PORTFOLIO THEORY

Presented by
Prof. Eduardus Tandelilin, CWM
 “Put all your eggs in the one basket and
WATCH THAT BASKET!” -- Mark Twain

 As we shall see in this statement, this is probably not the best

advice!

 Intuitively, we all know that diversification is important when we are

managing investments.

 In fact, diversification has a profound effect on portfolio return and

portfolio risk.

 But, how does diversification work, exactly?

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 PORTFOLIO RISK
Rate of Return Distribution
Two (W&M) stocks with perfect negative correlation (r = -1.0)
and for portfolio WM
a. Rates of Return
Stock W Stock M Portfolio WM

kw (%) kM (%) kP (%)

25 25 25

15 15 15

0 0 0
2003 2003 2003

-10 -10 -10

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 b. Probability Distributions of Return

Probability Probability Probability

Density Density Density
Stock M Portfolio WM
Stock W

Percent
0 15 Percent 0 15 Percent 0 15

kw kM kP

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 Portfolio WM – kP
Year W – kW (%) M - kM (%)
(%)
1999 40.0 -10.0 15.0

2000 -10.0 40.0 15.0

2001 35.0 -5.0 15.0

2002 -5.0 35.0 15.0

2003 15.0 15.0 15.0

Average return 15.0 15.0 15.0

Standard Deviation 22.6 22.6 0.0

Standard Deviation’s Portfolio   p  w12 12  w 22 22  2 w1w 2 1 2 r1, 2

w1 = weighted fund invested in asset 1

w2 = 1 - w1= weighted fund invested in asset 2
r1,2 = correlation coefficient between asset 1 and asset 2

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 PORTFOLIO RISK
Rate of Return Distribution
Two (M&M’) stocks with perfect positive correlation (r = +1.0)
and for portfolio MM’
c. Rates of Return
Stock M Stock M’ Portfolio MM’

kM (%) kM’ (%) kP (%)

25 25 25

15 15 15

0 0 0
2003 2003 2003

-10 -10 -10

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 d. Probability Distributions of Return

Probability Density Probability Density Probability Density

Stock M Stock M’ Portfolio MM’

0 15 Percent 0 15 Percent Percent

0 15

kM kM’ kP

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 Portfolio MM’ - kP
Year M - kM (%) M’– kM’ (%)
(%)
1999 -10.0 -10.0 -10.0

2000 40.0 40.0 40.0

2001 -5.0 -5.0 -5.0

2002 35.0 35.0 35.0

2003 15.0 15.0 15.0

Average Return 15.0 15.0 15.0

Standard Deviation 22.6 22.6 22.6

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 PORTFOLIO RISK
Rate of Return Distribution
Two (W&Y) stocks with partial correlation (r = +0.65)
and for portfolio WY
e. Return
Stock W Stock Y Stock WY
kW (%) kY (%) kWY (%)

25 25
25

15 15 15

0 0 0
2003 2003 2003

-10 -10 -10

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 f. Probability Distributions of Return
Probability Density

Portfolio WY

Stock W and Y

0 15 Percent
kP

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 Portfolio WY - kP
Year W - kW (%) Y – kY (%)
(%)

1999 40.0 28.0 34.0

2000 -10.0 20.0 5.0

2001 35.0 41.0 38.0

2002 -5.0 -17.0 -11.0

2003 15.0 3.0 9.0

Average Return 15.0 15.0 15.0

Standard Deviation 22.6 22.6 20.6

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 Average Return and Volatility For Portfolios
Portfolio Expected Return

0.025
0.020 50% WIRELESS + 50%
REINSURANCE 100% WIRELESS
0.015 TELECOM GROUP
50% WIRELESS + 50%
0.010 IMMUCELL

0.005 100% REINSURANCE 100% IMMUCELL CORP

GROUP OF AMERICA
0.000
0.000 0.050 0.100 0.150 0.200 0.250 0.300 0.350
Portfolio Standard Deviation

How Do Portfolios of These Stocks Perform?

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Two-Asset Portfolio Standard
Deviation
 p  w1  1  w2  2  2w1 w2 12 1 2
2 2 2 2 2

Standard Deviation   p
2

Correlation Between Stocks Influences Portfolio

Volatility

What is Correlation Between Wireless and Immucell?

0.80
What is Correlation Between Wireless and Reinsurance Group?
-0.66

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 Correlation of Reinsurance Group,
Immucell, and Wireless
Relative Performance of Three Stocks

Stock Price Relative to Price in 2.5

2
January 2000

1.5

0.5

0
January 2000 - December 2002
Reinsurance Group Immucell Corp. Wireless Telecom

Wireless and Immucell Move Together; Wireless and Reinsurance Move in

Opposite Directions
When Stocks Move Together, Combining Them Doesn’t Reduce Risk Much

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Correlation Coefficients And Risk
Reduction For Two-Asset Portfolios
Expected Return on the Portfolio
25%
-1.0 <  <1.0
20%

15%  is +1.0
 is -1.0
10%

0% 5% 10% 15% 20% 25%

Standard Deviation of Portfolio Returns

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 Variance – Covariance Matrix

Asset 1 2 3 4 5
1 2 2 2 2 2
1 1 2 1 1 1 1
  1    12    13    14    15
5 5 5 5 5
2
2 2 2 2 2 2
1 1 2 1 1 1
   21   2    23    24    25
5 5 5 5 5
3
3 2 2 2 2 2
1 1 1 2 1 1
   31    32   3    34    35
5 5 5 5 5
4
4 2 2 2 2 2
1 1 1 1 2 1
   41    42    43   4    45
5 5 5 5 5
5 2 2 2 2 2
5 1 1 1 1 1 2
   51    52    53    54   5
5 5 5 5 5

Variance of Individual Assets Account Only for 1/25th of the

Portfolio Variance
The Covariance Terms Determine To A Large Extent The
16 Variance Of The Portfolio
 The Impact Of Additional Assets
On The Risk Of A Portfolio
Portfolio Risk, kp

Diversifiable Risk

Total risk
Nondiversifiable Risk

1 5 10 15 20 25
Number of Securities (Assets) in Portfolio

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 Illustration of Portfolio Returns, Risk,
and the Attainable Set of Portfolios
a. Returns b. Risk c. Attainable Set of Risk/Return Combinations
Expected
Return, kP
Case I: Percent (%)
B=10
rAB = +1.0 kB=8
kP P
8 B
kA=5
A=4 5 A

100%A Portfolio 100%B 100%A Portfolio 100%B 4 10

Allocation Allocation
Risk, P (%)
rP (%)
Case II: B=10
kB=8
rAB = 0 kP
P 8 B
kA=5
A=4 Y
5 A
100%A Portfolio 100%B 100%A Portfolio 100%B 4 10
Allocation Allocation Risk, P (%)
rP (%)
B=10 Y
Case III: kB=8 8
kP B
rAB = -1.0 kA=5
A=4 P 5 A

100%A Portfolio 100%B 100%A Portfolio 100%B 4 10

Allocation Allocation Risk, P (%)

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 CHOOSING THE OPTIMAL PORTFOLIO
THE EFFICIENT SET OF INVESTMENT

Expected Portfolio
Return, kP

Efficient Set (BCDE)

E
D

C G
X
Feasible, or
B Attainable Set
H

Risk, P (%)

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 RISK/RETURN INDIFFERENCE CURVES
Expected Rate of Return, rP
IY
10
9 IZ
8
7
Y’s Risk Premium (RP) for
6 Risk = P = 3.3%; RPY = 2.5%
5
Z’s Risk Premium (RP) for
4
Risk = P = 3.3%; RPZ = 1.0%
3
2
1
0 1 2 3 4 5 6 7 8 9 Risk, p(%)
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 SELECTING OPTIMAL PORTFOLIO OF RISKY ASSET

Expected Rate of Return, kP(%)

IY3 I IZ2
Y2 IY1
IZ1
IZ3

B
8

7.2
7

A
6

2 4 6 8 10
4.2 7.1
Risk, p(%)

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 THE CAPITAL MARKET LINE
Investors Equilibrium: Combining the Risk Free Asset with the Market Portfolio

Expected Rate of
Return, kP Increasing utility
I3 Z
I2 I1
E
kM
M
N
G
B
H
kP
R
A
kRF

P M Risk, P

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 CAPITAL MARKET LINE (CML)

Expected Rate of
Return, kP
(k̂ M - k RF )
CML  k̂ p  k RF  P
σ M

k̂ M M

k̂ RF

0 M Risk, P

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 Thank You..

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