PORTFOLIO SELECTION

Ass.Prof. Dr Vu Ngoc Xuan

National Economics University
 Portfolio
• A portfolio is a grouping of financial assets
such as stocks, bonds, cash equivalents as
well as their mutual, exchange –traded and
closed-fund counterparts.
• His choice depends upon the risk-return
characteristics of individual securities.
 Portfolio Management

Security Portfolio Portfolio Portfolio Portfolio

Analysis Analysis Selection Revision Evaluation

1. Fundamental Diversificatio 1. Formula

Analysis n 1. Markowit 1. Sharpe’s
z Model Plans index
2. Technical
Analysis 2. Sharpe’s 2. Rupee 2. Treynor’s
3. Efficient Single cost measure
Market index Averaging 3. Jenson’s
Hypothesis model measure
3. CAPM
4. APT
 Building a Portfolio

• Step-1 : Use the Markowitz portfolio selection

model to identify optimal combinations.
• Step-2 : consider borrowing and lending
possibilities.
• Step-3 : choose the final portfolio based on
your preferences for return relative to risk.
 PORTFOLIO SELECTION

• Goal: finding the optimal portfolio

• OPTIMAL PORTFOLIO: Portfolio that

provides the highest return and lowest risk.

• Method of portfolio selection: Markowitz

model
 Portfolio Selection

The proper goal of portfolio construction

would be to generate a portfolio that provides
the highest return and the lowest risk is
called Optimal portfolio.
The process of finding the optimal
portfolio is described as Portfolio selection.
 Efficient Set of Portfolio

• The concept of efficient portfolio, let us

consider various combinations of securities
and designated them as portfolio 1 to n.
• The risk of these portfolios may be estimated
by measuring the standard deviation of
portfolio returns.
 Feasible set of portfolio

• Also known as portfolio opportunity set.

• With a limited no of securities an investor

can create a very large no. of portfolios
by combining theses securities in different
proportions.
 EFFICIENT PORTFOLIO
Portfolio no Expected return Standard deviation
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9
 Compare 4 & 5 which have same
standard deviation
Pf no Expecte Standard • Higher
d return deviation
1 5.6 4.5
return?? Pf
2 7.8 5.8 no.5 gives
3 9.2 7.6 higher expected
4 10.5 8.1 return which is
5 11.7 8.1 more efficient
6 12.4 9.3
portfolio
7 13.5 9.5
Compare 7 & 8 which have same Expected
return
Pf Expected Standard
no return deviation • Lower standard
1 5.6 4.5 deviation??
2 7.8 5.8
Pf no.7 which is
more efficient
3 9.2 7.6

por tfolio
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3

7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9
 CRITERIA: EFFICIENT PROTFOLIO

• Given 2 portfolio with the same expected return, the

investor would prefer the one with the lower risk.

• Given 2 portfolio with the same risk, the investor

would prefer the one with the higher expected return.
 GRAPH
Expected
return
Y
B

F F

E A

C
X D

Standard deviation (risk)

 GRAPH
Expected
return
• Consider E & F –
Y both have same
return but E has
less risk then
portfolio E would
F F be preferred
E
X

Standard deviation (risk)

 GRAPH
Expected • Now consider C & E
return B –both have same
Y risk but portfolio E
offer more return
then portfolio E
F would preferred.

E
C
X

Standard deviation (risk)

 GRAPH
Expected
• Consider C& A – both
return B have same return
Y but C has less risk
then portfolio C
would be preferred
F

A
C
X

Standard deviation (risk)

 Result

E F Same return E has preferred C has minimum

but
E has less risk risk & B has
than F Maximum risk
C E Same risk E has preferred
But E offer more Based on these
return
we drawing
C A Same return C has preferred efficient
But frontier.
C has less risk

A B Same level of risk B has preferred

But
B has higher
 GRAPH
Expected Portfolio C has the lowest
return
risk compared to all
Y
B other por tfolios. Here
por tfolio C represents
F F the global minimum
variance por tfolio.
A
E
X C
D

Standard deviation (risk)

 GRAPH
Expected EFFICIENT
return FRONTIER
Y
B

F F

E A
C
X D

Standard deviation (risk)

 • It contain all the
B efficient portfolio.
• Lying between the
global minimum
variance portfolio
(risk) & the maximum
return.

C
 • Harry Max Markowitz (born August 24, 1927) is
an American economist.
• He is best known for his pioneering work in
Modern Portfolio Theory.
• Harry Markowitz put forward this model in
1952.
• Studied the effects of asset risk, return, Harry Max Markowitz
correlation and diversification on probable
Essinevn
est
cemof
entMpa
orrtkfoolw
io irteztuMrnos
.
del
“Do not put all your eggs in one
1. basket”
An investor has a certain amount of capital he wants to invest over a single time
horizon.
2. He can choose between different investment instruments, like stocks, bonds,
options, currency, or portfolio. The investment decision depends on the future risk
and return.
3. The decision also depends on if he or she wants to either maximize the yield or
Essence of Markowitz Model
1. Markowitz model assists in the selection of the most efficient by analysing
various possible portfolios of the given securities.
2. By choosing securities that do not 'move' exactly together, the HM model
shows investors how to reduce their risk.
3. The HM model is also called Mean-Variance Model due to the fact that it is
based on expected returns (mean) and the standard deviation (variance) of
the various portfolios.

Diversification and Portfolio Risk

p p the standarddeviation

SR: Systematic Risk

Portfolio Risk

USR: Unsystematic Risk

S
R
US Total
R Risk
5 10 15 20

Number of Shares
• An investor has a certain amount of capital he wants to
invest over a single time horizon.
• He can choose between different investment instruments,
like stocks, bonds, options, currency, or portfolio.
• The investment decision depends on the future risk and
return.
• The decision also depends on if he or she wants to either
maximize the yield or minimize the risk.
• The investor is only willing to accept a higher risk if he or
she gets a higher expected return.
Tools for selection of portfolio- Markowitz Model
1. Expected return (Mean)
Mean and average to refer to the sum of all values divided
by the total number of values.
The mean is the usual average, so:
(13 + 18 + 13 + 14 + 13 + 16 + 14 + 21 + 13) ÷ 9 = 15
n 1. Expected return (Mean)

Expected Return (ER)   Wi  E ( Ri )

2. Standard deviation (variance)
3. Co-efficient of Correlation

Where: i 1
ER = the expected return on Portfolio
E(Ri) = the estimated return in scenario i
Wi= weight of security i occurring in the port folio

Rp=R1W1+R2W2………..
n Where: Rp = the expected return on Portfolio
R1 = the estimated return in Security 1
R2 = the estimated return in Security 1
W1= Proportion of security 1 occurring in the port folio
W2= Proportion of security 1 occurring in the port folio
Tools for selection of portfolio- Markowitz Model
n _ _
2. Variance & Co-variance Variance   Prob i ( RA  RA ) 2  (R B - RB ) 2
i 1

The variance is a measure of how far a set of numbers is

spread out. It is one of several descriptors of a probability
distribution, describing how far the numbers lie from the mean
(expected value).
Co-variance
1. Covariance reflects the degree to which the returns of the two securities vary or
change together.
2. A positive covariance means that the returns of the two securities move in the
same direction.
3. A negative covariance implies that the returns of the two securities move in
opposite direction.

n _ _ _
1
COV AB 
N
 Prob ( R
i 1
i A  RA )(R B - RB ) RA =Expected Return on security A
_

CovAB=Covariance between security A and B

RB =Expected Return on security B
RA=Return on security A
RB=Return on Security B
Tools for selection of portfolio- Markowitz Model
3. Co-efficient of Correlation
Covariance & Correlation are conceptually analogous in the
sense that of them reflect the degree of Variation between two
variables.
1. The Correlation coefficient is simply covariance divided the product of standard
deviations.
2. The correlation coefficient can vary between -1.0 and +1.0

-1.0 0 1.0
Perfectly negative No Perfectly Positive
Opposite direction Correlatio Opposite direction
n
Cov AB
rAB  
 
Standard deviation of A and
B security
A B
CovAB=Covariance between security A and B
rAB=Co-efficient correlation between security A and B
Returns
If returns of A and B are
%
20% perfectly negatively correlated,
a two-asset portfolio made up
of equal parts of Stock A and B
would be riskless. There would
15% be no variability
of the portfolios returns over
time.

10%

Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

CHAPTER 8 – Risk, Return and Portfolio Theory

Returns
If returns of A and B are
%
20% perfectly positively correlated,
a two-asset portfolio made up
of equal parts of Stock A and B
would be risky. There would be
15% no diversification (reduction of
portfolio risk).

10%
Returns on Stock A
Returns on Stock B
5%
Returns on Portfolio

Time 0 1 2

CHAPTER 8 – Risk, Return and Portfolio Theory

• The riskiness of a portfolio that is made of different risky assets is a
function of three different factors:
• the riskiness of the individual assets that make up the portfolio
• the relative weights of the assets in the portfolio
• the degree of variation of returns of the assets making up the portfolio
• The standard deviation of a two-asset portfolio may be measured
using the Markowitz model:
 p   w   w  2wA wB rAB A B
2
A
2
A
2
B
2
B

A
The data requirements for a three-asset portfolio grows dramatically if we are
using Markowitz Portfolio selection formulae.
ρa,b ρa,c
B C
ρb,c
We need 3 (three) correlation coefficients between A and B; A and C; and B
and C.

 p   A2 wA2   B2 wB2   C2 wC2  2wA wB rA, B A B  2wB wC rB ,C B C  2wA wC rA,C A C

• The optimal portfolio concept falls under the modern
portfolio theory. The theory assumes that investors
fanatically try to minimize risk while striving for the
highest return possible.
• WHAT IS A RISK FREE ASSET?

• DEFINITION: an asset whose terminal value is

certain
• variance of returns = 0,
• covariance with other assets = 0

If
i  0
then  ij   ij i j
0
• INVESTING IN BOTH: RISKFREE AND RISKY ASSET
PORTFOLIOS X1 X2 ri di

A .00 1.0 4 0
B .25 .75 7.05 3.02
C .50 .50 10.10 6.04
D .75 .25 13.15 9.06
E 1.00 .00 16.20 12.08

32
• RISKY AND RISK FREE PORTFOLIOS
rP E
D
C
B
A
rRF = 4% P
0

33
• IN RISKY AND RISK FREE PORTFOLIOS
• All portfolios lie on a straight line
• Any combination of the two assets lies on a straight line
connecting the risk free asset and the efficient set of the risky
assets
rP

• The Connection to the Risky

Portfolio
0
P
• The Connection to the Risky Portfolio
rP
S

P
0
P

35
36