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OBJECTIVES
❖ After you read this chapter, you should be able to answer the following questions:
❖ • What do we mean by risk aversion, and what evidence indicates that investors are
generally risk averse?
❖ • What are the basic assumptions behind the Markowitz portfolio theory?
CHAPTER 7 ❖ • What do we mean by risk, and what are some measures of risk used in
investments?
❖ • How do we compute the expected rate of return for a portfolio of assets?
❖ • How do we compute the standard deviation of rates of return for an individual risky
asset?
❖ • What do we mean by the covariance between rates of return, and how is it
computed?
Lecturer: Dr. Tien Trung, Nguyen Lecturer: Dr. Tien Trung, Nguyen 2

OBJECTIVES
❖ • What is the relationship between covariance and correlation?
❖ • What is the formula for the standard deviation for a portfolio of risky assets, and
how does it differ from the standard deviation of an individual risky asset?
❖ • Given the formula for the standard deviation of a portfolio, how do we diversify a
portfolio? PART 1
❖ • What happens to the portfolio standard deviation when the correlation between the
assets changes?
❖ • What is the risk–return efficient frontier of risky assets?
❖ • Why do different investors select different portfolios from the set of portfolios on
the efficient frontier?
❖ • What determines which portfolio an investor selects on the efficient frontier?
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SOME BACKGROUND ASSUMPTIONS 1 Risk Aversion

❖ We begin by clarifying some general assumptions of portfolio theory. This includes not only ❖ Portfolio theory also assumes that investors are basically risk averse,
what we mean by an optimum portfolio but also what we mean by the terms risk aversion and
meaning that, given a choice between two assets with equal rates of
risk.
return, they will select the asset with the lower level of risk.
❖ One basic assumption of portfolio theory is that investors want to maximize the returns from
the total set of investments for a given level of risk. ❖ Most investors are risk averse is that they purchase various types of
❖ First, your portfolio should include all of your assets and liabilities, not only your marketable insurance, including life insurance, car insurance, and health insurance
securities but also your car, house, and less marketable investments such as coins, stamps,
❖ Different investors have difference risk averse level.
art, antiques, and furniture.
❖ The full spectrum of investments must be considered because the returns from all these ❖ The fact is, not everybody buys insurance for everything. Some people
investments interact, and this relationship among the returns for assets in the portfolio is have no insurance against anything, either by choice or because they
important. cannot afford it
❖ Hence, a good portfolio is not simply a collection of individually good investments.

Lecturer: Dr. Tien Trung, Nguyen 5 Lecturer: Dr. Tien Trung, Nguyen 6

1 Risk Aversion 2 Definition of Risk

❖ Some individuals buy insurance related to some risks such as auto
❖Risk: the uncertainty of future outcomes
accidents or illness, but they also buy lottery tickets and gamble at race
tracks or in casinos, where it is known that the expected returns are
negative (which implies that participants are willing to pay for the
excitement of the risk involved)
❖ The case for people who like to gamble for small amounts (in lotteries or
slot machines) but buy insurance to protect themselves against large losses
such as fire or accidents
❖ Risk averse: The assumption about investors that they will choose the least
risky alternative, all else being equal.

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MARKOWITZ PORTFOLIO THEORY

❖ To build a portfolio model, however, investors had to quantify their risk variable.
❖ The basic portfolio model was developed by Harry Markowitz (1952, 1959), who
derived the expected rate of return for a portfolio of assets and an expected risk
measure.
PART II ❖ Markowitz showed that the variance of the rate of return was a meaningful measure
of portfolio risk under a reasonable set of assumptions.
❖ More important, he derived the formula for computing the variance of a portfolio. This
portfolio variance formula not only indicated the importance of diversifying
investments to reduce the total risk of a portfolio but also showed how to effectively
diversify

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1 Alternative Measures of Risk

❖ The Markowitz model is based on several assumptions regarding investor behavior: ❖ One of the best-known measures of risk is the variance, or standard
❖ 1. Investors consider each investment alternative as being represented by a probability distribution of
deviation of expected returns.
expected returns over some holding period.
❖ 2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing ❖ It is a statistical measure of the dispersion of returns around the expected
marginal utility of wealth. value whereby a larger variance or standard deviation indicates greater
❖ 3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
dispersion
❖ 4. Investors base decisions solely on expected return and risk, so their utility curves are a function of
expected return and the expected variance (or standard deviation) of returns only. ❖ the more dispersed the expected returns, the greater the uncertainty of
❖ 5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of future returns
expected return, investors prefer less risk to more risk.
❖ Another measure of risk is the range of returns. It is assumed that a larger
❖ Under these assumptions, a single asset or portfolio of assets is considered to be efficient if no other
asset or portfolio of assets offers higher expected return with the same (or lower) risk or lower risk with range of expected returns, from the lowest to the highest, means greater
the same (or higher) expected return uncertainty regarding future expected returns
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1 Alternative Measures of Risk 2 Expected Rates of Return

❖ Some observers believe that investors should be concerned only with
returns below expectations, which means only deviations below the mean
value.
❖ A measure that only considers deviations below the mean is the semi-
variance.
❖ An extension of the semi-variance measure only computes expected
returns below zero (that is, negative returns), or returns below the returns
of some specific asset such as T-bills, the rate of inflation, or a benchmark.
❖ These measures of risk implicitly assume that investors want to minimize
the damage (regret) from returns less than some target rate.
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2 Expected Rates of Return 2 Expected Rates of Return

❖We can generalize this computation of the expected return for
the portfolio E(Rport) as follows:

where:
❖wi = the weight of an individual asset in the portfolio, or the
percent of the portfolio in Asset i
❖Ri = the expected rate of return for Asset i
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3 Variance (Standard Deviation) of Returns for an 3 Variance (Standard Deviation) of Returns for an
Individual Investment Individual Investment
❖Variance: The larger the variance for an expected rate of return,
❖Standard Deviation: The standard deviation is the square root of
the greater the dispersion of expected returns and the greater the
the variance:
uncertainty, or risk, of the investment.

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3 Variance (Standard Deviation) of Returns for an 4. Variance (Standard Deviation) of Returns for a
Individual Investment Portfolio
❖Covariance of Returns:
❖Covariance is a measure of the degree to which two
variables move together relative to their individual mean
values over time.
❖In portfolio analysis, we usually are concerned with the
covariance of rates of return rather than prices or some
other variable
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4. Variance (Standard Deviation) of Returns for a 4. Variance (Standard Deviation) of Returns for a
Portfolio Portfolio
❖A positive covariance means that the rates of return for two ❖For two assets, i and j, we define the covariance of rates of
investments tend to move in the same direction relative to their return as
individual means during the same time period.
𝐶𝑜𝑣𝑖𝑗 = 𝐸 𝑅𝑖 − 𝐸 𝑅𝑖 𝑅𝑗 − 𝐸 𝑅𝑗
❖A negative covariance indicates that the rates of return for two
❖returns (𝑅𝑖 )
investments tend to move in different directions relative to their
means during specified time intervals over time. 𝐸𝑉 − 𝐵𝑉 + 𝐶𝐹
𝑅𝑖 =
❖The magnitude of the covariance depends on the variances of the 𝐵𝑉
individual return series, as well as on the relationship between the ❖where EV is ending value, BV is beginning value, and CF is the
series cash flow during the period.
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4. Variance (Standard Deviation) of Returns for a 4. Variance (Standard Deviation) of Returns for a
Portfolio Portfolio

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4. Variance (Standard Deviation) of Returns for a

Portfolio

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❖ Interpretation of a number such as −5.06 is difficult; is it high or low for covariance?

❖ We know the relationship between the two assets is clearly negative, but it is not
possible to be more specific.
❖ Exhibit 7.8 contains a scatterplot with paired values of Rit and Rjt plotted against each
other.
❖ This plot demonstrates the linear nature and strength of the relationship
❖ It is not surprising that the relationship during 2010 was a fairly strong negative value
since during nine of the twelve months the two assets moved counter to each other
as shown in Exhibit 7.7.
❖ As a result, the overall covariance was a definite negative value.

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4. Variance (Standard Deviation) of Returns for a 4. Variance (Standard Deviation) of Returns for a
Portfolio Portfolio
❖ The standard deviation for each index is the square root of the variance for each, as −𝟏 < 𝝆 <𝟏
𝑖,𝑗
follows:
❖ As noted, a correlation of +1.0 indicates perfect positive correlation, and a
value of −1.0 means that the returns moved in completely opposite
directions.
❖ As expected, the stock index series is more volatile than the Treasury bond series.
Thus, based on the covariance between the two indexes and the individual standard ❖ A value of zero means that the returns had no linear relationship, that is,
deviations, we can calculate the correlation coefficient between returns for common they were uncorrelated statistically.
stocks and Treasury bonds during 2010: ❖ That does not mean that they are independent. The value of rij = −0.746
is significantly different from zero.
❖ This significant negative correlation is not unusual for stocks versus bonds
during a short time period such as one year.
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Correlation coefficient Correlation coefficient

𝝆 𝑖,𝑗 = 0 : the returns had no linear relationship
𝝆 𝑖,𝑗 = 0 : the returns moved in completely opposite directions

33 34
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Correlation coefficient 5. Standard Deviation of a Portfolio

𝝆 𝑖,𝑗 = 0 : indicates perfect positive correlation, the returns moved in the ❖Portfolio Standard Deviation Formula: Markowitz (1959) derived the
same directions general formula for the standard deviation of a portfolio as follows:

35
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5. Standard Deviation of a Portfolio 6. Impact of a New Security in a Portfolio

❖ This formula indicates that the standard deviation for a portfolio of assets ❖ What happens to the portfolio’s standard deviation when we add a new security to
is a function of the weighted average of the individual variances (where the such a portfolio?

weights are squared), plus the weighted covariances between all the assets ❖ The first is the asset’s own variance of returns

in the portfolio. ❖ The second is the covariance between the returns of this new asset and the returns
of every other asset that is already in the portfolio.
❖ The very important point is that the standard deviation for a portfolio of
❖ The relative weight of these numerous covariances is substantially greater than the
assets encompasses not only the variances of the individual assets but also
asset’s unique variance; the more assets in the portfolio, the more this is true.
includes the covariances between all the pairs of individual assets in the
❖ This means that the important factor to consider when adding an investment to a
portfolio.
portfolio that contains a number of other investments is not the new security’s own
❖ Further, it can be shown that, in a portfolio with a large number of variance but the average covariance of this asset with all other investments in the
securities, this formula reduces to the sum of the weighted covariances. portfolio

Lecturer: Dr. Tien Trung, Nguyen 37 Lecturer: Dr. Tien Trung, Nguyen 38

6.1 Portfolio Standard Deviation Calculation 6.2 Equal Risk and Return — Changing Correlations
❖Because of the assumptions used in developing the Markowitz ❖Consider first the case in which both assets have the same expected
return and expected standard deviation of return. As an example, let’s
portfolio model, any asset or portfolio of assets can be
assume
described by two characteristics: the expected rate of return
and the expected standard deviation of returns.
❖Therefore, the following demonstrations can be applied to two ❖We also assume that the two assets have equal weights in the
individual assets, two portfolios of assets, or two asset classes portfolio (w1 = 0.50; w2 = 0.50). Therefore, the only value that
with the indicated rate of return-standard deviation changes in each example is the correlation between the returns for
characteristics and correlation coefficients. the two assets

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6.2 Equal Risk and Return — Changing Correlations 6.2 Equal Risk and Return — Changing Correlations

❖Now consider the following five correlation coefficients and

the covariances they yield. Since Covij = rijσiσj, the
covariance will be equal to r1,2(0.10)(0.10) because the
standard deviation of both assets is 0.10

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6.2 Equal Risk and Return — Changing Correlations

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6.3 Combining Stocks with Different Returns and Risk

❖ We now consider two assets (or portfolios) with different expected rates of
return and individual standard deviations.
❖ We will use the previous set of correlation coefficients, but we must
recalculate the covariances because this time the standard deviations of the
assets are different.

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6.3 Combining Stocks with Different Returns and Risk 6.3 Combining Stocks with Different Returns and Risk

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6.3 Combining Stocks with Different Returns and Risk 6.4 Constant Correlation with Changing Weights
❖If we changed the weights of the two assets while holding the
correlation coefficient constant, we would derive a set of
combinations that trace an ellipse starting at Asset 2, going through
the 0.50−0.50 point, and ending at Asset 1.
❖We can demonstrate this with Case c, in which the correlation
coefficient of zero eases the computations.
❖We begin with 100 percent in Asset 2 (Case f) and change the
weights as follows, ending with 100 percent in Asset 1 (Case l):

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6.4 Constant Correlation with Changing Weights 6.4 Constant Correlation with Changing Weights

We already know the standard deviations (σ) for portfolios f and i

(only one asset) and portfolio (i). In Cases g, h, j, and k, the
standard deviations are:
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6.4 Constant Correlation with Changing Weights

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❖ As shown in Exhibit 7.13, assuming the normal risk–return relationship where assets
❖Exhibit 7.13 also shows that the curvature in the graph
with higher risk (larger standard deviation of returns) provide high rates of return, it
is possible for a conservative investor to experience both lower risk and higher return depends on the correlation between the two assets or
by diversifying into a higher risk-higher return asset, assuming that the correlation portfolios. With rij = +1.00, the combinations lie along a
between the two assets is fairly low. Exhibit 7.13 shows that, in the case where we
used the correlation of zero (0.00), the low risk investor at Point L—who would straight line between the two assets. When rij = 0.50, the
receive a return of 10 percent and risk of 7 percent—could, by investing in portfolio j, curve is to the right of the rij = 0.00 curve; when rij = −0.50,
increase his/her return to 14 percent and experience a decline in risk to 5.8 percent
by investing (diversifying) 40 percent of the portfolio in riskier Asset 2. As noted, the the curve is to the left. Finally, when rij = −1.00, the graph
benefits of diversification are critically dependent on the correlation between assets. would be two straight lines that would touch at the vertical line
The exhibit shows that there is even some benefit when the correlation is 0.50 rather
than zero.
(zero risk) with some combination.
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Appendix 7A and 7B

❖See Appendix 7A and 7B

❖It is possible to solve for the specified set of weights that
would give a portfolio with zero risk. In this case, it is w1
= 0.412 and w2 = 0.588, which implies an E(R) of 0.1588.

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PART XXXX

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❖In this example, we will combine three asset classes we have

been discussing: stocks, bonds, and cash equivalents

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Estimation Issues
❖ It is important to keep in mind that the results of this portfolio asset allocation
depend on the accuracy of the statistical inputs.
❖ In the current instance, this means that for every asset (or asset class) being
considered for inclusion in the portfolio, we must estimate its expected returns and
standard deviation.
❖ We must also estimate the correlation coefficient among the entire set of assets.
❖ The number of correlation estimates can be significant—for example, for a portfolio of
100 securities, the number correlation estimates is 4,950 (that is, 99 + 98 + 97 + …).
The potential source of error that arises from these approximations is referred to as
estimation risk.

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Estimation Issues Estimation Issues

❖ If all the securities are similarly related to the market and a slope coefficient 𝑏𝑖 is
❖We can reduce the number of correlation coefficients that must
derived for each one, it can be shown that the correlation coefficient between two
be estimated by assuming that stock returns can be described securities 𝑖 and 𝑗 is

by the relationship of each stock to a market index—that is, a

single index market model, as follows:
𝑅𝑖 = 𝑎𝑖 + 𝑏𝑖𝑅𝑚 + 𝜀𝑖 σ2m = the variance of returns for the aggregate stock market

bi = the slope coefficient that relates the returns for Security i to ❖ This reduces the number of estimates from 4,950 to 100—that is, once we have
derived a slope estimate bi for each security, we can compute the correlation
the returns for the aggregate stock market estimates. Notably, this assumes that the single index market model provides a good
estimate of security returns
Rm = the returns for the aggregate stock market
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The Efficient Frontier

❖If we examined different two-asset combinations and derived
the curves assuming all the possible weights, we would have a
graph like that in Exhibit 7.14.
PART X ❖The envelope curve that contains the best of all these possible
combinations is referred to as the efficient frontier.
❖Specifically, the efficient frontier represents that set of
portfolios that has the maximum rate of return for every given
level of risk or the minimum risk for every level of return
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The Efficient Frontier

❖ Every portfolio that lies on the efficient frontier has either a higher rate of return for
equal risk or lower risk for an equal rate of return than some portfolio beneath the
frontier.
❖ Thus, we would say that Portfolio A in Exhibit 7.15 dominates Portfolio C because it
has an equal rate of return but substantially less risk. Similarly, Portfolio B dominates
Portfolio C because it has equal risk but a higher expected rate of return.
❖ Because of the benefits of diversification among imperfectly correlated assets, we
would expect the efficient frontier to be made up of portfolios of investments rather
than individual securities.
❖ Two possible exceptions arise at the end points, which represent the asset with the
highest return and the asset with the lowest risk.

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The Efficient Frontier and Investor Utility

❖The curve in Exhibit 7.15 shows that the slope of the efficient
frontier curve decreases steadily as we move upward. This
implies that adding equal increments of risk as we move up
the efficient frontier gives diminishing increments of expected
return. To evaluate this situation, we calculate the slope of the
efficient frontier as follows:

Δ𝐸 𝑅𝑝𝑜𝑟𝑡
Δ𝐸 𝜎𝑝𝑜𝑟𝑡

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❖ An individual investor’s utility curves specify the trade-offs he or she is willing to make
❖The optimal portfolio is the efficient portfolio that has the
between expected return and risk. In conjunction with the efficient frontier, these utility curves
determine which particular portfolio on the efficient frontier best suits an individual investor. highest utility for a given investor. It lies at the point of
❖ Two investors will choose the same portfolio from the efficient set only if their utility curves tangency between the efficient frontier and the U1 curve with
are identical.
the highest possible utility.
❖ Exhibit 7.16 shows two sets of utility curves along with an efficient frontier of investments.
The curves labeled U1, U2, and U3 are for a strongly risk-averse investor. ❖A conservative investor’s highest utility is at Point X in Exhibit
❖ These utility curves are quite steep, indicating that the investor will not tolerate much
7.16, where the U2 curve just touches the efficient frontier. A
additional risk to obtain additional returns.
❖ The investor is equally disposed toward any E(R), E(σ) combinations along the specific utility less risk-averse investor’s highest utility occurs at Point Y,
curve U1. The curves labeled (U3′ , U2′ , U1′ ) characterize a less risk-averse investor. Such an which represents a portfolio on the efficient frontier with
investor is willing to tolerate a bit more risk to get a higher expected return
higher expected returns and higher risk than the portfolio at X
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The End

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