FIN 402
Capital Budgeting and Corporate Objectives
Yunjeen Kim
5. Portfolio theory
Agenda
What gives the highest average return and what does it tell us? Over
70 years of capital market history.
Measuring risk. The meaning of risk and risk decomposition.
Portfolio risk.
Market risk and unique risk. Do portfolios and stocks have the same
risk? Diversification.
Return and Risk
We need to consider returns as well as risks.
We need to know how the market prices risky cash flows.
To address this, we need to understand:
how investors make decisions under risk.
how stock prices are determined.
how to measure risk.
Portfolio theory covers these interrelated issues and is very practical.
Investor Decisions: Uncertainty
What are the expected rates of return on each investment?
Which investment will be chosen?
What does that imply about investor risk preferences?
Evidence on risk attitudes.
Evidence on discount (capitalization) rates for risky assets.
Investor Decisions: Uncertainty
Differences: stock market investments are possible. The investor
must pick a portfolio (i.e., a set of asset weights summing to 1).
The best portfolio will depend on:
investor's tastes (e.g., risk tolerance).
available opportunities from the stocks.
We can say something about both investor tastes and opportunities.
The Value of $1 Investment in 1950
Portfolio Risk
Benchmark?
Since financial resources are finite, there is a hurdle that projects
have to cross before being deemed acceptable generate a certain
required rate of return.
This hurdle will be higher for riskier projects than for safer projects.
Required rate of return = Riskless Rate + Risk Premium
The two basic questions that every risk and return model in finance
tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?
Recap so far
Some assets (stocks) tend to produce higher average returns.
These stocks also tend to be volatile; i.e., their returns can vary a lot
We can capture this variation as the total risk of a stock by
computing the variance or standard deviation of past stock returns.
The more something varies, the more risky its likely to be, meaning
possibly a higher discount rate for its future cash flows.
How to Measure Expected Return?
Expected Return:
i) =
E(R
n
X
E(Ri)p(Ri)
i=1
Example: What is the expected return of Q and R?
State of
Economy
Probability of
State of
Economy
Returns if State Occurs
Stock Q
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
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How to Measure Risk?
It is critical to have an objective measure of risk.
Returns on actual stock portfolios follow a normal distribution.
Thus, risk is measured by the variance or standard deviation of
its return.
Variance of an assets return:
i ) = 2 (R
i) =
V ar(R
n
X
[Ri E(Ri)]2p(Ri)
i=1
Standard deviation of an assets return:
i) =
(R
2 (R
i) =
i)
V ar(R
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How to Measure Risk?
State of
Economy
Probability of
State of
Economy
Returns if State Occurs
Stock Q
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
What is the variance of each stock?
Standard deviation?
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Modern Portfolio Theory
Before Harry Markowitz pioneered portfolio theory and Gene Fama
and others pioneered efficient markets, investment analysis focused
on picking winners in the stock market.
Because the investment focus was on picking winners, risk was
usually measured by the stock return variance or stock return
standard deviation.
Markowitzs contribution: rational investors hold diversified
portfolios to minimize their risk.
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More formally: Portfolio Weight
A portfolio is uniquely defined by the portfolio weights.
Suppose there are N assets, i = 1, 2, ... , N.
Define the portfolio weight, wi as
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More formally: Portfolio Return
The portfolio expected return is equal to the weighted average of
the returns on the individual assets in the portfolio, where the
weights are given by the portfolio weights:
E(Rp) =
N
X
wiE(Ri)
i=1
Example (continued):
State of
Economy
Probability of
State of
Economy
Stock Q
Stock R
Boom
25%
18%
9%
Normal
75%
9%
5%
30%
70%
Weights
Returns if State Occurs
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Efficient Portfolios
With normally distributed portfolio returns, the only relevant
portfolio characteristics are the expected return and standard
deviation.
Investors only pick efficient portfolios.
An efficient portfolio has the lowest standard deviation for a given
level of expected return.
An efficient portfolio also has the highest expected return for a given
standard deviation.
This simplifies things. Many possible portfolios are inefficient and
will not be considered by the investor.
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Efficient Portfolios
High Return and Low Risk
In which stock would you prefer to invest?
E(R)
SD(R)
10%
25%
15%
25%
15%
20%
10%
15%
15%
15%
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Individual Asset Risk
For a portfolio, the measure of risk is the standard deviation (or
variance) of its return.
What about an asset?
Is the standard deviation a measure of an assets risk?
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Asset Returns
Suppose your current portfolio consists entirely of asset M. Would
you be better off taking half your money and putting it into another
asset? Should you add a low variance or a high variance asset?
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Individual Asset Risk
Although stock return standard deviation measures the risk of a
security, it is not very informative about how the security contributes
to the riskiness of a diversified portfolio.
The variance of an assets return is a poor measure of risk of a
portfolio.
To understand how risky an asset is, you need to know how the
assets return moves in relation to other assets in the portfolio.
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Portfolio Risk
Given several individual assets, calculating individual standard
deviation is not enough. Although stock return standard deviation
measures the risk of a security, it is not very informative about how
the security contributes to the riskiness of a diversified portfolio.
To understand how risky an asset is, you need to know how the
assets return moves in relation to other assets in the portfolio.
To get portfolio variance, we need to know:
the asset weights
the variances of each asset
the covariances
Covariances capture the degree of comovement.
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Two Assets Portfolio Risk.
Portfolio expected return is:
E(Rp) = w1E(R1) + w2E(R2)
The portfolio variance depends on both the variances of the
individual assets in the portfolio and their covariances:
2 = w2
p
1
= w12
2 + w2
1
2
2 + w2
1
2
2 + 2w w
1 2 12
2
2 + 2w w
1 2 12 1 2
2
where w1, w2 are asset weights, 12 is the correlation between asset
returns, and 1 and 2 are standard deviations of individual asset
returns ; 12 is covariance.
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Example: Exxon & Coca Cola
Suppose you invest 60% of your portfolio in Exxon Mobil and 40%
in Coca Cola. The expected return on your Exxon Mobil stock is
10% and on Coca Cola is 15%.
The standard deviation of their annualized daily returns are 18.2%
and 27.3%, respectively. Assume a correlation coefficient of 1.0 and
calculate the portfolio variance.
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Correlation and Diversification
The lower the correlation between the returns on two assets, the
lower the variance on a portfolio of the two assets.
So long as the returns on the two assets are not perfectly positively
correlated, the standard deviation of a portfolio will be less than a
weighted average of the standard deviation of the individual assets.
This means that so long as asset returns don't move in lockstep,
there is a benefit to diversification.
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Intuition Behind Diversification
So, what would happen if we were to invest into two stocks instead
of one? What would expected return and standard deviation be?
Should you hold one stock or multiple stocks?
Consider two stocks: Microsoft and Walmart.
Their expected returns are 20% and 10%, respectively, and their
standard deviations are 30% and 15%, respectively.
In addition, the stocks have a correlation of 0.2.
Compute the expected returns and risk of the various portfolios we
can create.
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Example: Microsoft Walmart
% in Microsoft
% in Walmart
Portfolio E(R)
Portfolio SD
0%
100%
10.0%
15.0%
10%
90%
20%
80%
30%
70%
40%
60%
50%
50%
60%
40%
70%
30%
80%
20%
90%
10%
100%
0%
20.0%
30.0%
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Example: Microsoft Walmart
Portfolio Expected Return
The Possible Risk/Return Combinations
21.0%
19.0%
17.0%
Series1
15.0%
13.0%
11.0%
9.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
Portfolio Standard Deviation
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What Have We Learned?
Notice the portfolio that is entirely invested in Walmart. Whats the
risk-return combination?
If you wanted to maintain this level of risk, can you do better than
the expected return offered by Walmart? Can you find a better
portfolio? Circle it on the graph!
Why is this portfolio better?
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Many Risky Assets
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Many Risky Assets
The minimum variance frontier is the set of portfolios that
minimize the portfolio standard deviation for a given level of
expected return.
The efficient frontier is the set of portfolios that maximizes the
expected return for a given portfolio standard deviation.
The efficient frontier is the upward sloping portion of the minimum
variance frontier.
If investors prefer more to less (other things equal, they prefer a
higher expected returns) and are risk averse (other things equal, they
prefer a lower portfolio standard deviation), then all investors should
choose portfolios from the efficient frontier.
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Minimum Variance Portfolio
MVP is the portfolio that has the minimum variance among all the
portfolios we can form by combining two assets.
We can find the MVP by solving:
min
w
2
p
= w2
2
1
First order condition:
+ (1
w=
w)2
2
1
2
2
2
2
+ 2w(1
2
2
12 1 2
212 1
w)
1 2 1,2
Can you plot them on the expected return-standard deviation space?
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Example 1
Suppose Assets 1 and 2 have expected returns and standard
deviations as follows:
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Also assume that the returns of the two securities are perfectly
negatively correlated. What is the composition of the minimum
variance portfolio and what is its expected return and variance?
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Example 2
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Suppose that the correlation between the returns of the two assets
from the previous example is 1. What is the minimum variance
portfolio? What is the expected return and standard deviation of the
50/50 portfolio?
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Example 3
Asset
1
2
Expected Return
20%
10%
Standard Deviation
20%
16%
Suppose that the correlation between the returns of the two assets
from the previous example is 0.5. What is the composition of the
minimum variance portfolio? What is its expected return and
standard deviation of a 50/50 portfolio?
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How Diversification Works
Portfolio SD
As the number of stocks becomes large, the unique risk of each
stock is diversified away. For independent stocks, the portfolio risk
is zero.
What does the picture of # of stocks versus portfolio standard
deviation look like?
0
30
60
# of Securities
90
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How Diversification Works
Returns on stocks are not independent, but positively correlated.
Stock returns depend on both company-specific events and marketwide events.
Market-wide events, such as good economic news, generally effect
all stocks in the same direction. This market or systematic
risk cannot be diversified away.
For a well diversified portfolio, the unique risk is diversified
away. Portfolio variance is equal to the average pair-wise
covariance.
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Portfolio SD
How Diversification Works
Unique
risk
Common or
Systematic risk
0
5
10
15
# of Securities
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Risk Aversion and Portfolio Choice
Remember that we assume all investors are risk averse.
So far, we learned that the investors prefer high-return and low-risk.
They will choose a portfolio on the efficient frontier.
Then, what does a risk-averse investor choose among the portfolios
on the efficient frontier? How? Why?
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Indifference Curve
An indifference curve is a graph showing different bundles of goods
between which an investor is indifferent.
Good Y
If both goods are good (they like them),
Good X
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Indifference Curve
Exp. Ret.
What if one is expected return and the other is standard deviation?
Std. Dev.
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Risk Aversion and Portfolio Choice
Exp. Ret.
So, put the efficient frontier and the indifference curve together.
Std. Dev.
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Think about it!
There are two risk averse investors, C and D. C is more risk averse
than D. Draw two indifference curves of the investors in standard
deviation-expected return space. Draw the efficient frontier over
the figure. Find the portfolio that each investor would choose.
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