one asset increases, the other asset is
expected to decrease and vice versa.
Two assets with negative covariance will give your overall portfolio
greater diversification.
This is why when selecting assets to add to your portfolio, you should
select assets with negative covariance.
That is if one asset falls, then the other would be expected to increase as
they move or co-vary in the opposite directions. If you selected two
assets with positive covariance and one asset falls in price then the other
asset is also expected to fall in price and that is something you want to
avoid.

Correlation Coefficient

Correlation Coefficient

Correlation Coefficient Risk Assets

Example

Example 2

Standard Deviation Measure of

Risk

Standard Deviation

Standard Deviation

Standard Deviation of two or more

asset porfolio

Example

Example contd

Diversification

An investor can reduce portfolio risk simply

by holding combinations of instruments that
are not perfectly positively correlated
(correlation coefficient ).
In other words, investors can reduce their
exposure to individual asset risk by holding
a diversified portfolio of assets.
Diversification may allow for the same
portfolio expected return with reduced risk.

Diversification

These ideas have been started with

Markowitz and then reinforced by
other economists and
mathematicians such as Andrew
Brennan who have expressed ideas
in the limitation of variance through
portfolio theory.

Diversification Contd.
If all the asset pairs have correlations
of 0
they are perfectly uncorrelatedthe
portfolio's return variance is the sum
over all assets of the square of the
fraction held in the asset times the
asset's return variance (and the
portfolio standard deviation is the
square root of this sum).

Illustration of Diversification
Intro.
A company that sells wool products like sweaters
and blankets is more profitable when the price of
wool is lower.
A company that is a wool wholesaler is generally
less profitable when the price of wool is lower,
unless they are able to sell a lot more wool. Though
the companies work together, their profits have a
low correlation.
In other words, the profitability of one company
does not follow the same lines as the profitability of
the other company. And sometimes they are even
inversely related

MPT Discussion
One important thing to understand
about Markowitzs calculations is that
he treatsvolatilityandriskas the
same thing.
In laymans terms, Markowitz
usesriskas a measurement of the
likelihood that an investment will go
up and down in value and how often
and by how much.

MPT theory discussion

The theory assumes that investors
prefer to minimize risk. The theory
assumes that given the choice of two
portfolios with equal returns,
investors will choose the one with the
least risk.
If investors take on additional risk,
they will expect to be compensated
with additional return.

MPT discussion
According to MPT, risk comes in two major
categories:
systematic risk the possibility that the
entire market and economy will show
losses negatively affecting nearly every
investment; also calledmarket risk
unsystematic risk the possibility that
an investment or a category of investments
will decline in value without having a major
impact upon the entire market

Diversification & Risk

Diversification generally does not protect against
systematic risk because a drop in the entire market
and economy typically affects all investments.
However, diversification is designed to decrease
unsystematic risk.
Since unsystematic risk is the possibility that one
single thing will decline in value, having a portfolio
invested in a variety of stocks, a variety of asset
classes and a variety of sectors will lower the risk
of losing much money when one investment type
declines in value.

The Efficient Frontier

In order to compare investment options,
Markowitz developed a system to describe
each investment or each asset class with
math, using unsystematic risk statistics.
Then he further applied that to the
portfolios that contain the investment
options. He looked at the expected rate-ofreturn and the expected volatility for each
investment. He named his risk-reward
equationThe Efficient Frontier.

The Efficient Frontier

The graph in the next slide is an
example of what the Efficient Frontier
equation looks like when plotted. The
purpose of The Efficient Frontier is to
maximize returns while minimizing
volatility

MPT

The efficient frontier

discussion
Notice that The Efficient Frontier line starts
with lower expected risks and returns, and it
moves upward to higher expected risks and
returns. So people with different Investor
Profiles (determined by investment time
horizon, tolerance for risk and personal
preferences) can find an appropriate portfolio
anywhere along The Efficient Frontier line.
The Efficient Frontier flattens as it goes higher
because there is a limit to the returns
investors can expect.

Efficient Frontier

Efficient Frontier
The hyperbola is sometimes referred to
as the 'Markowitz Bullet', and is the
efficient frontier if no risk-free asset is
available.
With a risk-free asset, the straight
line is the efficient frontier.

Efficient Fort folio

The efficient frontier is a concept in
modern portfolio theory introduced by
Harry Markowitz and others in 1952.
It is the set of portfolios each with the
feature that no other portfolio exists
with a higher expected return but with
the same standard deviation of return.

Concept overview
A combination of assets, i.e. a
portfolio, is referred to as "efficient" if
it has the best possible expected level
of return for its level of risk (which is
represented by the standard deviation
of the portfolio's return).

Concept overview
Here, every possible combination of risky
assets can be plotted in riskexpected return
space, and the collection of all such possible
portfolios defines a region in this space.
In the absence of the opportunity to hold a
risk-free asset, this region is the opportunity
set (the feasible set).
The positively sloped (upward-sloped) top
boundary of this region is a portion of a
hyperbola and is called the "efficient frontier."

Modern Portfolio Theory

Modern portfolio theory (MPT) is a
theory of finance that attempts to
maximize portfolio expected return for
a given amount of portfolio risk, or
equivalently minimize risk for a given
level of expected return, by carefully
choosing the proportions of various
assets.
.

Modern Portfolio Theory

Although MPT is widely used in
practice in the financial industry and
several of its creators won a Nobel
memorial prize for the theory, in
recent years the basic assumptions of
MPT have been widely challenged by
fields such as behavioural economics.

MPT
MPT is a mathematical formulation of the
concept of diversification in investing, with
the aim of selecting a collection of
investment assets that has lower overall
risk than any other combination of assets
with the same expected return.
This is possible, intuitively speaking,
because different types of assets
sometimes change in value in opposite
directions.

MPT
For example, to the extent prices in the
stock market move differently from
prices in the bond market, a
combination of both types of assets can
in theory generate lower overall risk
than either individually.
Diversification can lower risk even if
assets' returns are positively
correlated.

More technically, MPT models an asset's return as a

normally or elliptically distributed random variable,
defines risk as the standard deviation of return, and
models a portfolio as a weighted combination of
assets, so that the return of a portfolio is the
weighted combination of the assets' returns.
By combining different assets whose returns are not
perfectly positively correlated, MPT seeks to reduce
the total variance of the portfolio return.
MPT also assumes that investors are rational and
markets are efficient.

MPT
MPT was developed in the 1950s
through the early 1970s and was
considered an important advance in
the mathematical modelling of
finance.
Since then, some theoretical and
practical criticisms have been
levelled against it.

MPT
These include evidence that financial
returns do not follow a normal distribution
or indeed any symmetric distribution, and
that correlations between asset
classes are not fixed but can vary
depending on external events
(especially in crises).
Further, there remains evidence that
investors are not rational and
markets may not be efficient.

MPT
Finally, the low volatility anomaly
conflicts with CAPM's trade-off
assumption of higher risk for higher
return.
It states that a portfolio consisting of low
volatility equities (like blue chip stocks)
reaps higher risk-adjusted returns than a
portfolio with high volatility equities (like
illiquid penny stocks).

MPT
If a risk-free asset is also available, the
opportunity set is larger, and its upper
boundary, the efficient frontier, is a
straight line segment emanating from
the vertical axis at the value of the
risk-free asset's return and tangent to
the risky-assets-only opportunity set.

 A study conducted by Myron Scholes,

Michael Jensen, and Fischer Black in
1972 suggests that the relationship
between return and beta might be
flat or even negatively correlated.

Concept - MPT
The fundamental concept behind MPT
is that the assets in an investment
portfolio should not be selected merely
individually, each on its own merits.
Rather, it is important to consider how
each asset might change in price
relative to how every other asset in the
portfolio might change in price.

Concept - MPT
Investing is a tradeoff between risk and
expected return.
In general, assets with higher expected
returns are riskier. The stocks in an
efficient portfolio are chosen depending
on the investor's risk tolerance: an
efficient portfolio is said to be having a
combination of at least two stocks
above the minimum variance portfolio.

Concept - MPT
For a given amount of risk, and on a lot of assumptions
about the probability distribution of returns on each
asset, MPT shows how to select a portfolio with the
highest possible expected return. Or, for a given
expected return, MPT explains how to select a portfolio
with the lowest possible risk (the targeted expected
return cannot be more than the highest-returning
available security, of course, unless negative holdings
of assets are possible.)
Therefore, MPT is a theory of diversification. Under
certain assumptions and for specific quantitative
definitions of risk and return, MPT explains how to find
the best possible diversification strategy.

Some Statistics

Correlation Coefficient

Some Statistics

Correlation Coefficient

Some Statistics

Correlation Coefficient formula

Some Statistics

Correlation Coefficient formula

alternate

Some Statistics

Standard Deviation and Variance

Standard Deviation

THE MARKOWITZ MODEL

We all agree that holding two stocks

is less risky as compared to one
stock.
But building the optimal portfolio is
very difficult.
Markowitz provides an answer to it
with the help of risk and return
relationship.

Simple diversification
In case of simple diversification securities are
selected at random and no analytical procedure
is used.
The simple diversification reduces total risk.
The reason behind this is that the unsystematic
price fluctuations are not correlated with the
market fluctuations.
As the portfolio size increases the total risk
starts declining. It flattens out after a certain
point. Beyond that limit risk cannot be reduced.

Problems of vast
diversification

Purchase of poor performers

Information adequacy
High research cost
High transaction cost

Assumptions
For a given level of risk, investors
prefers higher return to lower return.
Likewise for given level of return
investors prefer low risk as compared
to high risk.

The concept
In developing the model, Markowitz has given
up the single stock portfolio and introduced
diversification.
The single stock portfolio would be preferable if
the investor is perfectly certain that his
expectation of higher return would turn out to
be real.
But in this era of uncertainty most of the
investors would like to join Markowitz rather
than single stock. It can be shown with the help
of example.

 In our example the correlation coefficient

is -1.0.
That means there is perfect negative correlation
between the two and the return moves in opposite
direction.
If the correlation is +1 it means securities will move
in same direction and if it is zero the return of both
the securities is independent.
Thus the correlation between two securities depend
upon the covariance between the two securities
and the standard deviation of each security.

 The attainable set of portfolios are illustrated in

fig. Each of the portfolios along the line or within
the line ABCDEFGJ is possible.
It is not possible for the investor to have portfolio
of this perimeter because no combination of
expected return and risk exists there.
But there are some attractive options. Portfolio B
is more attractive than portfolio F and H because
it offers more return on same level of risk.
Likewise, C is more attractive than portfolio G as
for same return there is lower level of risk.