Chapter 8 - Risk, Return, and Portfolio Theory

INTRODUCTION TO
CORPORATE FINANCE
Laurence Booth • W. Sean Cleary
Chapter 8 – Risk, Return and Portfolio

Theory
Prepared by
Ken Hartviksen
CHAPTER 8
Risk, Return and Portfolio
Theory
Lecture Agenda
• Learning Objectives
• Important Terms
• Measurement of Returns
• Measuring Risk
• Expected Return and Risk for Portfolios
• The Efficient Frontier
• Diversification
• Summary and Conclusions
– Concept Review Questions
CHAPTER 8 – Risk, Return and Portfolio Theory 8-3

Learning Objectives
• The difference among the most important types of

returns
• How to estimate expected returns and risk for
individual securities
• What happens to risk and return when securities are
combined in a portfolio
• What is meant by an “efficient frontier”
• Why diversification is so important to investors

Important Chapter Terms
• Arithmetic mean • Mark to market
• Attainable portfolios • Market risk
• Capital gain/loss • Minimum variance frontier
• Correlation coefficient • Minimum variance portfolio
• Covariance • Modern portfolio theory
• Day trader • Naïve or random
• Diversification diversification
• Efficient frontier • Paper losses
• Efficient portfolios • Portfolio
• Ex ante returns • Range
• Ex post returns • Risk averse
• Expected returns • Standard deviation
• Geometric mean • Total return
• Income yield • Unique (or non-systematic) or
diversifiable risk
• Variance

Introduction to Risk and Return
Risk, Return and Portfolio Theory

Introduction to Risk and Return
Risk and return are the two most
important attributes of an
investment.
Research has shown that the two

are linked in the capital Return
markets and that generally, %
higher returns can only be
achieved by taking on greater
risk. Risk Premium
Risk isn’t just the potential loss of

return, it is the potential loss RF Real Return
of the entire investment itself
(loss of both principal and Expected Inflation Rate
interest).
Ris
Consequently, taking on k
additional risk in search of
higher returns is a decision
that should not be taking
lightly.

Measuring Returns

Measuring Returns
Introduction
Ex Ante Returns
• Return calculations may be done ‘before-the-
fact,’ in which case, assumptions must be
made about the future
Ex Post Returns
• Return calculations done ‘after-the-fact,’ in
order to analyze what rate of return was
earned.

Measuring Returns
Introduction
In Chapter 7 you learned that the constant growth DDM can be

decomposed into the two forms of income that equity investors may
receive, dividends and capital gains.
 D1 
kc =   + [ g ] = [ Income / Dividend Yield] + [ Capital Gain (or loss) Yield]
 P0 
WHEREAS
Fixed-income investors (bond investors for example) can expect to

earn interest income as well as (depending on the movement of
interest rates) either capital gains or capital losses.
CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 10

Measuring Returns
Income Yield
• Income yield is the return earned in the form of

a periodic cash flow received by investors.
• The income yield return is calculated by the
periodic cash flow divided by the purchase price.
CF1
[8-1] Income yield =
P0
Where CF1 = the expected cash flow to be
received
P0 = the purchase price

Income Yield
Stocks versus Bonds
Figure 8-1 illustrates the income yields for both bonds and stock in Canada from the
1950s to 2005
• The dividend yield is calculated using trailing rather than

forecast earns (because next year’s dividends cannot be
predicted in aggregate), nevertheless dividend yields have
exceeded income yields on bonds.
• Reason – risk
• The risk of earning bond income is much less than the risk
incurred in earning dividend income.
(Remember, bond investors, as secured creditors of the first have a

legally-enforceable contractual claim to interest.)
(See Figure 8 -1 on the following slide)

Ex post versus Ex ante Returns
Market Income Yields
8-1 FIGURE
Insert Figure 8 - 1

Measuring Returns
Common Share and Long Canada Bond Yield Gap
– Table 8 – 1 illustrates the income yield gap between stocks and bonds over
recent decades
– The main reason that this yield gap has varied so much over time is that the
return to investors is not just the income yield but also the capital gain (or loss)
yield as well.
Table 8-1 Average Yield Gap
Average Yield Gap (%)

1950s 0.82
1960s 2.35
1970s 4.54
1980s 8.14
1990s 5.51
2000s 3.55
Overall 4.58

Measuring Returns
Dollar Returns
Investors in market-traded securities (bonds or stock)

receive investment returns in two different form:
• Income yield
• Capital gain (or loss) yield
The investor will receive dollar returns, for example:

• $1.00 of dividends
• Share price rise of $2.00
To be useful, dollar returns must be converted to percentage returns

as a function of the original investment. (Because a $3.00 return on a
$30 investment might be good, but a $3.00 return on a $300
investment would be unsatisfactory!)

Measuring Returns
Converting Dollar Returns to Percentage Returns
An investor receives the following dollar returns a

stock investment of $25:
• $1.00 of dividends
• Share price rise of $2.00
The capital gain (or loss) return component of total return is

calculated: ending price – minus beginning price, divided by
beginning price
P1 − P0 $27 - $25
[8-2] Capital gain (loss) return = = = .08 = 8%
P0 $25

Measuring Returns
Total Percentage Return
• The investor’s total return (holding period

return) is:
Total return = Income yield + Capital gain (or loss) yield

CF + P − P
= 1 1 0
[8-3] P0
 CF   P − P 
= 1+ 1 0
 P0   P0 
 $1.00   $27 − $25 
=  +  = 0.04 + 0.08 = 0.12 = 12%
 $25   $25 

Measuring Returns
Total Percentage Return – General Formula
• The general formula for holding period return

is:
Total return = Income yield + Capital gain (or loss) yield

CF1 + P1 − P0
=
[8-3] P0
 CF1   P1 − P0 
= + 
P
 0   0  P

Measuring Average Returns
Ex Post Returns
• Measurement of historical rates of return that

have been earned on a security or a class of
securities allows us to identify trends or
tendencies that may be useful in predicting
the future.
• There are two different types of ex post mean
or average returns used:
– Arithmetic average
– Geometric mean

Arithmetic Average
[8-4] ∑r i
Arithmetic Average (AM) = i =1
n
Where:
ri = the individual returns
n = the total number of observations
• Most commonly used value in statistics

• Sum of all returns divided by the total number of
observations

Geometric Mean
1
[8-5]
Geometric Mean (GM) = [( 1 + r1 )( 1 + r2 )( 1 + r3 )...( 1 + rn )] -1
n
• Measures the average or compound growth

rate over multiple periods.

Geometric Mean versus Arithmetic Average
If all returns (values) are identical the geometric mean =

arithmetic average.
If the return values are volatile the geometric mean <

arithmetic average
The greater the volatility of returns, the greater the

difference between geometric mean and arithmetic
average.
(Table 8 – 2 illustrates this principle on major asset classes 1938 – 2005)

Average Investment Returns and Standard Deviations
Table 8 - 2 Average Investment Returns and Standard Deviations, 1938-2005
Annual Annual Standard Deviation

Arithmetic Geometric of Annual Returns
Average (%) Mean (%) (%)
Government of Canada treasury bills 5.20 5.11 4.32

Government of Canada bonds 6.62 6.24 9.32
Canadian stocks 11.79 10.60 16.22
U.S. stocks 13.15 11.76 17.54
Source: Data are from the Canadian Institute of A ctuaries
The greater the difference,

the greater the volatility of
annual returns.

Measuring Expected (Ex Ante) Returns
• While past returns might be interesting,

investor’s are most concerned with future
returns.
• Sometimes, historical average returns will not
be realized in the future.
• Developing an independent estimate of ex
ante returns usually involves use of
forecasting discrete scenarios with outcomes
and probabilities of occurrence.

Estimating Expected Returns
Estimating Ex Ante (Forecast) Returns
• The general formula
n
[8-6] Expected Return (ER) = ∑ (ri × Prob i )
i =1
Where:
ER = the expected return on an investment
Ri = the estimated return in scenario i
Probi = the probability of state i occurring

Estimating Ex Ante (Forecast) Returns
Example:
This is type of forecast data that are required to
make an ex ante estimate of expected return.
Possible
Returns on
Probability of Stock A in that
State of the Economy Occurrence State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%

Estimating Ex Ante (Forecast) Returns Using a Spreadsheet Approach
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.
(1) (2) (3) (4)=(2)×(1)

Possible Weighted
Returns on Possible
Probability of Stock A in that Returns on
State of the Economy Occurrence State the Stock
Economic Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock = 7.25%

Estimating Ex Ante (Forecast) Returns Using a Formula Approach
Example Solution:
Sum the products of the probabilities and possible
returns in each state of the economy.
n
Expected Return (ER) = ∑ (ri × Prob i )
i =1
= (r1 × Prob1 ) + (r2 × Prob 2 ) + (r3 × Prob 3 )

= (30% × 0.25) + (12% × 0.5) + (-25% × 0.25)
= 7.25%

Measuring Risk

Risk
• Probability of incurring harm

• For investors, risk is the probability of earning
an inadequate return.
– If investors require a 10% rate of return on a given
investment, then any return less than 10% is
considered harmful.

Risk
Illustrated
The range of total possible returns

on the stock A runs from -30% to
Probability
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
Outcomes that produce harm represent risk to the investor.
-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock

Range
• The difference between the maximum and

minimum values is called the range
– Canadian common stocks have had a range of annual
returns of 74.36 % over the 1938-2005 period
– Treasury bills had a range of 21.07% over the same
period.
• As a rough measure of risk, range tells us that
common stock is more risky than treasury
bills.

Differences in Levels of Risk
Illustrated
Outcomes that produce harm The wider the range of probable

outcomes the greater the risk of the
Probability
investment.
B A is a much riskier investment than B
-30% -20% -10% 0% 10% 20% 30% 40%

Possible Returns on the Stock

Historical Returns on Different Asset
Classes
• Figure 8-2 illustrates the volatility in annual returns on

three different assets classes from 1938 – 2005.
• Note:
– Treasury bills always yielded returns greater than 0%
– Long Canadian bond returns have been less than 0% in some
years (when prices fall because of rising interest rates), and the
range of returns has been greater than T-bills but less than
stocks
– Common stock returns have experienced the greatest range of
returns
(See Figure 8-2 on the following slide)

Measuring Risk
Annual Returns by Asset Class, 1938 - 2005
FIGURE 8-2

Refining the Measurement of Risk
Standard Deviation (σ)
• Range measures risk based on only two

observations (minimum and maximum value)
• Standard deviation uses all observations.
– Standard deviation can be calculated on forecast or
possible returns as well as historical or ex post
returns.
(The following two slides show the two different formula used for Standard
Deviation)

Measuring Risk
Ex post Standard Deviation
n _
∑ i
( r − r ) 2
[8-7] Ex post σ = i =1
n −1
Where :
σ = the standard deviation
_
r = the average return
ri = the return in year i
n = the number of observations

Measuring Risk
Example Using the Ex post Standard Deviation
Problem
Estimate the standard deviation of the historical returns on
investment A that were: 10%, 24%, -12%, 8% and 10%.
Step 1 – Calculate the Historical Average Return
∑r i
10 + 24 - 12 + 8 + 10 40
Arithmetic Average (AM) = i =1
= = = 8.0%
n 5 5
Step 2 – Calculate the Standard Deviation

n _
∑ (r − r )
i
2
(10 - 8) 2 + (24 − 8) 2 + (−12 − 8) 2 + (8 − 8) 2 + (14 − 8) 2
Ex post σ = i =1
=
n −1 5 −1
2 2 + 16 2 − 20 2 + 0 2 + 2 2 4 + 256 + 400 + 0 + 4 664
= = = = 166 = 12.88%
4 4 4

Ex Post Risk
Stability of Risk Over Time
Figure 8-3 (on the next slide) demonstrates that the relative
riskiness of equities and bonds has changed over time.
Until the 1960s, the annual returns on common shares were about
four times more variable than those on bonds.
Over the past 20 years, they have only been twice as variable.
Consequently, scenario-based estimates of risk (standard deviation)

is required when seeking to measure risk in the future. (We cannot
safely assume the future is going to be like the past!)
Scenario-based estimates of risk is done through ex ante estimates

and calculations.

Relative Uncertainty
Equities versus Bonds
FIGURE 8-3

Measuring Risk
Ex ante Standard Deviation
A Scenario-Based Estimate of Risk
n
[8-8] Ex ante σ = ∑ (Prob
i =1
i ) × ( ri − ERi ) 2

Scenario-based Estimate of Risk
Example Using the Ex ante Standard Deviation – Raw Data
GIVEN INFORMATION INCLUDES:

- Possible returns on the investment for different
discrete states
- Associated probabilities for those possible returns
Possible
State of the Returns on
Economy Probability Security A
Recession 25.0% -22.0%

Normal 50.0% 14.0%
Economic Boom 25.0% 35.0%

Ex ante Standard Deviation – Spreadsheet Approach
• The following two slides illustrate an approach

to solving for standard deviation using a
spreadsheet model.

First Step – Calculate the Expected Return
Determined by multiplying
the probability times the
possible return.
Possible Weighted
State of the Returns on Possible
Economy Probability Security A Returns
Recession 25.0% -22.0% -5.5%

Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
Expected return equals the sum of

the weighted possible returns.

Second Step – Measure the Weighted and Squared Deviations
Now multiply the square deviations by

First calculate the deviation of
their probability of occurrence.
possible returns from the expected.
Deviation of Weighted
Possible Weighted Possible and
State of the Returns on Possible Return from Squared Squared
Economy Probability Security A Returns Expected Deviations Deviations
Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600

Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070
Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
Expected Return = 10.3% Variance = 0.0420
Standard Deviation = 20.50%
Second, square those deviations

The sum of thestandard
The weighted
from the and square
mean.
deviation deviations
is the square root
is the variance
of theinvariance
percent (in
squared terms.
percent terms).
Example Using the Ex ante Standard Deviation Formula
Possible Weighted
State of the Returns on Possible
Economy Probability Security A Returns
Recession 25.0% -22.0% -5.5%

Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
n
Ex ante σ = ∑ (Prob ) × (r − ER )
i =1
i i i
2
= P1 (r1 − ER1 ) 2 + P2 (r2 − ER2 ) 2 + P1 ( r3 − ER3 ) 2

= .25(−22 − 10.3) 2 + .5(14 − 10.3) 2 + .25(35 − 10.3) 2
= .25(−32.3) 2 + .5(3.8) 2 + .25(24.8) 2
= .25(.10401) + .5(.00141) + .25(.06126)
= .0420
= .205 = 20.5%

Modern Portfolio Theory

Portfolios
• A portfolio is a collection of different securities such as

stocks and bonds, that are combined and considered a
single asset
• The risk-return characteristics of the portfolio is

demonstrably different than the characteristics of the
assets that make up that portfolio, especially with regard to
risk.
• Combining different securities into portfolios is done to

achieve diversification.

Diversification
Diversification has two faces:
1. Diversification results in an overall reduction in portfolio risk (return

volatility over time) with little sacrifice in returns, and
2. Diversification helps to immunize the portfolio from potentially
catastrophic events such as the outright failure of one of the
constituent investments.
(If only one investment is held, and the issuing firm goes
bankrupt, the entire portfolio value and returns are lost. If
a portfolio is made up of many different investments, the
outright failure of one is more than likely to be offset by
gains on others, helping to make the portfolio immune to
such events.)
Expected Return of a Portfolio
The Expected Return on a Portfolio is simply the

weighted average of the returns of the individual assets
that make up the portfolio:
n
[8-9] ER p = ∑ ( wi × ERi )
i =1
The portfolio weight of a particular security is the

percentage of the portfolio’s total value that is invested
in that security.
Expected Return of a Portfolio
Example
Portfolio value = $2,000 + $5,000 = $7,000

rA = 14%, rB = 6%,
wA = weight of security A = $2,000 / $7,000 = 28.6%
wB = weight of security B = $5,000 / $7,000 = (1-28.6%)=
71.4%
n
ER p = ∑ ( wi × ERi ) = (.286 ×14%) + (.714 × 6% )
i =1
= 4.004% + 4.284% = 8.288%

Range of Returns in a Two Asset Portfolio
In a two asset portfolio, simply by changing the weight of the

constituent assets, different portfolio returns can be achieved.
Because the expected return on the portfolio is a simple

weighted average of the individual returns of the assets, you
can achieve portfolio returns bounded by the highest and the
lowest individual asset returns.

Example 1:
Assume ERA = 8% and ERB = 10%
(See the following 6 slides based on Figure 8-4)

Expected Portfolio Return
Affect on Portfolio Return of Changing Relative Weights in A and B
8 - 4 FIGURE
10.50
10.00 ERB= 10%
9.50
9.00
8.50
8.00 ERA=8%
%nr ut e R det ce px E
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

8 - 4 FIGURE
A portfolio manager can select the relative weights of the two

assets in the portfolio to get a desired return between 8%
(100% invested in A) and 10% (100% invested in B)
10.50
10.00 ERB= 10%
9.50
9.00
8.50
8.00 ERA=8%
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

8 - 4 FIGURE
10.50
ERB= 10%
10.00
9.50 The potential returns of

the portfolio are
bounded by the highest
9.00 and lowest returns of
the individual assets
8.50 that make up the
portfolio.
8.00
ERA=8%
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

8 - 4 FIGURE
10.50
ERB= 10%
10.00
9.50
9.00
The expected return on
the portfolio if 100% is
8.50 invested in Asset A is
8%.
8.00 ER p = wA ER A + wB ERB = (1.0)(8%) + (0)(10%) = 8%
ERA=8%
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

8 - 4 FIGURE
10.50 The expected return on

invested in Asset B is ERB= 10%
10.00 10%.
9.50
9.00
8.50
ER p = wA ER A + wB ERB = (0)(8%) + (1.0)(10%) = 10%
8.00
ERA=8%
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

8 - 4 FIGURE
10.50 The expected return on

invested in Asset A and ERB= 10%
10.00 50% in B is 9%.
9.50
ER p = wA ERA + wB ERB
9.00
= (0.5)(8%) + (0.5)(10%)
8.50 = 4% + 5% = 9%
8.00
ERA=8%
7.50
7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
Portfolio Weight

Example 1:
Assume ERA = 14% and ERB = 6%
(See the following 2 slides )

E(r)A= 14%, E(r)B= 6%
Expected return on Asset A = 14.0%

Expected return on Asset B = 6.0%
Expected
Weight of Weight of Return on the
Asset A Asset B Portfolio
0.0% 100.0% 6.0%
10.0% 90.0% 6.8%
20.0% 80.0% 7.6%
30.0% 70.0% 8.4%
40.0% 60.0% 9.2%
50.0% 50.0% 10.0%
60.0% 40.0% 10.8% A graph of this
70.0% 30.0% 11.6%
relationship is
80.0% 20.0% 12.4%
90.0% 10.0% 13.2% found on the
100.0% 0.0% 14.0% following slide.

E(r)A= 14%, E(r)B= 6%
Ran g e o f Po rtfo lio Re tu rn s
1 6.00 %
1 4.00 %
Expected Return on Two
1 2.00 %
Asset Portfolio
1 0.00 %
8.00 %
6.00 %
4.00 %
2.00 %
0.00 %
0%
%
%
%
%
%
.0
.0
.0
.0
.0
.0
.0
.0
.0
0
0.
0.
30
50
80
10
20
40
60
70
90
10
W eight Inves te d in As s et A

Expected Portfolio Returns
Example of a Three Asset Portfolio
Relative Expected Weighted

Weight Return Return
Stock X 0.400 8.0% 0.03
Stock Y 0.350 15.0% 0.05
Stock Z 0.250 25.0% 0.06
Expected Portfolio Return = 14.70%
CHAPTER 8 – Risk,K.Return
Hartviksen
and Portfolio Theory 8 - 63
Risk in Portfolios

Modern Portfolio Theory - MPT
• Prior to the establishment of Modern Portfolio Theory

(MPT), most people only focused upon investment
returns…they ignored risk.
• With MPT, investors had a tool that they could use to

dramatically reduce the risk of the portfolio without a
significant reduction in the expected return of the portfolio.

Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Covariance
[8-11] σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )(COVA, B )
Risk of Asset A Risk of Asset B Factor to take into

adjusted for weight adjusted for weight account comovement
in the portfolio in the portfolio of returns. This factor
can be negative.

Expected Return and Risk For Portfolios
Standard Deviation of a Two-Asset Portfolio using Correlation
Coefficient
[8-15] σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A, B )(σ A )(σ B )
Factor that takes into

account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.

Grouping Individual Assets into Portfolios
• The riskiness of a portfolio that is made of different risky

assets is a function of three different factors:
– the riskiness of the individual assets that make up the portfolio
– the relative weights of the assets in the portfolio
– the degree of comovement of returns of the assets making up the
portfolio
• The standard deviation of a two-asset portfolio may be
measured using the Markowitz model:
σ p = σ w + σ w + 2 wA wB ρ A, Bσ Aσ B
2
A
2
A
2
B
2
B

Risk of a Three-Asset Portfolio
The data requirements for a three-asset portfolio grows

dramatically if we are using Markowitz Portfolio selection formulae.
We need 3 (three) correlation coefficients between A and B; A and

C; and B and C.
A
ρa,b ρa,c
B C
ρb,c
σ p = σ A2 wA2 + σ B2 wB2 + σ C2 wC2 + 2wA wB ρ A, Bσ Aσ B + 2 wB wC ρ B ,Cσ Bσ C + 2 wA wC ρ A,Cσ Aσ C

Risk of a Four-asset Portfolio
The data requirements for a four-asset portfolio grows dramatically

if we are using Markowitz Portfolio selection formulae.
We need 6 correlation coefficients between A and B; A and C; A

and D; B and C; C and D; and B and D.
A
ρa,b ρa,d
ρa,c
B D
ρb,d
ρb,c ρc,d
C

Covariance
• A statistical measure of the correlation of

the fluctuations of the annual rates of
return of different investments.
n _ _
[8-12] COV AB = ∑ Prob i (k A,i − ki )(k B ,i - k B )
i =1

Correlation
• The degree to which the returns of two stocks

co-move is measured by the correlation
coefficient (ρ).
• The correlation coefficient (ρ) between the
returns on two securities will lie in the range of
+1 through - 1.
+1 is perfect positive correlation
-1 is perfect negative correlation
COV AB
[8-13] ρ AB =
σ Aσ B

Covariance and Correlation Coefficient
• Solving for covariance given the correlation

coefficient and standard deviation of the two
assets:
[8-14] COVAB = ρ ABσ Aσ B

Importance of Correlation
• Correlation is important because it affects the

degree to which diversification can be
achieved using various assets.
• Theoretically, if two assets returns are
perfectly positively correlated, it is possible to
build a riskless portfolio with a return that is
greater than the risk-free rate.

Affect of Perfectly Negatively Correlated Returns
Elimination of Portfolio Risk
Returns
If returns of A and B are
%
20% perfectly negatively correlated,
a two-asset portfolio made up of
equal parts of Stock A and B
would be riskless. There would
15% be no variability
of the portfolios returns over
time.
10%
Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio
Time 0 1 2
Example of Perfectly Positively Correlated Returns
No Diversification of Portfolio Risk
Returns
%
20% perfectly positively correlated,
would be risky. There would be
15% no diversification (reduction of
portfolio risk).
10%
Returns on Stock A
Returns on Stock B
5%
Time 0 1 2
Elimination of Portfolio Risk
Returns
%
20% perfectly negatively correlated,
would be riskless. There would
15% be no variability
of the portfolios returns over
time.
10%
Returns on Stock A
Returns on Stock B
5%
Time 0 1 2
Numerical Example
W eight of A s s et A = 50.0%
W eight of A s s et B = 50.0%
Ex pe cte d n
ER p = ∑ ( wi × ERi ) = (.5 × 5%) + (.5 ×15% )
Re turn on Re turn on Re turn on the i =1
Ye a r Asse t A Asse t B P ortfolio = 2.5% + 7.5% = 10%

x x07 5.0% 15.0% 10.0%
x x08 10.0% 10.0% 10.0%
x x09 15.0% 5.0% 10.0%
n
ER p = ∑ ( wi × ERi ) = (.5 ×15%) + (.5 × 5% )
i =1
= 7.5% + 2.5% = 10%

Perfectly Negatively
Correlated Returns
over time

Diversification Potential
• The potential of an asset to diversify a portfolio is

dependent upon the degree of co-movement of returns of
the asset with those other assets that make up the
portfolio.
• In a simple, two-asset case, if the returns of the two assets
are perfectly negatively correlated it is possible
(depending on the relative weighting) to eliminate all
portfolio risk.
• This is demonstrated through the following series of
spreadsheets, and then summarized in graph format.

Example of Portfolio Combinations and
Correlation
Perfect
Expected Standard Correlation Positive
Asset Return Deviation Coefficient Correlation –
A 5.0% 15.0% 1 no
B 14.0% 40.0% diversification
Portfolio Components Portfolio Characteristics

Expected Standard Both
Weight of A Weight of B Return Deviation portfolio
100.00% 0.00% 5.00% 15.0% returns and
90.00% 10.00% 5.90% 17.5% risk are
80.00% 20.00% 6.80% 20.0% bounded by
70.00% 30.00% 7.70% 22.5% the range set
60.00% 40.00% 8.60% 25.0% by the
50.00% 50.00% 9.50% 27.5% constituent
40.00% 60.00% 10.40% 30.0% assets when
30.00% 70.00% 11.30% 32.5% ρ=+1
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%
Correlation
Positive
Expected Standard Correlation Correlation –
Asset Return Deviation Coefficient weak
A 5.0% 15.0% 0.5 diversification
B 14.0% 40.0% potential

Expected Standard
Weight of A Weight of B Return Deviation When
ρ=+0.5
100.00% 0.00% 5.00% 15.0%
these
90.00% 10.00% 5.90% 15.9%
portfolio
80.00% 20.00% 6.80% 17.4%
combination
70.00% 30.00% 7.70% 19.5%
s have lower
60.00% 40.00% 8.60% 21.9%
risk –
50.00% 50.00% 9.50% 24.6%
expected
40.00% 60.00% 10.40% 27.5%
portfolio
30.00% 70.00% 11.30% 30.5%
return is
20.00% 80.00% 12.20% 33.6%
unaffected.
10.00% 90.00% 13.10% 36.8%
0.00% 100.00% 14.00% 40.0%
Correlation
No
Asset Return Deviation Coefficient some
A 5.0% 15.0% 0 diversification

Expected Standard
Weight of A Weight of B Return Deviation
Portfolio
100.00% 0.00% 5.00% 15.0% risk is
90.00% 10.00% 5.90% 14.1% lower than
80.00% 20.00% 6.80% 14.4% the risk of
70.00% 30.00% 7.70% 15.9% either
60.00% 40.00% 8.60% 18.4% asset A or
50.00% 50.00% 9.50% 21.4% B.
40.00% 60.00% 10.40% 24.7%
30.00% 70.00% 11.30% 28.4%
20.00% 80.00% 12.20% 32.1%
10.00% 90.00% 13.10% 36.0%
0.00% 100.00% 14.00% 40.0%
Correlation
Negative
Asset Return Deviation Coefficient greater
A 5.0% 15.0% -0.5 diversification

Expected Standard
Weight of A Weight of B Return Deviation Portfolio risk
100.00% 0.00% 5.00% 15.0% for more
90.00% 10.00% 5.90% 12.0%
combinations
80.00% 20.00% 6.80% 10.6%
is lower than
70.00% 30.00% 7.70% 11.3%
the risk of
60.00% 40.00% 8.60% 13.9%
either asset
50.00% 50.00% 9.50% 17.5%
40.00% 60.00% 10.40% 21.6%
30.00% 70.00% 11.30% 26.0%
20.00% 80.00% 12.20% 30.6%
10.00% 90.00% 13.10% 35.3%
0.00% 100.00% 14.00% 40.0%
Correlation
Perfect
Negative
Asset Return Deviation Coefficient
greatest
A 5.0% 15.0% -1
B 14.0% 40.0% diversification
potential
Expected Standard
Weight of A Weight of B Return Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5%
80.00% 20.00% 6.80% 4.0%
70.00% 30.00% 7.70% 1.5% Risk of the
60.00% 40.00% 8.60% 7.0% portfolio is
50.00% 50.00% 9.50% 12.5% almost
40.00% 60.00% 10.40% 18.0% eliminated at
30.00% 70.00% 11.30% 23.5% 70% invested
20.00% 80.00% 12.20% 29.0% in asset A
10.00% 90.00% 13.10% 34.5%
0.00% 100.00% 14.00% 40.0%

Diversification of a Two Asset Portfolio
Demonstrated Graphically
The Effect of Correlation on Portfolio Risk:
The Two-Asset Case
Expected Return B
ρ AB = -0.5
12%
ρ AB = -1
8%
ρ AB =0
ρ AB = +1
A
4%
0%
0% 10% 20% 30% 40%
Standard Deviation

Impact of the Correlation Coefficient
• Figure 8-7 (see the next slide) illustrates the

relationship between portfolio risk (σ) and the
correlation coefficient
– The slope is not linear a significant amount of
diversification is possible with assets with no
correlation (it is not necessary, nor is it possible to
find, perfectly negatively correlated securities in the
real world)
– With perfect negative correlation, the variability of
portfolio returns is reduced to nearly zero.

Impact of the Correlation Coefficient
8 - 7 FIGURE
15
10
5
( noi t ai ve D dr a dnat S
s nr ut e R oil oft r o Pf o
0
-1 -0.5 0 0.5 1
Correlation Coefficient (ρ)
) %

Zero Risk Portfolio
• We can calculate the portfolio that removes all risk.

• When ρ = -1, then
[8-15] σ p = ( wA ) 2 (σ A ) 2 + ( wB ) 2 (σ B ) 2 + 2( wA )( wB )( ρ A, B )(σ A )(σ B )
• Becomes:
[8-16] σ p = wσ A − (1 − w)σ B

An Exercise to Produce the Efficient
Frontier Using Three Assets

An Exercise using T-bills, Stocks and Bonds
Base Data: Stocks T-bills Bonds
Expected Return(%) 12.73383 6.151702 7.0078723
Historical
Standard Deviation (%) 0.168 0.042 0.102 averages for
returns and risk for
Correlation Coefficient Matrix:
Stocks 1 -0.216 0.048 three asset
T-bills -0.216 1 0.380 Each achievable
classes
Bonds 0.048 0.380 1
portfolio
Portfolio Combinations: combination is
Historical
Weights Portfolio plotted correlation
on
Combination Stocks T-bills Bonds
Expected
Return
Standard
Variance Deviation
expected return,
coefficients
1 100.0% 0.0% 0.0% 12.7 0.0283 16.8% risk between the asset
(σ) space,
2 90.0% 10.0% 0.0% 12.1 0.0226 15.0% classes
3 80.0% 20.0% 0.0% 11.4 0.0177 13.3% found on the
4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%
5 60.0% 40.0% 0.0% 10.1 0.0097 9.9% following slide.
6 50.0% 50.0% 0.0% 9.4 0.0067 8.2% Portfolio
7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%
8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%
characteristics for
9 20.0% 80.0% 0.0% 7.5 0.0018 4.2% each combination
10 10.0% 90.0% 0.0% 6.8 0.0014 3.8% of securities

Achievable Portfolios
Results Using only Three Asset Classes
Attainable Portfolio Combinations The efficient set is that set of

and Efficient Set of Portfolio Combinations
achievable portfolio
combinations that offer the
14.0 highest rate of return for a
Efficient Set
12.0 given level of risk. The solid
Portfolio Expected Return (%)
Minimum Variance
10.0 Portfolio blue line indicates the efficient

set.
8.0
6.0
4.0 The plotted points are
attainable portfolio
2.0
combinations.
0.0
0.0 5.0 10.0 15.0 20.0
Standard Deviation of the Portfolio (%)

Achievable Two-Security Portfolios
8 - 9 FIGURE
This line
represents
13 the set of
12
portfolio
combinations
11
that are
10 achievable by
9
varying
relative
8 weights and
7 using two
non-
6
0 10 20 30 40 50 60
correlated
Standard Deviation (%) securities.

Dominance
• It is assumed that investors are rational,

wealth-maximizing and risk averse.
• If so, then some investment choices dominate
others.

Investment Choices
The Concept of Dominance Illustrated
Return A dominates B
% because it offers
A B the same return
10% but for less risk.
A dominates C
C because it offers a
5% higher return but
for the same risk.
5% 20% Risk
To the risk-averse wealth maximizer, the choices are clear, A dominates B,
A dominates C.

Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
A is not attainable
B,E lie on the
efficient frontier and
are attainable
A B E is the minimum
variance portfolio
C (lowest risk
combination)
C, D are
E attainable but are
D dominated by
superior portfolios
that line on the line
above E
Standard Deviation (%)

Efficient Frontier
The Two-Asset Portfolio Combinations
8 - 10 FIGURE
Rational, risk
averse
investors will
only want to
A B hold portfolios
such as B.
C
The actual
E choice will
D depend on
her/his risk
preferences.
Standard Deviation (%)

Diversification

Diversification
• We have demonstrated that risk of a portfolio can be
reduced by spreading the value of the portfolio across,
two, three, four or more assets.
• The key to efficient diversification is to choose assets
whose returns are less than perfectly positively
correlated.
• Even with random or naïve diversification, risk of the
portfolio can be reduced.
– This is illustrated in Figure 8 -11 and Table 8 -3 found on the
following slides.
• As the portfolio is divided across more and more securities, the risk
of the portfolio falls rapidly at first, until a point is reached where,
further division of the portfolio does not result in a reduction in risk.
• Going beyond this point is known as superfluous diversification.

Diversification
Domestic Diversification
8 - 11 FIGURE
Average Portfolio Risk

January 1985 to December 1997
14
12
10
2
0
0 50 100 150 200 250 300
Number of Stocks in Portfolio

) %
Diversification
Domestic Diversification
Table 8-3 Monthly Canadian Stock Portfolio Returns, January 1985 to December 1997
Number of Average Standard Deviation Ratio of Portfolio Percentage of

Stocks in Monthly of Average Standard Deviation to Total Achievable
Portfolio Portfolio Monthly Portfolio Standard Deviation of a Risk Reduction
Return (%) Return (%) Single Stock
1 1.51 13.47 1.00 0.00
2 1.51 10.99 0.82 27.50
3 1.52 9.91 0.74 39.56
4 1.53 9.30 0.69 46.37
5 1.52 8.67 0.64 53.31
6 1.52 8.30 0.62 57.50
7 1.51 7.95 0.59 61.35
8 1.52 7.71 0.57 64.02
9 1.52 7.52 0.56 66.17
10 1.51 7.33 0.54 68.30
14 1.51 6.80 0.50 74.19
40 1.52 5.62 0.42 87.24
50 1.52 5.41 0.40 89.64
100 1.51 4.86 0.36 95.70
200 1.51 4.51 0.34 99.58
222 1.51 4.48 0.33 100.00
Source: Cleary, S. and Copp D. "Diversification with Canadian Stocks: How M uch is Enough?" Canadian Investment Review (Fall 1999), Table 1.

Total Risk of an Individual Asset
Equals the Sum of Market and Unique Risk
• This graph illustrates

Average Portfolio Risk
that total risk of a
stock is made up of
market risk (that
cannot be diversified
Diversifiable away because it is a
(unique) risk
function of the
[8-19] economic ‘system’)
and unique, company-
Nondiversifiable specific risk that is
(systematic) risk eliminated from the
portfolio through
Number of Stocks in Portfolio
diversification.
) %
[8-19] Total risk = Market (systematic) risk + Unique (non - systematic) risk

International Diversification
• Clearly, diversification adds value to a

portfolio by reducing risk while not reducing
the return on the portfolio significantly.
• Most of the benefits of diversification can be
achieved by investing in 40 – 50 different
‘positions’ (investments)
• However, if the investment universe is
expanded to include investments beyond the
domestic capital markets, additional risk
reduction is possible.
(See Figure 8 -12 found on the following slide.)

Diversification
International Diversification
8 - 12 FIGURE
100
80
60
40
ksi r t necr e P
U.S. stocks
20
International stocks
11.7
0
0 10 20 30 40 50 60
Number of Stocks

Summary and Conclusions
In this chapter you have learned:

– How to measure different types of returns
– How to calculate the standard deviation and
interpret its meaning
– How to measure returns and risk of portfolios and
the importance of correlation in the diversification
process.
– How the efficient frontier is that set of achievable
portfolios that offer the highest rate of return for a
given level of risk.

Concept Review Questions

Concept Review Question 1
Ex Ante and Ex Post Returns
What is the difference between ex ante and

ex post returns?

Copyright
Copyright © 2007 John Wiley &
Sons Canada, Ltd. All rights
reserved. Reproduction or
translation of this work beyond that
permitted by Access Copyright (the
Canadian copyright licensing
agency) is unlawful. Requests for
further information should be
addressed to the Permissions
Department, John Wiley & Sons
Canada, Ltd. The purchaser may
make back-up copies for his or her
own use only and not for distribution
or resale. The author and the
publisher assume no responsibility
for errors, omissions, or damages
caused by the use of these files or
programs or from the use of the
information contained herein.

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INTRODUCTION TO

Chapter 8 – Risk, Return and Portfolio

CHAPTER 8 – Risk, Return and Portfolio Theory 8-3

• The difference among the most important types of

CHAPTER 8 – Risk, Return and Portfolio Theory 8-4

CHAPTER 8 – Risk, Return and Portfolio Theory 8-5

Risk, Return and Portfolio Theory

Research has shown that the two

Risk isn’t just the potential loss of

CHAPTER 8 – Risk, Return and Portfolio Theory 8-7

Risk, Return and Portfolio Theory

CHAPTER 8 – Risk, Return and Portfolio Theory 8-9

In Chapter 7 you learned that the constant growth DDM can be

Fixed-income investors (bond investors for example) can expect to

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 10

• Income yield is the return earned in the form of

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 11

• The dividend yield is calculated using trailing rather than

(Remember, bond investors, as secured creditors of the first have a

(See Figure 8 -1 on the following slide)

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 12

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 13

Average Yield Gap (%)

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 14

Investors in market-traded securities (bonds or stock)

The investor will receive dollar returns, for example:

To be useful, dollar returns must be converted to percentage returns

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 15

An investor receives the following dollar returns a

The capital gain (or loss) return component of total return is

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 16

• The investor’s total return (holding period

Total return = Income yield + Capital gain (or loss) yield

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 17

• The general formula for holding period return

Total return = Income yield + Capital gain (or loss) yield

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 18

• Measurement of historical rates of return that

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 19

• Most commonly used value in statistics

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 20

• Measures the average or compound growth

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 21

If all returns (values) are identical the geometric mean =

If the return values are volatile the geometric mean <

The greater the volatility of returns, the greater the

(Table 8 – 2 illustrates this principle on major asset classes 1938 – 2005)

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 22

Table 8 - 2 Average Investment Returns and Standard Deviations, 1938-2005

Annual Annual Standard Deviation

Government of Canada treasury bills 5.20 5.11 4.32

Source: Data are from the Canadian Institute of A ctuaries

The greater the difference,

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 23

• While past returns might be interesting,

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 24

• The general formula

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 25

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 26

(1) (2) (3) (4)=(2)×(1)

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 27

= (r1 × Prob1 ) + (r2 × Prob 2 ) + (r3 × Prob 3 )

CHAPTER 8 – Risk, Return and Portfolio Theory 8 - 28