MGB Portfolio Management I

MARKET EFFICIENCY
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RANDOM WALK
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Random Walk

In 1973 when author Burton Malkiel wrote "A Random Walk Down Wall Street", which
remains on the top-seller list for finance books.

 Strict Definition
─ Successive stock returns are independent and identically distributed. This implies that past
movement or trend of a stock price or market cannot be used to predict its future movement.

 Common Definition
─ Price changes are essentially unpredictable

This is the idea that stocks take a random and unpredictable path. A follower of the
random walk theory believes it's impossible to outperform the market without
assuming additional risk.

Critics of the theory, however, contend that stocks do maintain price trends over time
- in other words, that it is possible to outperform the market by carefully selecting
entry and exit points for equity investments.
MGB Portfolio Management I

Random Walk

Financial Economists were disturbed as this seemed to

imply that stock markets were dominated by some
erratic market psychology or some “animal spirit” that
followed no logical rules.

It soon became apparent however, that random price

movements indicated a well-functioning or efficient market,
not an irrational one.
MGB Portfolio Management I

Random Walk

And why is that?

Because any new information that could be used to predict stock performance must
already reflect in the stock price. As soon as any new information is available that can
impact stock prices, investors will buy/sell the security immediately to its fair level
where only ordinary return can be expected (rate of return commensurate with the
risk).
However, if prices are bid immediately to fair levels. On getting new information, it
must be that the increase/decrease is due to only that new information. But New
information, by definition, must be unpredictable. If not, then the information would
already be priced into the price of the security!

So, stock prices should follow a random walk, that is, price changes should be random
and unpredictable. Randomly evolving prices are a result of intelligent investors
discovering relevant information and by their action moving the prices.
MGB Portfolio Management I

THE EFFICIENT MARKET HYPOTHESIS

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The Efficient Market Hypothesis

 Expectations are very important in our financial system.

─ Expectations of returns, risk, and liquidity impact asset demand
─ Inflationary expectations impact bond prices
─ Expectations not only affect our understanding of markets, but also
how financial institutions operate.

 To better understand expectations, we examine the efficient

markets hypothesis.
─ Framework for understanding what information is useful and what is
not
─ However, we need to validate the hypothesis with real market data.
The results are mixed, but generally supportive of the idea.
MGB Portfolio Management I

The Efficient Market Hypothesis

 In sum, we will look at the basic reasoning behind the efficient

market hypothesis. We also examine empirical evidence
examining this idea:
─ The Efficient Market Hypothesis
─ Evidence on the Efficient Market Hypothesis
─ Behavioral Finance
MGB Portfolio Management I

Efficient Market Hypothesis

• The rate of return for any position is the sum of the capital gains (Pt+1 – Pt)
plus any cash payments (C):

• At the start of a period, the unknown element is the future price: Pt+1. But,
investors do have some expectation of that price, thus giving us an
expected rate of return.
MGB Portfolio Management I

Efficient Market Hypothesis

The Efficient Market Hypothesis views the expectations as equal

to optimal forecasts using all available information. This implies:

Assuming the market is in equilibrium:

Re = R* [market’s equilibrium return]
Put these ideas together: efficient market hypothesis
Rof = R*
MGB Portfolio Management I

Efficient Market Hypothesis

Rof = R*
•This equation tells us that current prices in a financial market
will be set so that the optimal forecast of a security’s return
using all available information equals the security’s
equilibrium return.
•As a result, a security’s price fully reflects all available
information in an efficient market.
•Note, R* depends on risk, liquidity, other asset returns …
MGB Portfolio Management I

Rationale Behind the Hypothesis

 When an unexploited profit opportunity arises on a

security (so-called because, on average, people would
be earning more than they should, given the
characteristics of that security), investors will rush to
buy until the price rises to the point that the returns
are normal again.
 Investors do not leave $ bills lying on the sidewalk.
MGB Portfolio Management I

Rationale Behind the Hypothesis

• Why efficient market hypothesis makes sense

If Rof > R* → Pt ↑ → Rof ↓
If Rof < R* → Pt ↓ → Rof ↑
Until Rof = R*
• All unexploited profit opportunities eliminated
• Efficient market condition holds even if there are uninformed,
irrational participants in market
MGB Portfolio Management I

Rationale Behind the Hypothesis

 In an efficient market, all unexploited profit

opportunities will be eliminated.
 Not every investor need be aware of every security
and situation.
 Only a few investors (even 1 big one) are needed to
eliminate unexploited profit opportunities and push
the market price to its equilibrium level.
MGB Portfolio Management I

Efficient Capital Markets

• In an efficient capital market, security prices adjust rapidly to

the arrival of new information, therefore the current prices of
securities reflect all information about the security
• Whether markets are efficient has been extensively
researched and remains controversial
MGB Portfolio Management I

Why Should Capital Markets Be Efficient?

The premises of an efficient market

– A large number of competing profit-maximizing participants analyze and
value securities, each independently of the others
– New information regarding securities comes to the market in a random
fashion
– Profit-maximizing investors adjust security prices rapidly to reflect the
effect of new information
Conclusion: the expected returns implicit in the current price of a
security should reflect its risk
MGB Portfolio Management I

Alternative Efficient Market Hypotheses (EMH)

• Random Walk Hypothesis – changes in security prices occur

randomly
• Fair Game Model – current market price reflect all available
information about a security and the expected return based
upon this price is consistent with its risk
• Efficient Market Hypothesis (EMH) - divided into three sub-
hypotheses depending on the information set involved
MGB Portfolio Management I

Efficient Market Hypotheses (EMH)

• Weak-Form EMH - prices reflect all security-market

information
• Semistrong-form EMH - prices reflect all public
information
• Strong-form EMH - prices reflect all public and
private information
MGB Portfolio Management I

Weak-Form EMH

• Current prices reflect all security-market information,

including the historical sequence of prices, rates of return,
trading volume data, and other market-generated information
• This implies that past rates of return and other market data
should have no relationship with future rates of return
MGB Portfolio Management I

Semistrong-Form EMH

• Current security prices reflect all public information,

including market and non-market information
• This implies that decisions made on new information
after it is public should not lead to above-average
risk-adjusted profits from those transactions
MGB Portfolio Management I

Strong-Form EMH

• Stock prices fully reflect all information from public

and private sources
• This implies that no group of investors should be able
to consistently derive above-average risk-adjusted
rates of return
• This assumes perfect markets in which all
information is cost-free and available to everyone at
the same time
MGB Portfolio Management I

Tests and Results of

Weak-Form EMH

• Statistical tests of independence between rates of

return
– Autocorrelation tests have mixed results
– Runs tests indicate randomness in prices
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Tests and Results of

Weak-Form EMH

• Comparison of trading rules to a buy-and-hold policy is

difficult because trading rules can be complex and
there are too many to test them all
– Filter rules yield above-average profits with small filters, but
only before taking into account transactions costs
– Trading rule results have been mixed, and most have not
been able to beat a buy-and-hold policy
MGB Portfolio Management I

Tests and Results of

Weak-Form EMH

• Testing constraints
– Use only publicly available data
– Include all transactions costs
– Adjust the results for risk
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Tests and Results of

Weak-Form EMH

• Results generally support the weak-form EMH, but results are

not unanimous
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Tests of the Semistrong Form of Market Efficiency

Two sets of studies

• Time series analysis of returns or the cross section
distribution of returns for individual stocks
• Event studies that examine how fast stock prices
adjust to specific significant economic events
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Test results should adjusted a security’s rate of return for the

rates of return of the overall market during the period
considered
Arit = Rit - Rmt
where:
Arit = abnormal rate of return on security i during period t
Rit = rate of return on security i during period t
Rmt =rate of return on a market index during period t
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Time series tests for abnormal rates of return

– short-horizon returns have limited results
– long-horizon returns analysis has been quite successful
based on
• dividend yield (D/P)
• default spread
• term structure spread
– Quarterly earnings reports may yield abnormal returns due
to
• unanticipated earnings change
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Quarterly Earnings Reports

– Large Standardized Unexpected Earnings (SUEs) result in
abnormal stock price changes, with over 50% of the
change happening after the announcement
– Unexpected earnings can explain up to 80% of stock drift
over a time period
• These results suggest that the earnings surprise is
not instantaneously reflected in security prices
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• The January Anomaly

– Stocks with negative returns during the prior year had
higher returns right after the first of the year
– Tax selling toward the end of the year has been mentioned
as the reason for this phenomenon
– Such a seasonal pattern is inconsistent with the EMH
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH
• Other calendar effects
– All the market’s cumulative advance occurs during the
first half of trading months
– Monday/weekend returns were significantly negative
– For large firms, the negative Monday effect occurred
before the market opened (it was a weekend effect),
whereas for smaller firms, most of the negative
Monday effect occurred during the day on Monday (it
was a Monday trading effect)
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Predicting cross-sectional returns

– All securities should have equal risk-adjusted returns
• Studies examine alternative measures of size or
quality as a tool to rank stocks in terms of risk-
adjusted returns
– These tests involve a joint hypothesis and are dependent
both on market efficiency and the asset pricing model
used
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Price-earnings ratios and returns

– Low P/E stocks experienced superior risk-adjusted results
relative to the market, whereas high P/E stocks had
significantly inferior risk-adjusted results
– Publicly available P/E ratios possess valuable information
regarding future returns
– This is inconsistent with semistrong efficiency
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Price-Earnings/Growth Rate (PEG) ratios

– Studies have hypothesized an inverse relationship between
the PEG ratio and subsequent rates of return. This is
inconsistent with the EMH
– However, the results related to using the PEG ratio to
select stocks are mixed
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH
• The size effect (total market value)
– Several studies have examined the impact of size on the
risk-adjusted rates of return
– The studies indicate that risk-adjusted returns for
extended periods indicate that the small firms consistently
experienced significantly larger risk-adjusted returns than
large firms
– Firm size is a major efficient market anomaly
– Could this have caused the P/E results previously studied?
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• The P/E studies and size studies are dual tests of the
EMH and the CAPM
• Abnormal returns could occur because either
– markets are inefficient or
– market model is not properly specified and provides
incorrect estimates of risk and expected returns
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Adjustments for riskiness of small firms did not

explain the large differences in rate of return
• The impact of transactions costs of investing in small
firms depends on frequency of trading
– Daily trading reverses small firm gains
• The small-firm effect is not stable from year to year
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Neglected Firms
– Firms divided by number of analysts following a stock
– Small-firm effect was confirmed
– Neglected firm effect caused by lack of information
and limited institutional interest
– Neglected firm concept applied across size classes
– Another study contradicted the above results
MGB Portfolio Management I

Tests and Results of Semistrong-form EMH

• Trading volume
– Studied relationship between returns, market value, and
trading activity.
– Size effect was confirmed. But no significant difference
was found between the mean returns of the highest and
lowest trading activity portfolios
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Ratio of Book Value of a firm’s Equity to Market Value of

its equity
– Significant positive relationship found between current
values for this ratio and future stock returns
– Results inconsistent with the EMH
• Size and BV/MV dominate other ratios such as E/P ratio or
leverage
• This combination only works during expansive monetary
policy
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH

• Firm size has emerged as a major predictor of future returns

• This is an anomaly in the efficient markets literature
• Attempts to explain the size anomaly in terms of superior risk
measurements, transactions costs, analysts attention, trading
activity, and differential information have not succeeded
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH
• Event studies
– Stock split studies show that splits do not result in
abnormal gains after the split announcement, but
before
– Initial public offerings seems to be underpriced by
almost 18%, but that varies over time, and the price is
adjusted within one day after the offering
– Listing of a stock on an national exchange such as the
NYSE may offer some short term profit opportunities
for investors
MGB Portfolio Management I

Tests and Results of

Semistrong-Form EMH
• Event studies (continued)
– Stock prices quickly adjust to unexpected world events
and economic news and hence do not provide
opportunities for abnormal profits
– Announcements of accounting changes are quickly
adjusted for and do not seem to provide opportunities
– Stock prices rapidly adjust to corporate events such as
mergers and offerings
– The above studies provide support for the semistrong-
form EMH
MGB Portfolio Management I

Summary on the
Semistrong-Form EMH

• Evidence is mixed
• Strong support from numerous event studies with
the exception of exchange listing studies
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Summary on the
Semistrong-Form EMH

• Studies on predicting rates of return for a cross-

section of stocks indicates markets are not
semistrong efficient
MGB Portfolio Management I

Summary on the
Semistrong-Form EMH

• Studies on predicting rates of return for a cross-

section of stocks indicates markets are not
semistrong efficient
– Dividend yields, risk premiums, calendar patterns, and
earnings surprises
• This also included cross-sectional predictors such as
size, the BV/MV ratio (when there is expansive
monetary policy), E/P ratios, and neglected firms.
MGB Portfolio Management I

Tests and Results of

Strong-Form EMH

• Strong-form EMH contends that stock prices fully

reflect all information, both public and private
• This implies that no group of investors has access to
private information that will allow them to
consistently earn above-average profits
MGB Portfolio Management I

Testing Groups of Investors

• Corporate insiders
• Stock exchange specialists
• Security analysts
• Professional money managers
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Corporate Insider Trading

• Corporate insiders include major corporate officers,

directors, and owners of 10% or more of any equity
class of securities
• Insiders must report to the SEC each month on their
transactions in the stock of the firm for which they
are insiders
• These insider trades are made public about six weeks
later and allowed to be studied
MGB Portfolio Management I

Corporate Insider Trading

• Corporate insiders generally experience above-

average profits especially on purchase transaction
• This implies that many insiders had private
information from which they derived above-average
returns on their company stock
MGB Portfolio Management I

Corporate Insider Trading

• Studies showed that public investors who traded

with the insiders based on announced transactions
would have enjoyed excess risk-adjusted returns
(after commissions), but the markets now seem to
have eliminated this inefficiency (soon after it was
discovered)
MGB Portfolio Management I

Corporate Insider Trading

• Other studies indicate that you can increase returns

from using insider trading information by combining
it with key financial ratios and considering what
group of insiders is doing the buying and selling
MGB Portfolio Management I

Stock Exchange Specialists

• Specialists have monopolistic access to information

about unfilled limit orders
• You would expect specialists to derive above-average
returns from this information
• The data generally supports this expectation
MGB Portfolio Management I

Security Analysts

• Tests have considered whether it is possible to

identify a set of analysts who have the ability to
select undervalued stocks
• This looks at whether, after a stock selection by an
analyst is made known, a significant abnormal return
is available to those who follow their
recommendations
MGB Portfolio Management I

The Value Line Enigma

• Value Line (VL) publishes financial information on

about 1,700 stocks
• The report includes a timing rank from 1 down to 5
• Firms ranked 1 substantially outperform the market
• Firms ranked 5 substantially underperform the
market
MGB Portfolio Management I

The Value Line Enigma

• Changes in rankings result in a fast price adjustment

• Some contend that the Value Line effect is merely
the unexpected earnings anomaly due to changes in
rankings from unexpected earnings
MGB Portfolio Management I

Security Analysts

• There is evidence in favor of existence of superior

analysts who apparently possess private information
MGB Portfolio Management I

Professional Money Managers

• Trained professionals, working full time at

investment management
• If any investor can achieve above-average returns, it
should be this group
• If any non-insider can obtain inside information, it
would be this group due to the extensive
management interviews that they conduct
MGB Portfolio Management I

Performance of
Professional Money Managers

• Most tests examine mutual funds

• New tests also examine trust departments, insurance
companies, and investment advisors
• Risk-adjusted, after expenses, returns of mutual
funds generally show that most funds did not match
aggregate market performance
MGB Portfolio Management I

Conclusions Regarding the

Strong-Form EMH

• Mixed results, but much support

• Tests for corporate insiders and stock exchange
specialists do not support the hypothesis (Both
groups seem to have monopolistic access to
important information and use it to derive above-
average returns)
MGB Portfolio Management I

Conclusions Regarding the

Strong-Form EMH

• Tests results for analysts are concentrated on Value Line

rankings
– Results have changed over time
– Currently tend to support EMH
• Individual analyst recommendations seem to contain
significant information
• Performance of professional money managers seem to
provide support for strong-form EMH
MGB Portfolio Management I

Behavioral Finance

It is concerned with the analysis of various

psychological traits of individuals and how these
traits affect the manner in which they act as
investors, analysts, and portfolio managers
MGB Portfolio Management I

Implications of
Efficient Capital Markets

• Overall results indicate the capital markets are

efficient as related to numerous sets of information
• There are substantial instances where the market
fails to rapidly adjust to public information
MGB Portfolio Management I

Efficient Markets
and Technical Analysis

• Assumptions of technical analysis directly oppose the

notion of efficient markets
• Technicians believe that new information is not
immediately available to everyone, but disseminated
from the informed professional first to the aggressive
investing public and then to the masses
MGB Portfolio Management I

Efficient Markets
and Technical Analysis

• Technicians also believe that investors do not analyze

information and act immediately - it takes time
• Therefore, stock prices move to a new equilibrium after the
release of new information in a gradual manner, causing
trends in stock price movements that persist for periods
MGB Portfolio Management I

Efficient Markets
and Technical Analysis

• Technical analysts develop systems to detect

movement to a new equilibrium (breakout) and
trade based on that
• Contradicts rapid price adjustments indicated by the
EMH
• If the capital market is weak-form efficient, a trading
system that depends on past trading data can have
no value
MGB Portfolio Management I

Efficient Markets
and Fundamental Analysis

• Fundamental analysts believe that there is a basic

intrinsic value for the aggregate stock market,
various industries, or individual securities and these
values depend on underlying economic factors
• Investors should determine the intrinsic value of an
investment at a point in time and compare it to the
market price
MGB Portfolio Management I

Efficient Markets
and Fundamental Analysis

• If you can do a superior job of estimating intrinsic value you

can make superior market timing decisions and generate
above-average returns
• This involves aggregate market analysis, industry analysis,
company analysis, and portfolio management
• Intrinsic value analysis should start with aggregate market
analysis
MGB Portfolio Management I

Aggregate Market Analysis with Efficient Capital

Markets

• EMH implies that examining only past economic events is not

likely to lead to outperforming a buy-and-hold policy because
the market adjusts rapidly to known economic events
• Merely using historical data to estimate future values is not
sufficient
• You must estimate the relevant variables that cause long-run
movements
MGB Portfolio Management I

Industry and Company Analysis with Efficient Capital

Markets

• Wide distribution of returns from different industries and

companies justifies industry and company analysis
• Must understand the variables that effect rates of return and
• Do a superior job of estimating future values of these relevant
valuation variables, not just look at past data
MGB Portfolio Management I

Industry and Company Analysis with Efficient

Capital Markets
• Important relationship between expected
earnings and actual earnings
• Accurately predicting earnings surprises
• Strong-form EMH indicates likely existence of
superior analysts
• Studies indicate that fundamental analysis based
on E/P ratios, size, and the BV/MV ratios can lead
to differentiating future return patterns
MGB Portfolio Management I

How to Evaluate Analysts or Investors

• Examine the performance of numerous securities

that this analyst recommends over time in relation to
a set of randomly selected stocks in the same risk
class
• Selected stocks should consistently outperform the
randomly selected stocks
MGB Portfolio Management I

Efficient Markets
and Portfolio Management

• Portfolio Managers with Superior Analysts

– concentrate efforts in mid-cap stocks that do not receive
the attention given by institutional portfolio managers to
the top-tier stocks
– the market for these neglected stocks may be less efficient
than the market for large well-known stocks
MGB Portfolio Management I

Efficient Markets
and Portfolio Management

• Portfolio Managers without Superior Analysts

– Determine and quantify your client's risk preferences
– Construct the appropriate portfolio
– Diversify completely on a global basis to eliminate all
unsystematic risk
– Maintain the desired risk level by rebalancing the portfolio
whenever necessary
– Minimize total transaction costs
MGB Portfolio Management I

The Rationale and

Use of Index Funds

• Efficient capital markets and a lack of superior analysts imply

that many portfolios should be managed passively (so their
performance matches the aggregate market, minimizes the
costs of research and trading)
• Institutions created market (index) funds which duplicate the
composition and performance of a selected index series
MGB Portfolio Management I

Insights from Behavioral Finance

• Growth companies will usually not be growth stocks

due to the overconfidence of analysts regarding
future growth rates and valuations
• Notion of “herd mentality” of analysts in stock
recommendations or quarterly earnings estimates is
confirmed
MGB Portfolio Management I

Evidence on Efficient Market Hypothesis

 Favorable Evidence
1. Investment analysts and mutual funds don't beat
the market
2. Stock prices reflect publicly available info:
anticipated announcements don't affect stock price
3. Stock prices and exchange rates close to random walk; if
predictions of DP big, Rof > R*  predictions
of DP small
4. Technical analysis does not outperform market
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

• Performance of Investment Analysts and Mutual Funds

should not be able to consistently beat the market
– The “Investment Dartboard” often beats investment managers.
– Mutual funds not only do not outperform the market on average, but
when they are separated into groups according to whether they had
the highest or lowest profits in a chosen period, the mutual funds that
did well in the first period do not beat the market in the second
period.
– Investment strategies using inside information is the only “proven
method” to beat the market. In the U.S., it is illegal to trade on such
information, but that is not true in all countries.
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

 Do Stock Prices Reflect Publicly Available

Information as the EMH predicts they will?
─ Thus if information is already publicly available, a positive
announcement about a company will not, on average,
raise the price of its stock because this information is
already reflected in the stock price.
─ Early empirical evidence confirms: favorable earnings
announcements or announcements of stock splits (a
division of a share of stock into multiple shares, which is
usually followed by higher earnings) do not, on average,
cause stock prices to rise.
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

 Random-Walk Behavior of Stock Prices that is, future

changes in stock prices should, for all practical purposes, be
unpredictable
─ If stock is predicted to rise, people will buy to equilibrium
level; if stock is predicted to fall, people will sell to
equilibrium level (both in concert with EMH)
─ Thus, if stock prices were predictable, thereby causing the
above behavior, price changes would be near zero, which
has not been the case historically
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

 Technical Analysis means to study past stock price data and

search for patterns such as trends and regular cycles,
suggesting rules for when to buy and sell stocks
─ The EMH suggests that technical analysis is a waste of time
─ The simplest way to understand why is to use the random-walk result
that holds that past stock price data cannot help predict changes
─ Therefore, technical analysis, which relies on such data to produce its
forecasts, cannot successfully predict changes in stock prices
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

• 2: Empirical Evidence for TA is Negligible

• Much of the faith in TA hinges on anecdotal experience, not any kind of long-term statistical
evidence, unlike value investing or other quantitative/fundamental methodologies we discuss on
this site. Most of the statistical work done by academics to determine whether the chart patterns
are actually predictive has been inconclusive at best. Indeed, a recent study by finance professors at
Massey University in New Zealand examined 49 developed and emerging markets to see if TA
added value. They looked at more than 5,000 technical trading rules across four rule families :
• Filter Rules - These rules involve opening long (short) positions after price increases (decreases)
by x% and closing these positions when price decreases (increases) by x% from a subsequent high
(low).
• Moving Average Rules - These rules generate buy (sell) signals when the price or a short moving
average moves above (below) a long moving average.
• Channel Break-outs - These rules involve opening long (short) positions when the closing price
moves above (below) a channel. A channel (sometimes referred to as a trading range) can be said to
occur when the high over the previous n days is within x percent of the low over the
previous n days, not including the current price.
• Support and Resistance Rules - These “Trading Range Break” rules involve opening a long (short)
position when the closing price breaches the maximum (minimum) price over the
previous n periods.
• The result? Using statistical methods to adjust for data snooping bias, the authors concluded that
there wasno evidence that the profits [attributed] to the technical trading rules considered were
greater than those that might be expected due to random data variation.
MGB Portfolio Management I

Evidence in Favor of Market Efficiency

But wait – it’s not all bad….

• As you can tell, trading purely on the basis of TA is a mug’s game. However, despite inconsistencies
in predictive value,
• 1. TA may be a useful tool as part of a broader strategy for managing holdings (e.g. to help you
time any investments that are decided on other, hopefully fundamentally-focused, criteria).The fact
is that many (misguided) market participants use TA to drive their investment decisions. These
collective actions result in tangible changes in asset values, so they need to be understood even by
less mis-guided investors. A fundamental investor need not agree that a stock should be moving but
it’s worth understand why a stock is nevertheless moving. As Birinyi, a research and money-
management firm, noted in a research note:
• 2. “technical approaches can and should be a useful adjunct to every investor’s — amateur and
professional — arsenal, if and only if used properly and with understanding… Technicals detail
and hopefully illuminate, but do not predict.”
• 3. TA may be particularly useful on the sell-side where it is deemed (according to William
O’Neill) prudent to sell based on “unusual market action such as price and volume movement”…
• 4. Good investing is about managing your losses too, and here TA can be a useful tool to
determine where best to place a stop-loss (given the number of TA practitioners out there that are
likely to be anchoring around certain price points).
MGB Portfolio Management I

Case: Foreign Exchange Rates

• Could you make a bundle if you could predict FX

rates? Of course.
• EMH predicts, then, that FX rates should be
unpredictable.
• That is exactly what empirical tests show—FX rates
are not very predictable.
MGB Portfolio Management I

Evidence on Efficient Market Hypothesis

 Unfavorable Evidence
1. Small-firm effect: small firms have abnormally high returns
2. January effect: high returns in January
3. Market overreaction
4. Excessive volatility
5. Mean reversion
6. New information is not always immediately incorporated into stock
prices
 Overview
─ Reasonable starting point but not whole story
MGB Portfolio Management I

Evidence Against Market Efficiency

• The Small-Firm Effect is an anomaly. Many empirical studies

have shown that small firms have earned abnormally high
returns over long periods of time, even when the greater risk
for these firms has been considered.
– The small-firm effect seems to have diminished in recent years but is
still a challenge to the theory of efficient markets
– Various theories have been developed to explain the small-firm effect,
suggesting that it may be due to rebalancing of portfolios by
institutional investors, tax issues, low liquidity of small-firm stocks,
large information costs in evaluating small firms, or an inappropriate
measurement of risk for small-firm stocks
MGB Portfolio Management I

Evidence Against Market Efficiency

 The January Effect is the tendency of stock prices to

experience an abnormal positive return in the month of
January that is predictable and, hence, inconsistent with
random-walk behavior
– Investors have an incentive to sell stocks before the end of the
year in December because they can then take capital losses on
their tax return and reduce their tax liability. Then when the
new year starts in January, they can repurchase the stocks,
driving up their prices and producing abnormally high returns.
– Although this explanation seems sensible, it does not explain
why institutional investors such as private pension funds, which
are not subject to income taxes, do not take advantage of the
abnormal returns in January and buy stocks in December, thus
bidding up their price and eliminating the abnormal returns.
MGB Portfolio Management I

Evidence Against Market Efficiency

 Market Overreaction: recent research suggests that stock

prices may overreact to news announcements and that the
pricing errors are corrected only slowly
─ When corporations announce a major change in earnings, say, a large
decline, the stock price may overshoot, and after an initial large
decline, it may rise back to more normal levels over a period of several
weeks.
─ This violates the EMH because an investor could earn abnormally high
returns, on average, by buying a stock immediately after a poor
earnings announcement and then selling it after a couple of weeks
when it has risen back to normal levels.
MGB Portfolio Management I

Evidence Against Market Efficiency

 Excessive Volatility: the stock market appears to display

excessive volatility; that is, fluctuations in stock prices may be
much greater than is warranted by fluctuations in their
fundamental value.
─ Researchers have found that fluctuations in the S&P 500 stock index
could not be justified by the subsequent fluctuations in the dividends
of the stocks making up this index.
─ Other research finds that there are smaller fluctuations in stock prices
when stock markets are closed, which has produced a consensus that
stock market prices appear to be driven by factors other than
fundamentals.
MGB Portfolio Management I

Evidence Against Market Efficiency

 Mean Reversion: Some researchers have found that stocks

with low returns today tend to have high returns in the future,
and vice versa.
─ Hence stocks that have done poorly in the past are more likely to do
well in the future because mean reversion indicates that there will be
a predictable positive change in the future price, suggesting that stock
prices are not a random walk.
─ Newer data is less conclusive; nevertheless, mean reversion remains
controversial.
MGB Portfolio Management I

Evidence Against Market Efficiency

 New Information Is Not Always Immediately Incorporated

into Stock Prices
─ Although generally true, recent evidence suggests that, inconsistent
with the efficient market hypothesis, stock prices do not
instantaneously adjust to profit announcements.
─ Instead, on average stock prices continue to rise for some time after
the announcement of unexpectedly high profits, and they continue to
fall after surprisingly low profit announcements.
MGB Portfolio Management I

Implications for Investing

1. How valuable are published reports by investment advisors?

2. Should you be skeptical of hot tips?
3. Do stock prices always rise when there is good news?
4. Efficient Markets prescription for investor
MGB Portfolio Management I

Implications for Investing

 How valuable are published reports by investment advisors?

MGB Portfolio Management I

Implications for Investing

1. Should you be skeptical of hot tips?

─ YES. The EMH indicates that you should be skeptical of hot tips since, if
the stock market is efficient, it has already priced the hot tip stock so
that its expected return will equal the equilibrium return.
─ Thus, the hot tip is not particularly valuable and will not enable you to
earn an abnormally high return.
– As soon as the information hits the street, the unexploited profit
opportunity it creates will be quickly eliminated.
– The stock’s price will already reflect the information, and you should
expect to realize only the equilibrium return.
MGB Portfolio Management I

Implications for Investing

3. Do stock prices always rise when there is

good news?
– NO. In an efficient market, stock prices will respond to announcements
only when the information being announced is new and unexpected.
– So, if good news was expected (or as good as expected), there will be no
stock price response.
– And, if good news was unexpected (or not as good as expected), there
will be a stock price response.
MGB Portfolio Management I

Implications for Investing

 Efficient Markets prescription for investor

─ Investors should not try to outguess the market by constantly buying
and selling securities. This process does nothing but incur
commissions costs on each trade.
─ Instead, the investor should pursue a “buy and hold” strategy—
purchase stocks and hold them for long periods of time. This will lead
to the same returns, on average, but the investor’s net profits will be
higher because fewer brokerage commissions will have to be paid.
─ It is frequently a sensible strategy for a small investor, whose costs of
managing a portfolio may be high relative to its size, to buy into a
mutual fund rather than individual stocks. Because the EMH indicates
that no mutual fund can consistently outperform the market, an
investor should not buy into one that has high management fees or
that pays sales commissions to brokers but rather should purchase a
no-load (commission-free) mutual fund that has low management
fees.
MGB Portfolio Management I
All mutual funds sold to the public – performance of all

Implications for Investing general equity mutual funds compared to the Wilshire
5000 Index. In most years more than ½ of the funds
were outperformed by the index. Over the 26.5 year
period about 2/3 of the funds proved inferior to the
market as a whole. Same result holds for professional
pension managers.

Cost Compare
Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 6-97
MGB Portfolio Management I

Case: Any Efficient Markets Lessons from Black Monday of 1987

and the Tech Crash of 2000?

 Does any version of Efficient Markets Hypothesis (EMH) hold

in light of sudden or dramatic market declines?
 Strong version EMH?
 Weaker version EMH?
 A bubble is a situation in which the price of an asset differs
from its fundamental market value?
 Can bubbles be rational?
 Role of behavioral finance
MGB Portfolio Management I

Behavioral Finance
BF argues that a few psychological phenomena pervade
financial markets:

1. Practitioners rely on rules of thumb called heuristics to process

information.

– Heuristic—a process by which people find things out for themselves,

usually by trial and error. Leads to the development of rules of thumb
which are imperfect and result in errors which lead to heuristic-driven
bias.
2. In addition to objective considerations, practitioners perception of risk
& return are highly influenced by how decision problems are framed
 frame dependence.

3. Heuristic-driven bias and framing effects cause market prices to

deviate from fundamental values, i.e. markets are inefficient.
MGB Portfolio Management I

Heuristic Driven Bias

• Representativeness—reliance on stereotypes
– Example of High School GPA as predictor of College GPA
and reversion to the mean.
• Overconfidence
– People set overly narrow confidence bands, high guess is
too low and low guess is too high.
– Results in being surprised too often.
• Anchoring to old information
– Security analysts do not revise their earnings estimates
enough to reflect new info.
MGB Portfolio Management I

Frame Dependence
• EMH assumes framing is transparent—If you move a $ from your right pocket to
your left pocket, you are no wealthier! (Merton Miller)
… In other words, practitioners can see through all the different ways that cash
flow might be described.

• But if frame is opaque, a difference in form (which pocket) is also a difference in

substance and affects behavior.

• Loss Aversion
– Choose between
• Sure loss of $7,500 or
• 75% chance of loosing $10K or 25% chance of loosing $0.

• Hedonic editing
– Organizing Gains and Losses in separate mental accounts.
• One loss and one gain are netted against each other.
• Two gains are savored separately
• But multiple losses are difficult to net out against moderate gains.
MGB Portfolio Management I

Frame Dependence

• Hedonic editing
1. Imagine that you face the following choice. You can accept
a guaranteed $1500 or play a lottery. The outcome of the
lottery is determined by the toss of a fair coin.

Heads—> you win $1950

Tails—> you win $1050

Which would you chose?

Are you risk averse?
MGB Portfolio Management I

Frame Dependence
• Hedonic editing
2. Imagine that you face the following choice. You can
accept a guaranteed loss of $750 or play a lottery. The
outcome of the lottery is determined by the toss of a fair
coin.

Heads—> you lose $750

Tails—> you lose $525

Which would you chose?

MGB Portfolio Management I

Frame Dependence
• Hedonic editing
3. Now imagine that you have just won $1500 in one lottery,
and you can choose to participate in another. The outcome
of this second lottery is determined by the toss of a fair
coin.

Heads—> you win $450

Tails—> you win $450

Would you choose to participate in the second lottery?

MGB Portfolio Management I

Frame Dependence

• Hedonic editing has both cognitive and emotional

causes
– Main cognitive issue in choice 3 above—Do you ignore the
preliminary $1500 winnings or not?
– Those that begin by seeing themselves $1500 ahead then
experience the emotion of loosing $450 as the equivalent
of winning $1050 (i.e. a smaller gain, not a loss).
– Those that ignore the $1500 are less prone to accept the
gamble because they will feel a $450 loss as a loss.
MGB Portfolio Management I

Assignment
Q1: If the weak form of the efficient market is valid must the strong
form also hold? Conversely, does strong-form efficiency imply weak-
form efficiency?

Q2: What would happen to market efficiency if every investor followed

a passive strategy?

Q3. A portfolio manager outperforms the market in 11 of 14 years.

Does this violate the concept of market efficiency?

Q4. A segment of the market believes that continued economic worries

brought about the stock market crash of 1987. Is this explanation for
the crash consistent with the Efficient Market Hypothesis?
MGB Portfolio Management I

PORTFOLIO THEORY
MGB Portfolio Management I
MGB Portfolio Management I

cov(X,Y)=E(XY)−E(X)E(Y).
Proof:
Let μ=E(X) and ν=E(Y). Then

cov(X,Y)=E[(X−μ)(Y−ν)]=E(XY−μY−νX+μν)=E(XY)−μE(Y)−νE(X)+μν=E(XY)−μν
MGB Portfolio Management I

The "Population Standard

Deviation":
The "Sample Standard
Deviation":
MGB Portfolio Management I

In probability theory and statistics, the mathematical concepts of covariance and

correlation are very similar. Both describe the degree to which two random
variables or sets of random variables tend to deviate from their expected values in
similar ways.

correlation
covariance

where E is the expected value operator and σx and σy are the standard
deviations of X and Y, respectively. Notably, correlation is dimensionless while
covariance is in units obtained by multiplying the units of the two variables. The
covariance of a variable with itself (i.e. σxx ) is called the variance and is more
commonly denoted as σ2x the square of the standard deviation. The correlation
of a variable with itself is always 1
MGB Portfolio Management I

Last year, five randomly selected students took a math aptitude test before they began their statistics
course. The Statistics Department has three questions.
What linear regression equation best predicts statistics performance, based on math aptitude scores?
If a student made an 80 on the aptitude test, what grade would we expect her to make in statistics?
How well does the regression equation fit the data?

How to Find the Regression Equation

In the table below, the xi column shows scores on the aptitude test. Similarly, the yi column shows
statistics grades. The last two rows show sums and mean scores that we will use to conduct the
regression analysis.
Student xi yi (xi - x) (yi - y) (xi - x)2 (yi - y)2 (xi - x)(yi - y)

1 95 85 17 8 289 64 136
2 85 95 7 18 49 324 126
3 80 70 2 -7 4 49 -14
4 70 65 -8 -12 64 144 96
5 60 70 -18 -7 324 49 126

Sum 390 385 730 630 470

Mean 78 77

The regression equation is a linear equation of the form: ŷ = b0 + b1x . To conduct a regression analysis,
we need to solve for b0 and b1. Computations are shown below.
b1 = Σ [ (xi - x)(yi - y) ] / Σ [ (xi - x)2] b0 = y - b1 * x
b1 = 470/730 = 0.644 b0 = 77 - (0.644)(78) = 26.768

Therefore, the regression equation is: ŷ = 26.768 + 0.644x .

MGB Portfolio Management I

The Coefficient of Determination

Whenever you use a regression equation, you should ask how well the equation fits
the data. One way to assess fit is to check the coefficient of determination, which can
be computed from the following formula.
R2 = { ( 1 / N ) * Σ [ (xi - x) * (yi - y) ] / (σx * σy ) }2
where N is the number of observations used to fit the model, Σ is the summation
symbol, xi is the x value for observation i, x is the mean x value, yi is the y value for
observation i, y is the mean y value, σx is the standard deviation of x, and σy is the
standard deviation of y. Computations for the sample problem of this lesson are shown
below.
σx = sqrt [ Σ ( xi - x )2 / N ] σy = sqrt [ Σ ( yi - y )2 / N ]
σx = sqrt( 730/5 ) = sqrt(146) = 12.083 σy = sqrt( 630/5 ) = sqrt(126) = 11.225

R2 = { ( 1 / N ) * Σ [ (xi - x) * (yi - y) ] / (σx * σy ) }2

R2 = [ ( 1/5 ) * 470 / ( 12.083 * 11.225 ) ]2 = ( 94 / 135.632 )2 = ( 0.693 )2 = 0.48

A coefficient of determination equal to 0.48 indicates that about 48% of the variation
in statistics grades (the dependent variable) can be explained by the relationship to
math aptitude scores (the independent variable). This would be considered a good fit
to the data, in the sense that it would substantially improve an educator's ability to
predict student performance in statistics class.
MGB Portfolio Management I

Portfolio Mathematics
• Of course, in practice, assets are not correlated in this
simplistic way. Let us look at how portfolio risk is
affected when we put two arbitrarily correlated assets in
a portfolio. Let us call the two assets, a bond, D, and a
stock (equity), E.
• Then, we can write out the following relationship:
rp  wr D D
 wE r E
rP  Portfolio Return
wD  Bond Weight E (rp )  wD E (rD )  wE E (rE )
rD  Bond Return
wE  Equity Weight
rE  Equity Return
114
MGB Portfolio Management I

Portfolio Mathematics

The expected return

on a portfolio
consisting of several
assets is simply a
weighted average of
the expected returns
on the assets
comprising the
portfolio.

115
MGB Portfolio Management I

Portfolio Mathematics
• If we denote variance by s2, then we have the
relationship:
s p  wDs D  wEs E  2wD wECovrD , rE 
2 2 2 2 2

 where Cov(rD, rE) represents the covariance between the

returns on assets D and E.
 If we use DE to represent the correlation coefficient between
the returns on the two assets, then
 Cov(rD,rE) = DEsDsE
 The formula for portfolio variance can be written either
with covariance or with correlation.
116
MGB Portfolio Management I

Portfolio Mathematics
• The correlation coefficient can take values between
+1 and -1.
• If DE = +1, there is no diversification and the
portfolio standard deviation equals wDsD + wEsE,
i.e. a linear combination of the standard deviations
of the two assets.
• If DE= -1, the portfolio variance equals (wDsD –
wEsE)2. In this case, we can construct a risk-free
combination of D and E.
• Setting this equal to zero and solving for wD and wE,
we find
sD
wE   1  wD
s D s E
117
MGB Portfolio Management I

Portfolio Mathematics

For intermediate values of r,

the portfolio standard
deviations fall in the
middle, as shown on the
graph to the right.

In this example, the stock

asset has a standard
deviation of returns of 20%
and the bond asset, of 12%.

118
MGB Portfolio Management I

Problem
Seventy-five percent of a portfolio is invested in Honeybell stock and the
remaining 25% is invested in MBIB stock. Honeybell stock has an expected
return of 6% and an expected standard deviation of returns of 9%. MBIB stock
has an expected return of 20% and an expected standard deviation of 30%.
The coefficient of correlation between returns of the two securities is
expected to be 0.4. Determine the following:

(a) the expected return of the portfolio;

(b) the expected variance of the portfolio;
(c) the expected standard deviation for the portfolio.
MGB Portfolio Management I

Measuring Mean: Scenario

or Subjective Returns

Subjective returns
s
E(r)  p i  ri
i 1
‘s’ = number of scenarios considered
pi = probability that scenario ‘i’ will occur
ri = return if scenario ‘i’ occurs
MGB Portfolio Management I

Numerical example:
Scenario Distributions

Scenario Probability Return

1 0.1 -5%
2 0.2 5%
3 0.4 15%
4 0.2 25%
5 0.1 35%
E(r) = (.1)(-.05)+(.2)(.05)...+(.1)(.35)
E(r) = .15 = 15%
MGB Portfolio Management I

Measuring Variance or
Dispersion of Returns

Subjective or Scenario Distributions

s 2

Variance  s2   p(i)  [r(i)  E(r)]

i 1

Standard deviation = [variance]1/2 = s

Using Our Example:

s2=[(.1)(-.05-.15)2+(.2)(.05- .15)2+…]
=.01199
s = [ .01199]1/2 = .1095 = 10.95%
MGB Portfolio Management I

Risk - Uncertain Outcomes

W1 = 150; Profit = 50
W = 100
1-p = .4 W2 = 80; Profit = -20

E(W) = pW1 + (1-p)W2 = 122

s2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2
s2 = 1,176 and s = 34.29%
MGB Portfolio Management I

Risky Investments
with Risk-Free Investment

Risky W1 = 150 Profit = 50

Investment
1-p = .4 W2 = 80 Profit = -20
100

Risk Free T-bills Profit = 5

Risk Premium = 22-5 = 17

MGB Portfolio Management I

Risk Aversion & Utility

• Investor’s view of risk

– Risk Averse
– Risk Neutral
– Risk Seeking
• Utility
• Utility Function
U = E ( r ) – .005 A s 2
• A measures the degree of risk aversion
MGB Portfolio Management I

Risk Aversion and Value:

The Sample Investment

U = E ( r ) - .005 A s 2
= 22% - .005 A (34%) 2
Risk Aversion A Utility
High 5 -6.90 T-bill = 5%
3 4.66
Low 1 16.22
MGB Portfolio Management I

Dominance Principle

Expected Return

4
2 3
1

Variance or Standard Deviation

• 2 dominates 1; has a higher
return
• 2 dominates 3; has a lower risk
• 4 dominates 3; has a higher
MGB Portfolio Management I

Utility and Indifference Curves

• Represent an investor’s willingness to trade-off return and

risk
Example (for an investor with A=4):

Exp Return St Deviation U=E(r)-.005As2

(%) (%)
10 20.0 2
15 25.5 2
20 30.0 2
25 33.9 2
MGB Portfolio Management I

Indifference Curves

Expected Return

Increasing Utility

Standard Deviation
MGB Portfolio Management I

Portfolio Mathematics:
Assets’ Expected Return

Rule 1 : The return for an asset is the

probability weighted average return
in all scenarios.
s
E(r)  p i  ri
i 1
MGB Portfolio Management I

Portfolio Mathematics:
Assets’ Variance of Return

Rule 2: The variance of an asset’s return is the

expected value of the squared
deviations from the expected return.
s 2

s  2
p i  [ri  E(r)]
i 1
MGB Portfolio Management I

Portfolio Mathematics: Return

on a Portfolio

Rule 3: The rate of return on a portfolio is a

weighted average of the rates of
return of each asset comprising the
portfolio, with the portfolio
proportions as weights.

rp = w1r1 + w2r2
MGB Portfolio Management I

Portfolio Mathematics:
Risk with Risk-Free Asset

Rule 4: When a risky asset is combined with a

risk-free asset, the portfolio standard
deviation equals the risky asset’s
standard deviation multiplied by the
portfolio proportion invested in the
risky asset.

s p
 wrisky asset  srisky asset
MGB Portfolio Management I

Portfolio Mathematics:
Risk with two Risky Assets

Rule 5: When two risky assets with variances

s12 and s22 respectively, are combined
into a portfolio with portfolio weights
w1 and w2, respectively, the portfolio
variance is given by:

s p
2
 w12 s12  w22 s22  2w1w2Cov(r1, r2)
MGB Portfolio Management I

Asset Mix Decision

Asset mix decisions consider both investment opportunities and investor

preferences. These are best described within a risk-reward framework.

Investment Opportunities
The goal of assessing investment opportunities can be expressed in terms
of:
• Expected investment returns and
• Potential deviations from these expectations

Asset returns are typically viewed in a probabilistic sense as:

𝑛
E(R) = 𝑃𝑖*ri n= number of possible outcomes
𝑖=0
Pi is the probability that outcome I will occur

ri= Realized returns if outcome I occurs

MGB Portfolio Management I

Asset Mix Decision

The expected return on portfolio is written as

𝑘
E(Rm) = 𝑥𝑖*E(Ri) k= number of assets in the portfolio
𝑖=0
xi is the proportion of the portfolio invested in asset i

E(Ri)= Realized returns if outcome i occurs

The variability of the returns about the expectations is measured by the

standard deviation of the returns:

The right hand side of the equation is collectively known as the capital
market conditions. The resulting risk return characteristics of each mix can
be plotted on a return-standard deviation graph to get a chart of all the
portfolios that are constructed.
MGB Portfolio Management I

Asset Mix Decision

The Efficient Frontier

It's clear that for any given value of standard deviation, you would like to choose a portfolio that gives you
the greatest possible rate of return; so you always want a portfolio that lies up along the efficient frontier,
rather than lower down, in the interior of the region. This is the first important property of the efficient
frontier: it's where the best portfolios are.

The second important property of the efficient frontier is that it's curved, not straight. This is actually
significant -- in fact, it's the key to how diversification lets you improve your reward-to-risk ratio. To see why,
imagine a 50/50 allocation between just two securities. Assuming that the year-to-year performance of these
two securities is not perfectly in sync -- that is, assuming that the great years and the lousy years for Security
1 don't correspond perfectly to the great years and lousy years for Security 2, but that their cycles are at least
a little off -- then the standard deviation of the 50/50 allocation will be less than the average of the standard
deviations of the two securities separately. Graphically, this stretches the possible allocations to the left of
the straight line joining the two securities.
In statistical terms, this effect is due to lack of covariance. The smaller the covariance between the two
securities -- the more out of sync they are -- the smaller the standard deviation of a portfolio that combines
them. The ultimate would be to find two securities with negative covariance.
MGB Portfolio Management I

Asset Mix Decision

Investor Preferences

Investor preference is quantified in terms of utility derived from owning a

security. They
• Like Return
• Dislike Risk

• Umk = E(Rm) – σm2 = Return – “Risk Penalty”

tk

Umk = Expected utility of asset mix m derived by investor k

tk = Investor k’s risk tolerance
MGB Portfolio Management I

Asset Mix Decision

Utility Curves

• An investor is indifferent between any two portfolios that lie on the same
indifference curve.
• Investors want to be on the highest indifference curve that is available given
current capital market conditions.
• Indifference curves do not intersect.
• Flatter indifference curves indicate that the investor has higher tolerance for risk
• Certainty equivalent rate of return is given by the y intercept and is greater than
the risk free rate of return.
MGB Portfolio Management I

Utility Functions
• Utility is a measure of well-being.
• A utility function shows the relationship between utility
and return (or wealth) when the returns are risk-free.
• Risk-Neutral Utility Functions: Investors are
indifferent to risk. They only analyze return when making
investment decisions.
• Risk-Loving Utility Functions: For any given rate of
return, investors prefer more risk.
• Risk-Averse Utility Functions: For any given rate of
return, investors prefer less risk.
MGB Portfolio Management I

Utility Functions (Continued)

• To illustrate the different types of utility functions, we will

analyze the following risky investment for three different
investors:
Possible Return (%) Probability
(ri) (pi)
_________ _________
10% .5
50% .5

E(r i )  .5(10% ) .5(50% )  30%

σ(ri )  .5(10%  30% )2  .5(50%  30% )2  20%

MGB Portfolio Management I

Risk-Neutral Investor

• Assume the following linear utility function:

ui = 10ri
Return (%) Total Utility Constant
(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 100 100
20 200 100
30 300 100
40 400 100
50 500 100
MGB Portfolio Management I

Risk-Neutral Investor (Continued)

• Expected Utility of the Risky Investment:

E(u)  .5 * u(10% )  .5 * u(50% )
E(u)  .5(100)  .5(500)  300

• Note: The expected utility of the risky investment

with an expected return of 30% (300) is equal to
the utility associated with receiving 30% risk-free
(300).
MGB Portfolio Management I

Risk-Neutral Utility Function

ui = 10ri
Total Utility
600

500

400

300

200

100

0
0 10 20 30 40 50 60
Percent Return
MGB Portfolio Management I

Risk-Loving Investor
• Assume the following quadratic utility function:
ui = 0 + 5ri + .1ri2

Return (%) Total Utility Increasing

(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 60 60
20 140 80
30 240 100
40 360 120
50 500 140
MGB Portfolio Management I

Risk-Loving Investor (Continued)

• Expected Utility of the Risky Investment:
E(u)  .5 * u(10% )  .5 * u(50% )
E(u)  .5(60)  .5(500)  280
• Note: The expected utility of the risky investment with an
expected return of 30% (280) is greater than the utility
associated with receiving 30% risk-free (240).
- 5 + 25 - 4(.1)(-280 )
Certainty Equivalent :  33.5%
2(.1)
• That is, the investor would be indifferent between
receiving 33.5% risk-free and investing in a risky asset that
has E(r) = 30% and s(r) = 20%
MGB Portfolio Management I

Risk-Loving Utility Function

ui = 0 + 5ri + .1ri2
Total Utility
600

500

280
240

60
0
0 10 30 33.5 50 60
Percent Return
MGB Portfolio Management I

Risk-Averse Investor

• Assume the following quadratic utility function:

ui = 0 + 20ri - .2ri2
Return (%) Total Utility Diminishing
(ri) (ui) Marginal Utility
__________ __________ __________
0 0
10 180 180
20 320 140
30 420 100
40 480 60
50 500 20
MGB Portfolio Management I

Risk-Averse Investor (Continued)

• Expected Utility of the Risky Investment:
E(u)  .5 * u(10% )  .5 * u(50% )
E(u)  .5(180)  .5(500)  340

• Note: The expected utility of the risky investment with an

expected return of 30% (340) is less than the utility
associated with receiving 30% risk-free (420).

- 20 + 400 - 4(-.2)(-34 0)
Certainty Equivalent :  21.7%
2(.2)
• That is, the investor would be indifferent between
receiving 21.7% risk-free and investing in a risky asset that
has E(r) = 30% and s(r) = 20%.
MGB Portfolio Management I

Risk-Averse Utility Function

ui = 0 + 20ri - .2ri2

Total Utility
600

500
420
340

180

0
0 10 21.7 30 50 60
Percent Return
MGB Portfolio Management I

Indifference Curve

• Given the total utility function, an indifference curve can

be generated for any given level of utility. First, for
quadratic utility functions, the following equation for
expected utility is derived in the text:

2 2
E(u)  a 0  a1E(r)  a 2E(r)  a 2σ (r)
Solving for σ(r) :
E(u) a0 a1E(r) 2
σ(r) =    E(r)
a2 a2 a2
MGB Portfolio Management I

Indifference Curve (Continued)

• Using the previous utility function for the risk-averse

investor, (ui = 0 + 20ri - .2ri2), and a given level of utility
of 180:
180 20 E(r)
σ(r)    E(r) 2
 .2  .2
• Therefore, the indifference curve would be:
E(r) s(r)
10 0
20 26.5
30 34.6
40 38.7
50 40.0
MGB Portfolio Management I

Risk-Averse Indifference Curve

When E(u) = 180, and ui = 0 + 20ri - .2ri2

Expected Return
60

50

40

30

20

10

0
0 10 20 30 40 50
Standard Deviation of Returns
MGB Portfolio Management I
Maximizing Utility
• Given the efficient set of investment possibilities and a
“mass” of indifference curves, an investor would maximize
his/her utility by finding the point of tangency between an
indifference curve and the efficient set.
Expected Return E(u) = 380 E(u) = 280
60

50 Portfolio That E(u) = 180

Maximizes
40
Utility
30

20

10

0
0 10 20 30 40 50
Standard Deviation of Returns
MGB Portfolio Management I

Problems With Quadratic Utility Functions

Quadratic utility functions turn down after they reach a
certain level of return (or wealth). This aspect is obviously
unrealistic:
Total Utility
600

500

400

300 Unrealistic
200

100

0
0 20 40 60 80
Percent Return
MGB Portfolio Management I

Problems With Quadratic Utility

Functions (Continued)
• With a quadratic utility function, as your wealth level
increases, your willingness to take on risk decreases (i.e.,
both absolute risk aversion [dollars you are willing to
commit to risky investments] and relative risk aversion [%
of wealth you are willing to commit to risky investments]
increase with wealth levels). In general, however, rich
people are more willing to take on risk than poor people.
Therefore, other mathematical functions (e.g.,
logarithmic) may be more appropriate.
MGB Portfolio Management I

What do you think about the move to a more active stock-picking strategy?

stock standard deviation return

Index fund 4.61% 1.10%

California R.E.I.T. 9.23% -2.27%
Brown Group 8.17% -0.67%
Portfolio of 99% index 4.57% 1.07%
fund and 1 % California
R.E.I.T.

4.61% 1.08%
Portfolio of 99% index
fund and 1 % Brown
Group

Thus we see that the index fund has the highest return of 1.10%
with the standard deviation of 4.61%
By including California REIT the standard deviation (risk) is reduced to 4.57%
but the return also reduces to 1.07%

Thus there can be a tradeoff between these two strategies

However including Brown Group is not a good idea as return drops but the risk (standard deviation remains the same)
MGB Portfolio Management I

Asset Mix Decision

Optimal Portfolio - Where the Efficient frontier and Utility curve meet
MGB Portfolio Management I

Estimating Risk Aversion

• Use questionnaires
• Observe individuals’ decisions when
confronted with risk
• Observe how much people are willing to
pay to avoid risk
MGB Portfolio Management I

Risk Aversion and Capital Allocation to

Risky Assets
MGB Portfolio Management I

The Investment Decision

• Top-down process with 3 steps:
1. Capital allocation between the risky portfolio and
risk-free asset
2. Asset allocation across broad asset classes
3. Security selection of individual assets within each
asset class
MGB Portfolio Management I

Allocation to Risky Assets

• Investors will avoid risk unless there is a

reward.
– i.e. Risk Premium should be positive

• Agents preference (taste) gives the

optimal allocation between a risky
portfolio and a risk-free asset.
MGB Portfolio Management I

Speculation vs. Gamble

• Speculation
– Taking considerable risk for a commensurate gain
– Parties have heterogeneous expectations
• Gamble
– Bet or wager on an uncertain outcome for
enjoyment
– Parties assign the same probabilities to the possible
outcomes
MGB Portfolio Management I

Available Risky Portfolios (Risk-free Rate = 5%)

Each portfolio receives a utility score to

assess the investor’s risk/return trade off
MGB Portfolio Management I

Utility Function
U = utility of portfolio
with return r
E ( r ) = expected
1
return portfolio
U  E (r )  As 2
A = coefficient of risk 2
aversion
s2 = variance of
returns of portfolio
½ = a scaling factor
MGB Portfolio Management I

Utility Scores of Alternative Portfolios for Investors with

Varying Degree of Risk Aversion

IN CLASS EXERCISE. Answer: How high

does the risk aversion coefficient (A) has to be
so that L is preferred over M and H?
MGB Portfolio Management I

Mean-Variance (M-V) Criterion

• Portfolio A dominates portfolio B if:

E rA   E rB 
• And

sA sB
• As noted before: this does not determine the choice of one
portfolio, but a whole set of efficient portfolios.
MGB Portfolio Management I

Capital Allocation Across Risky and Risk-Free Portfolios

Asset Allocation: Controlling Risk:

• Is a very important part
• Simplest way:
of portfolio
Manipulate the fraction
construction.
of the portfolio invested
• Refers to the choice in risk-free assets versus
among broad asset the portion invested in
classes. the risky assets
– % of total Investment in risky
vs. risk-free assets
MGB Portfolio Management I

Basic Asset Allocation Example

Total Amount Invested $300,000
Risk-free money market $90,000
fund
Total risk assets $210,000
Equities $113,400
Bonds (long-term) $96,600

$113 ,400 $96 ,600

WE   0.54 WB   0.46
$210 ,000 $210 ,00
Proportion of Risk assets Proportion of Risk assets
on Equities on Bonds
MGB Portfolio Management I

Basic Asset Allocation

• P is the complete portfolio where we have y as
the weight on the risky portfolio and (1-y) =
weight of risk-free assets:

$210 ,000 $90 ,000

y  0.7 1 y   0.3
$300 ,000 $300 ,000
$113 ,400 $96 ,600
E:  .378 B:  .322
$300 ,000 $300 ,000
• Complete Portfolio is:
(0.3, 0.378, 0.322)
MGB Portfolio Management I

The Risk-Free Asset

• Only the government can issue default-
free bonds.
– Risk-free in real terms only if price indexed
and maturity equal to investor’s holding
period.
• T-bills viewed as “the” risk-free asset
• Money market funds also considered risk-
free in practice
MGB Portfolio Management I

Figure 6.3 Spread Between 3-Month

CD and T-bill Rates
MGB Portfolio Management I

Portfolios of One Risky Asset and a Risk-Free Asset

• It’s possible to create a complete portfolio by

splitting investment funds between safe and
risky assets.

– Let y=portion allocated to the risky portfolio, P

– (1-y)=portion to be invested in risk-free asset, F.
MGB Portfolio Management I

Example

rf = 7% srf = 0%

E(rp) = 15% sp = 22%

y = % in p (1-y) = % in rf
MGB Portfolio Management I

Example (Ctd.)

The expected
return on the
complete portfolio E (rc )  rf  y  E (rP )  rf 
is the risk-free
rate plus the

E rc   7  y15  7 
weight of P times
the risk premium
of P
MGB Portfolio Management I

Example (Ctd.)

• The risk of the complete portfolio is

the weight of P times the risk of P:

s C  ys P  22 y
– This follows straight from the formulas we saw
before and the fact that any constant random
variable has zero variance.
MGB Portfolio Management I

Feasible (var, mean)

• Taken together this determines the set

of feasible (mean,variance) portfolio
return:
E rc   7  y15  7 
s C  ys P  22 y
– This determines a straight line, which we call
Capital Allocation Line. Next we derive it’s
equation completely
MGB Portfolio Management I

Example (Ctd.)
• Rearrange and substitute y=sC/sP:
sC
E rC   rf 
sP
E rP   rf   7  s C
8
22
– The sub-index C is to stand for complete portfolio
E rP   rf 8
Slope  
sP 22
– The slope has a special name: Sharpe ratio.
MGB Portfolio Management I

The Investment Opportunity Set

MGB Portfolio Management I

Capital Allocation Line - Changing Allocation

Increasing he fraction of the overall portfolio

invested in the risky asset increases the
expected return by the risk premium of the
equation (which is 8%) but also increases
portfolio standard deviation at the rate of 22%.

The extra return per extra risk is 8/22 = 0.36

MGB Portfolio Management I

Capital Allocation Line Changing Allocation

I have invested 300,000 risky assets and if I borrow

120,000 and invest it into the risky asset as well

y = 420,000/300,000 = 1.4
1-y = 1-1.4 = -0.4

E(rc) = 7% + (1.4 x 8%) = 18.2%

σc = 1.4 X 22% = 30.8%
S= E(rc) – rf = 18.2 – 7 = 0.36
σc 30.8
MGB Portfolio Management I

Capital Allocation Line with Leverage

• Lend at rf=7% and borrow at rf=9%

– Lending range slope = 8/22 = 0.36
– Borrowing range slope = 6/22 = 0.27

• CAL kinks at P
MGB Portfolio Management I

The Opportunity Set with Differential Borrowing and Lending

Rates
MGB Portfolio Management I
Utility Levels for Various Positions in Risky Assets (y) for an
Investor with Risk Aversion A = 4
MGB Portfolio Management I

Utility as a Function of Allocation to the Risky Asset, y

MGB Portfolio Management I

Table 6.5 Spreadsheet Calculations of

Indifference Curves
MGB Portfolio Management I

Portfolio problem
• Agent’s problem with one risky and one risk-
free asset is thus:
• Pick portfolio (y, 1-y) to maximize utility U
– U(y,1-y) = E(rC) -0.005*A*Var(rC)
• Where rC is the complete portfolio
– This is the same as
– rf + y[E(r) – rf] -0.5*A*y2*Var(r)
– Solution: y* = E(r) – rf )/0.01A*Var(rC)
MGB Portfolio Management I

Indifference Curves for

U = .05 and U = .09 with A = 2 and A = 4
MGB Portfolio Management I

Finding the Optimal Complete Portfolio Using

Indifference Curves
MGB Portfolio Management I

Expected Returns on Four Indifference Curves and the CAL

MGB Portfolio Management I

Risk Tolerance and Asset Allocation

• The investor must choose one optimal

portfolio, C, from the set of feasible choices
– Expected return of the complete portfolio:

E (rc )  rf  y  E (rP )  rf 
– Variance:

s ys
2
C
2 2
P
MGB Portfolio Management I

Summary

The Asset Allocation process has 2 steps:

1. Determine the CAL
2. Find the point of highest utility along that
line
MGB Portfolio Management I

One word on Indifference Curves

• If you see the IC curves over (mean,st. dev) you will

note that these are all nice smooth concave curves.
– This is an assumption.
– Note that investors have preference over random variables
(representing payoff/return). A random variable, in general, is
not completely described by (mean, variance).
• That is, in general, we can have X and Y with mean(X) < mean (Y)
and var(X)=var(Y) BUT X is ranked better than Y nonetheless.
MGB Portfolio Management I

Passive Strategies:
The Capital Market Line
• A natural candidate for a passively held risky
asset would be a well-diversified portfolio of
common stocks such as the S&P 500.
• The capital market line (CML) is the capital
allocation line formed from 1-month T-bills
and a broad index of common stocks (e.g. the
S&P 500).
MGB Portfolio Management I

Passive Strategies:
The Capital Market Line

• The CML is given by a strategy that involves

investment in two passive portfolios:

1. virtually risk-free short-term T-bills (or a

money market fund)
2. a fund of common stocks that mimics a
broad market index.
MGB Portfolio Management I

Passive Strategies:
The Capital Market Line

• From 1926 to 2009, the passive risky

portfolio offered an average risk premium of
7.9% with a standard deviation of 20.8%,
resulting in a reward-to-volatility ratio of
.38.
MGB Portfolio Management I

Diversification and Portfolio Risk

• Suppose there is a single common source of risk in the economy.
• All assets are exposed both to this single common source of risk and a separate
idiosyncratic source of risk that is uncorrelated across assets.
• Then the insurance principle says that if we construct a portfolio of a very large
number of these assets, the combined portfolio will only reflect the common
risk. The idiosyncratic risk will average out and tend to zero as the number of
securities grows very large.
• Thus, if there are many home fire insurance policyholders and the risk of fire is
uncorrelated across similarly sized homes, then if the number of policy holders
is very large, the actual losses in the portfolio tends to the expected loss per
home times the number of homes.
• This means that homeowners, by pooling their risk, can remove their exposure
to risk completely.
• In practice, the risks are not completed uncorrelated across homes but a fair
amount of risk reduction is possible.
• The next slide shows graphically how portfolio risk would be affected in these
conditions.

197
MGB Portfolio Management I

Diversification and Portfolio Risk

198
MGB Portfolio Management I

Diversification and Portfolio Risk

199
MGB Portfolio Management I

Investment Opportunity Sets: Risky Assets

This graph shows the portfolio opportunity

set for different values of .
That is, the combination of portfolio E(r)
and s than can be obtained by combining
the two asset.
In our example, the equity asset has an
expected return of 13%, while the bond
asset has an expected return of 8%.
The curved line joining the two assets D
and E is, in effect, part of the opportunity
set of (E(R), s) combinations available to
the investor. To get the entire opportunity
set, we simply extend this curve both
beyond E and beyond D.
MGB Portfolio Management I

Optimal Portfolio: Two Risky Assets

MGB Portfolio Management I

Covariance and Correlation

• Portfolio risk depends on the correlation
between the returns of the assets in the
portfolio

• Covariance and the correlation coefficient

provide a measure of the way returns of
two assets vary

7-202
MGB Portfolio Management I

Two-Security Portfolio: Return

rp  wr D D
 wE r E
rP  Portfolio Return
wD  Bond Weight
rD  Bond Return
wE  Equity Weight
rE  Equity Return

E (rp )  wD E (rD )  wE E (rE )

7-203
MGB Portfolio Management I

Two-Security Portfolio: Risk

s p2  wD2 s D2  wE2s E2  2wD wECovrD , rE 

s = Variance of Security D
2
D

s 2
E = Variance of Security E

CovrD , rE  = Covariance of returns for

Security D and Security E

7-204
MGB Portfolio Management I

Two-Security Portfolio: Risk

• Another way to express variance of the

portfolio:

s P2  wD wDCov(rD , rD )  wE wE Cov(rE , rE )  2wD wE Cov(rD , rE )

MGB Portfolio Management I

Covariance
Cov(rD,rE) = DEsDsE

D,E = Correlation coefficient of

returns
sD = Standard deviation of
returns for Security D

sE = Standard deviation of
returns for Security E
MGB Portfolio Management I

Correlation Coefficients: Possible Values

Range of values for 1,2

+ 1.0 >  > -1.0
If  = 1.0, the securities are perfectly
positively correlated
If  = - 1.0, the securities are perfectly
negatively correlated
MGB Portfolio Management I

Correlation Coefficients
• When ρDE = 1, there is no diversification

s P  wEs E  wDs D

• When ρDE = -1, a perfect hedge is possible

sD
wE   1  wD
s D s E
MGB Portfolio Management I

Computation of Portfolio Variance From the Covariance Matrix

MGB Portfolio Management I

Three-Asset Portfolio

E (rp )  w1E (r1 )  w2 E (r2 )  w3 E (r3 )

s p2  w12s12  w22s 22  w32s 32

 2 w1w2s 1, 2  2 w1w3s 1,3  2 w2 w3s 2,3
MGB Portfolio Management I

Portfolio Expected Return as a Function of Investment

Proportions
MGB Portfolio Management I

Portfolio Standard Deviation as a Function of Investment

Proportions
MGB Portfolio Management I

The Minimum Variance Portfolio

• The minimum variance • When correlation is less
portfolio is the portfolio than +1, the portfolio
composed of the risky standard deviation may
assets that has the be smaller than that of
smallest standard either of the individual
deviation, the portfolio component assets.
with least risk.
• When correlation is -1,
the standard deviation
of the minimum
variance portfolio is
zero.

7-213
MGB Portfolio Management I

Portfolio Expected Return as a Function of Standard Deviation

MGB Portfolio Management I

Correlation Effects
• The amount of possible risk reduction through
diversification depends on the correlation.
• The risk reduction potential increases as the
correlation approaches -1.
– If  = +1.0, no risk reduction is possible.
– If  = 0, σP may be less than the standard deviation
of either component asset.
– If  = -1.0, a riskless hedge is possible.
MGB Portfolio Management I

Optimal Portfolio Selection

• We can solve the optimization problem to
compute the following useful formulas:
• The minimum variance portfolio of risky assets
D, E is given by the following formula:

• The optimal portfolio for an investor with a risk

aversion parameter, A, is given by this formula:
𝐸 𝑟𝐷 − 𝐸 𝑟𝐸 + 0.01𝐴[𝜎 2 𝐸 − 𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸 ]
𝑤𝐷 =
0.01𝐴[𝜎 2 𝐸 + 𝜎 2 𝐷 − 𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸 ]
MGB Portfolio Management I

Numerical Example
2 mutual funds

Debt Equity
Expected Return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov (rD, rE) 72
Correlation Coefficient, ρDE 0.30

Wmin(D) = σ2E – Cov (rD,rE) = 202 -72 = 0.82

σ2D + σ2E – 2Cov (rD,rE) 122 + 202 – 2x72

Wmin(E) = 1-0.82 = 0.18

The minimum variance portfolio

σ = [0.822 x 122 + 0.182 x 202 + 2x0.82x0.18x72]1/2 = 11.45%
Sharpe Ratio SA= E(rA) – rf = 8.9 – 5 = 0.34
σA 11.45
MGB Portfolio Management I

Optimal Portfolio Selection

We now introduce a risk free asset.

The expected return on a portfolio

consisting of a risk free asset and a risky
portfolio is, of course, a weighted
average of the expected returns on the
component assets. But the standard
deviation of the portfolio is also linear in
the standard deviation of the risky asset.
Hence the CAL if there is one risk free
asset and a risky portfolio is simply a
straight line passing through the two
assets, as shown in the figure on the
right.
MGB Portfolio Management I

Numerical Example
2 mutual funds

Debt Equity
Expected Return, E(r) 8% 13%
Standard deviation, σ 12% 20%
Covariance, Cov (rD, rE) 72
Correlation Coefficient, ρDE 0.30

B has an E(r) = 9.5% and a σ of 11.7% giving it a risk premium of 4.5%

Its Sharpe Ratio is SB = 9.5 – 5.0 = 0.38

11.7

SB – SA = .38 - .34 = 0.04. We get 4 basis points per percentage point increase in risk.
MGB Portfolio Management I

Optimal Portfolio Selection

The slope of each of the CALs drawn

in the previous figure is a reward-to-
volatility (Sharpe) ratio. Since we
want this ratio to be maximized, the
single CAL for the set of risky and risk
free assets is the CAL with the
steepest slope, i.e. the highest
Sharpe ratio.
MGB Portfolio Management I

Optimal Portfolio Selection

If we now superimpose the

indifference curve map on the
CAL, we can compute the
complete optimal portfolio.
MGB Portfolio Management I

Optimal Portfolio Selection

• The formula for the tangency portfolio (shown as
portfolio C on the picture in the previous slide) is:
𝐸 𝑟𝑃 −𝑟𝑓
Max Sp =
𝜎𝑃

• Note that the investor risk aversion coefficient does not

show up in this formula.
• Once the tangency portfolio is available, all investors
choose a combination of this portfolio (denoted p in the
formula below) and the risk-free asset. The formula for
this, which we know already, is:
𝐸 𝑟𝑃 − 𝑟𝑓
𝑦∗=
0.01𝐴𝜎𝑃 2
MGB Portfolio Management I

Optimal Portfolio Selection

• WD = (8-5)400 – (13-5)72__________ = 0.40

(8-5)400 + (13-5)144 – (8-5+13-5)72
• WE = 1-0.4 = 0.60
• σp = (0.42 x 144 + 0.62x400 + 2 x 0.4 x 0.6 x 72)1/2 = 14.2
• Sp = 11-5/14.2 = 0.42

• Note that the investor risk aversion coefficient does not show up in
this formula.
• Once the tangency portfolio is available, all investors choose a
combination of this portfolio (denoted p in the formula below) and
the risk-free asset. The formula for this, which we know already, is:
𝐸 𝑟𝑃 −𝑟𝑓
𝑦∗= 2 = 11 – 5 /(0.01 x 4 x 14.22) = -.7439
0.01𝐴𝜎𝑃
MGB Portfolio Management I

Optimal Portfolio Selection

The investor will invest 74.39% of the wealth in Portfolio P and 25.62 in T-bills.

Portfolio P consists of 40% bonds and 60% stocks so 0.4x74.39 = 29.76% of the
wealth will be in bonds and 0.6 x 74.39 = 44.63% of the wealth will be in stocks.

224
MGB Portfolio Management I
MGB Portfolio Management I

Numerical Example
You have available to you, two mutual funds, whose returns have a correlation of
0.23. Both funds belong to the fund category “Balanced – Domestic.” Here is
some information on the fund returns for the last six years (obtained from
http://www.financialweb.com/funds/):
In addition, you can also invest in a risk free 1-year T-bill yielding 6.286%. The
expected return on the market portfolio is 20%.
a.If you have a risk aversion coefficient of 4, and you have a total of $20,000 to
invest, how much should you invest in each of the three investment vehicles?
b.What is the standard deviation of your optimal portfolio?

Capital Value Green Century Capital Value Green Century

Year Fund Balanced Year Fund Balanced
1999 21.32% -10.12% 1996 21.48% 18.26%
1998 21.44% 18.91% 1995 0.91% -4.28%
1997 9.86% 24.91% 1994 10.79% -0.47%
average 14.30% 7.87%
stdev 8.52% 14.57%
226
MGB Portfolio Management I

Solution
• a. Using the formula, we can find the portfolio weights for the tangent
portfolio of risky assets as follows:

which works out to 1641.13/1529.31 = 1.073. Hence wGCB = 1-(1.073) = -

0.073.
In order to find the optimal combination of the tangent portfolio and the
risk free asset for our investor, we need to compute the expected return
on the tangent portfolio and the variance of portfolio returns.
E(Rtgtport) = 1.073(14.3) + (-0.073)(7.87) = 14.77%
Var(Rtgtport) = (1.073)2(8.52)2 + (-0.073)2(14.57)2 +
2(-0.073)(1.073)(8.52)(14.57)(0.23) = 82.47. Hence, stgtport = 9.08%
MGB Portfolio Management I

Solution (Contd.)
Using the formula y* = [E(Rport) – Rf]/0.01AVar(Rtgtport), we get y* = = 2.57;
hence the proportion in the riskfree asset is -1.57. In other words, the
investor borrows to invest in the tangent portfolio.
If the investor’s total outlay is $20,000, the amount borrowed equals
(20000)(1.57) = $31,400. This provides a total of $51,400 for investment
in the tangent portfolio. However, the tangent portfolio itself consists of
shortselling Green Century Balanced to the extent of (0.073)(51,400) =
3752.20, providing a total of 51,400 + 3752.2 = $55,152.20 for investment
in Capital Value Fund.
b. The standard deviation of the optimal portfolio is 2.57(9.08) =
23.34%. The expected return on the optimal portfolio is 2.57(14.77) + (-
1.57)(6.286) = 28.09%
MGB Portfolio Management I

Optimal Portfolio Selection

• Until now, we have dealt with the case of two risky assets. We now
increase the number of risky assets to more than two.
• In this case, graphically, the situation remains the same, as we will
see, except that the opportunity set instead of being a simple
parabolic curve becomes an area, bounded by a parabolic curve.
• However, since all investors are interested in higher expected return
and lower variance of returns, only the northwestern frontier of this
set is relevant, and so the graphic illustration remains comparable.
• Mathematically, the computation of the tangency portfolio is a bit
more complicated, and will require the solution of a system of n
equations. We will not go further into it, here.
• We now look at the graphical illustration of the problem
MGB Portfolio Management I

Markowitz Portfolio Selection

• The first step is to
determine the risk-
return opportunities
available.
• All portfolios that lie
on the minimum-
variance frontier
from the global
minimum-variance
portfolio and
upward provide the
best risk-return
combinations
MGB Portfolio Management I

Markowitz Portfolio Selection

• We now search
for the CAL with
the highest
reward-to-
variability ratio
MGB Portfolio Management I

Markowitz Portfolio Selection

• The separation property tells us that the portfolio choice
problem may be separated into two independent tasks
– Determination of the optimal risky portfolio is purely
technical.
– Allocation of the complete portfolio to T-bills versus the risky
portfolio depends on personal preference.
• Thus, everyone invests in P, regardless of their degree of risk
aversion.
– More risk averse investors put more in the risk-free asset.
– Less risk averse investors put more in P.
MGB Portfolio Management I

More on Diversification
• We have seen that
s p2  wD2 s D2  wE2s E2  2wD wECovrD , rE 
• If we have three assets, portfolio variance is given by:
s p2  w12s12  w22s 22  w32s 32
 2 w1w2s 1, 2  2 w1w3s 1,3  2 w2 w3s 2,3

• If we generalize it to n assets, we can write the formula as:

• Defining the average variance and the average covariance, we then get

• That is, the portfolio variance is a weighted average of the average variance and
the average covariance.
• However, as the number of assets increases, the relative weight on the variance
goes to zero, while that on the covariance goes to 1.
• Hence we see that it is the covariance between the returns on the component
assets that is important for the determination of the portfolio variance.