Portfolio Selection

Chapter 8

Gerald R. Jensen and Charles P. Jones,

Investments: Analysis and Management,
14th Edition, John Wiley & Sons
Building a Portfolio
 Diversification is key to risk management
 Asset allocation most important single decision
 Using Markowitz Principles
◦ Step 1: Identify optimal risk-return combinations
using the Markowitz analysis
 Inputs: Expected returns, variances, covariances

◦ Step 2: Choose the final portfolio based on your

preferences for return relative to risk

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Portfolio Theory
 Optimal diversification takes into account
all available information
 Assumptions in portfolio theory
◦ A single investment period (one year)

◦ Liquid position (no transaction costs)

◦ Preferences based only on a portfolio’s risk

and expected return

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The Efficient Frontier
 Efficient Frontier – represents the set of all
mean/variance efficient (optimal) portfolios
◦ Optimal portfolio has maximum return for a given
level of risk or minimum risk for a given level of
return
◦ Portfolios on the efficient frontier dominate all
other portfolios
◦ No portfolio on the efficient frontier dominates
another portfolio on the frontier

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Efficient Portfolios
 Efficient frontier or
Efficient set
(curved line from A
B
to B)
 Global minimum

E(R) variance portfolio

A (represented by
point A)
 Portfolios on AB
C dominate all other
Risk =  possible portfolios

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Selecting an Optimal Portfolio
of Risky Assets
 Portfolio weights are the output from
Markowitz analysis
 Assume investors are risk averse
 Indifference curves (ICs) determine individual’s
optimal portfolio
◦ IC, description of preferences for risk and return
◦ IC reflects portfolio combinations that are equally
desirable
◦ ICs match investor preferences with portfolio
possibilities

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 The Optimal Portfolio
 

Investor 2 indifference/utility curves

Investor 1 indifference curves

Efficient Frontier
•
•

Goal is to achieve highest (most NW) attainable curve

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Selecting an Optimal Portfolio
of Risky Assets
 International diversification unlikely to offer as
much risk reduction as in the past
 Markowitz portfolio selection model
◦ Assumes investors use only risk and return to
decide
◦ Generates a set of equally “good” portfolios
◦ Does not address the issues of borrowed money
or risk-free assets
◦ Cumbersome to apply

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Selecting Optimal Asset Classes
 Another way to use Markowitz model is with
asset classes
◦ Allocation of portfolio to asset types
 Asset class, rather than individual security, is
most important for investors
◦ Can be used when investing internationally
◦ Different asset classes offer various returns
and levels of risk
 Correlation coefficients may be quite low

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Asset Allocation
 Includes two dimensions
◦ Diversifying across asset classes
◦ Diversifying within asset classes
 Asset classes include:
◦ Equities – foreign and domestic
◦ Bonds – foreign, domestic, and government
◦ Treasury Inflation-Protected Securities (TIPS)
◦ Alternative assets – real estate, commodities,
private equity, hedge funds, etc.

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 Correlation among asset classes must be
considered
 Correlations change over time
 For investors, allocation depends on
◦ Time horizon
◦ Risk tolerance
 Diversified asset allocation does not
guarantee against loss

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Commodity Funds
Commodities:
• Precious metals, industrial metals, livestock,
grains, oil products, etc.

Types of commodity funds:

• Bullion – hold physical asset
• Synthetic – use derivative security
• Equity – hold equities of firms engaged in
business

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 Index Mutual Funds, ETFs and ETNs
◦ Cover various asset classes: domestic and foreign
stocks (all investment styles), alternative assets
(e.g. real estate, commodities), bonds of all types

 Life Cycle Analysis

◦ Varies asset allocation based on investor age
◦ Life-cycle funds (target-date funds) vary allocation
as investor ages

 No one “correct” approach to allocation

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Systematic & Unsystematic Risk

Total = Systematic + Unsystematic

Risk Risk Risk

p2 = Systematic + Unsystematic

Variance Variance

The variance (risk) of a portfolio, or a single

security, consists of both systematic risk
and unsystematic risk

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Systematic & Unsystematic Risk

 Systematic risk is not diversifiable

◦ Systematic risk - risk of an overall movement in the
market
 nondiversifiable  systematic  market risk
 Unsystematic risk is diversifiable
◦ Unsystematic risk - risk of an event that is unique to
the asset or a small group of assets
 diversifiable  unsystematic  unique risk

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Portfolio Risk and Diversification
sp %
35
Total risk

Diversifiable (nonsystematic) risk

20
Nondiversifiable (systematic) risk

0 10 20 30 40 ...... 100+
Number of securities in portfolio
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