15.

433 INVESTMENTS
Class 5: Portfolio Theory
Part 3: Optimal Risky Portfolio

Spring 2003
 Introduction

• Having determined the appropriate exposure to risk, the investor’s next task is to
build his risky portfolio rp .

• This selection will be made from the whole universe of risky assets that are avail-
able for investment.
 How Big is the Universe of Risky Assets?

We live in an exciting time, with an expansive investment environment. Here is a list

c
of the plain-vanilla instruments reported by RiskMetrics
, source : RiskM etricsT M −
T echnical Document

Equity Indices: 31 countries.

Foreign Exchange Rates: 31 currencies.

Money Markets around the world: 111.

Swaps around the world: 121.

Gov’t Bonds around the world: 153.

Commodities: 33.

Over 400 different instruments!

This does not include individual equities, mutual funds, venture capital funds, futures, options, and
other derivatives ... .
 Two Risky Assets

1. r1 µ1 = 13%, σ1 = 20%
2. r1 µ2 = 8%, σ2 = 12%
3. correlated returns : ρ = corr (r1 , r2 ) = 30%.

Mixing the Risky Assets

• a fraction of w in equity

• a fraction of 1 - w in debt

• the risky portfolio rp = w · r1 + (1 − w) · r2

wy

wi

E(rP)
σ
σP
rf
0
0

Figure 4: Efficient frontier.

 The Risky Portfolios

Let’s first calculate the mean and variance of the risky portfolio:

µP = w · µ1 + (1 − w) · µ2 (1)

σp2 = w2 · σ12 + (1 − w)2 · σ2

2 + 2 · w · (1 − w) · cov (r1 , r2 ) (2)
= w2 · σ12
+ (1 − w)2 · σ22 + 2 · w · (1 − w) · σ1 σ2 ρ1,2 (3)

Spanning the mean-std space:

µi

µ1 risky P1
o
mean µ (%)

µ2 risky P 2
o

0 σ2 σ1
σi
0 std σ (%)

Figure 5: Efficient frontier.

 The Optimal Portfolio Problem

the investment opportunity

• one riskfree rf

• two risky assets r1 and r2

a mean-variance investor
1 1
U (r) = E (r) − · A · var (r) + · B · E (r − E (r))3 (4)
2 6

investment decisions:

1. choose the overall exposure to risk:

y in the risky portfolio rp and 1 − y in rf .

2. choose the right risky portfolio rp :

w in r1 , and 1 − w in r2 .

possible portfolios:

ry,w = (1 − y) · rf + y · (w · r1 + (1 − w) · r2 ) (5)

the optimal portfolio:

max
U (ry,w ) (6)
y ∈ R, w ∈ R
 The Separation Principle

In addition to the choice variable y, which controls the investor’s overall exposure to
risk, our current problem also involves the choice variable w, which controls the right
mix of the risky assets.

The Complication: Need to solve y and w simultaneously in the optimization problem:

max
U (ry,w ) (7)
y ∈ R, w ∈ R

Solution: The Separation Principle (James Tobin 1958):

• the choice y of the overall risk exposure is investor specific, depending on his
degree of risk aversion;

• the choice w of the optimal risky portfolio is the same for all investors.
 A Brief Review of CAL

µi
mean µ (%)

rf o

0
σi
0
std σ (%)

Figure 6: Efficient frontier.

Pick any risky portfolio rp , invest a fraction y in it, leaving the rest in the riskfree
account rf .

What are the possible (E-Std) combinations?

E (ry ) − rf
E (ry ) − rf = std (ry ) (8)
std (rp )
 A Brief Review of the Sharpe Ratio

µi

µ1 risky P1

mean µ (%)

rf o
risky P2

0
σi
0 std σ (%)

Figure 7: Efficient frontier.

One measure of the attractiveness of a portfolio r is its Sharpe Ratio:

E (r) − rf
S= (9)
std (r)

What is its graphical interpretation?

 The Optimal Risky Portfolio

µi

µ1 risky P1
o
mean µ (%)

rf o µ risky P2
2
o

0 σ2 σ1
0
σi
std σ (%)

Figure 8: Efficient frontier.

Each CAL is uniquely identified by its slope.

The best CAL is the one with the steepest slope, or the highest Sharpe Ratio.

The Optimal Risky Portfolio is the Tangency Portfolio: the unique portfolio with
the highest Sharpe-Ratio.

Conceptually, it is very important to notice that the definition of the Optimal Risky
Portfolio does not involve the degree of risk aversion of any individual investor.

In such an ideal world, every investor, regardless of his level of risk aversion, will
agree on the best CAL, and allocate his wealth between rf and the optimal risky port-
folio.

The portion y invested in the optimal risky portfolio, however, will depend on each
investor’s degree of risk aversion, as discussed in Class 3.

In practice, however, different investors might have very different ideas about their
Optimal Risky Portfolio. Why?
 Multiple Risky Assets

The opportunity set generated by the two risky assets is relatively simple. As we gen-
eralize to the case of multiple risky assets, the opportunity set becomes considerably
more complicated. Suppose that we have n securities, whose random returns are de-
noted by r1 , r2 , . . . , rn

As usual, we construct portfolios by mixing these n securities:

rp = w 1 · r 1 + w 2 · r 2 + · · · + w n · r n (10)

where the w’s are the portfolio weights, adding up to 1.

Each chosen w gives rise to an investment opportunity with

�
n
E (rp ) = wi · E (ri ) (11)
i=1
�n �n
var (rp ) = wi · wj · cov (ri , rj ) (12)
i=1 j=1

�n
1
covi,j = (ri − r̄i ) · (rj − r̄j ) equal weighted (13)
i=1
n
�
n
covi,j = pt · (ri − r̄i ) · (rj − r̄j ) probability weighted (14)
i=1

This results in an enormous degree of freedom, and a very rich opportunity set. Of
course, not all portfolios in the opportunity set are good deals.

Constructing the mean?variance frontier: an efficient set of portfolios that achieve

the lowest possible risk for any given target rate of return.
 The Optimal Portfolio in Practice

Implication of the Separation Principle: A portfolio manager will offer the same risky
portfolio to all clients.

In practice, different managers focus on different subsets of the whole universe of finan-
cial assets, derive different efficient frontiers, and offer different ”optimal” portfolios to
their clients.Why?

The theory of portfolio selection builds on many simplifying assumptions:

• No Market Frictions (tax, transactions costs, limited divisibility of financial assets,

market segmentation).

• No Heterogeneity in Investors (e.g. rich vs. poor, informed vs. uninformed, young
vs. old).

• Static expected returns and variance - no forecastability in returns or volatility

(e.g. financial analysts, accounting information, macro?economic variables do not
play any role in making an investment decision).

Our next step toward reality (in Classes 19-20): link the following two bodies of ideas,

• Security Analysis: subjective, judgmental

• Portfolio Selection: objective, statistical.

Some important questions to think about:

• Can security analysis improve portfolio performance?

• How do analysts’ opinions enter in security selection?

 A Digression to Diversification

Diversification is a universal concept. Put in simple terms, one should not put all eggs
in one basket.

In investments, diversifying means holding similar amounts of many risky assets in-
stead of concentrating all of your investment in only one.
In social science, it is believed that individuals are of ”bounded rationality”. One way
to mitigate such a problem is through decision-making by multiple agents.

For example, in gymnastics or figure skating competitions, the score is averaged over
multiple judges, after taking away extremes on either end.

The mathematical foundation of diversification - the strong law of large numbers!

BKM, p.
n � �2
� 299 f.
1 1
σε2p = σε2i = σε2 (15)
i=1
n n
1�
n
βp = ·βi (16)
n i=1
1�
n
αp = ·αi (17)
n i=1
1�
n
εp = ·εi (18)
n i=1
σp2 = βp2 σM
2
+ σε2p (19)
 Leisure Readings

”The Interior Decorator Fallacy” Chapter 3 of Capital Ideas by Peter Bernstein.

Focus:
BKM Chapter 8

• p. 210-213 (eq. 8.2, eq. 8.4, table 8.2)

• p. 217 middle to 229 (Markowitz, efficient frontier, mean variance)

• p. 234-239 (separation property, CAL)

Reader: Kritzman (1994)

type of potential questions: concept check question 1, 2, 3, p. 286 ff. questions 5,

11, 18
 Questions for the Next Class

Please read BKM Chapters 9-11, Roll and Ross (1995) and Kritzman (1991), and think
about the following questions:

The separation principle implies that every investor, regardless of his degree of risk
aversion, will hold the same optimal risky portfolio. What implication does this result
have on the entire market? Suppose there are I investors in the market. Each investor i
has? a risk aversion coefficient Aj , with optimal exposure to the optimal risky portfolio.

E (rp ) − rf
yi∗ = (20)
var (rp ) · Ai

In equilibrium, adding yi∗ across all investors, what do we get?, (Hint: In equilibrium,
supply equals demand, e.g., the amount of borrowing equals that of lending.)