Portfolio Risk and Return:

Part I

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INTRODUCTION
• Constructing an optimal portfolio is a crucial goal for investors.
• The process involves evaluating the risk and return of individual assets, creating various portfolios, and
selecting the most efficient ones.
• Key factors considered in portfolio construction are the risk and return of individual assets and the
correlations among them.
• Understanding the investor's risk profile is essential for tailoring the optimal portfolio to their
preferences.
• Different types of investors have varying risk-return preferences.
• The process involves formalizing these preferences using concepts like indifference curves.
• Portfolio risk is a critical aspect, and its calculation and diversification are discussed.
• The reading outlines how to create numerous risky portfolios and narrow down choices to an efficient
set before identifying the optimal one.
• The final step involves combining the chosen risky portfolio with the investor's risk preferences to
determine their optimal portfolio.
• The reading concludes with a summary of the key points and concepts discussed.
Return on Financial Assets

Total Return

Periodic Capital Gain or

Income Loss

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Returns

❑ HPR ❑ Geometric Mean

❑ Arithmetic Mean ❑ Pre-tax and after tax returns

❑ Annualized return ❑ Real returns

❑ Portfolio return ❑ Leveraged returns

❑ Gross and Net Return

➢ Gross – Return earned by an asset
manager

➢ Net – Less the fees and other

expenses (actual returns to the
investor)

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HISTORICAL RETURN AND RISK
• Historical return and expected return are distinct concepts often confused.
• Historical return refers to past earnings, while expected return is what investors anticipate in the
future.
• Expected return is calculated based on the real risk-free interest rate (rrF), expected inflation (E(π)),
and expected risk premium (E(RP)).
• Expected return is generally positive and is calculated using the formula:
1 + E(R) = (1 + rrF) × [1 + E(π)] × [1 + E(RP)].
• Historical mean return is the actual return earned by an investor from a specific asset in the past.
• Because investments are risky, historical and expected returns are unlikely to be equal for a given time
period.
HISTORICAL RETURN AND RISK
• Over a very long period, historical returns may approach expected returns, but the exact duration is
unknown.
• For practical purposes, historical mean return is often assumed to represent expected return.
• This assumption may not always be accurate, as historical returns can vary significantly from expected
returns.
• Exhibit 1 illustrates the variation in historical returns for large US company stocks over different time
periods.
• While shorter-term returns may differ from expected returns, longer-term returns may align more
closely with expected returns.
• The use of historical mean returns as a proxy for expected returns is a common but uncertain practice.
HISTORICAL RETURN AND RISK
Real Returns of Major US Asset Classes
• Annual inflation rates have fluctuated significantly over the past 92 years, ranging from -10.30 percent
to +13.31 percent.
• Comparing investment returns across different time periods using nominal returns can be misleading,
so it's better to rely on real returns.
• Real returns on stocks, bonds, and T-bills have been reported since 1900.
• Exhibit 2 illustrates the substantial difference in growth among these asset categories: $1 invested in
stocks grew to $1,654, in bonds to only $10.20, and in T-bills to $2.60 over time.
• Despite the seemingly modest difference in annual real returns (6.5 percent for equities compared to
2.0 percent for bonds), the substantial growth difference arises from compounding over a 118-year
period.
• Exhibit 3 provides real rates of return, with a focus on the geometric mean as a more accurate
representation of returns over multiple holding periods.
• The analysis reveals that real returns for stocks consistently outperform those for bonds.
Real Returns of Major US Asset Classes
Nominal Returns and Real Returns

Assume the bank pays interest of 5% per year on the funds in savings account. If the
inflation rate is currently 3% per year, the real return on your savings is 2%.
In other words, even though the nominal rate of return on savings is 5%, the real rate
of return is only 2%, which means the real value of your savings only increases by 2%
during a one-year period.
Assume your bank pays you interest of 5% per year on the funds in your savings
account. If the inflation rate is currently 3% per year, the real return on your savings is
2%. In other words, even though the nominal rate of return on your savings is 5%, the
real rate of return is only 2%, which means the real value of your savings only
increases by 2% during a one-year period.

A real rate of return is the annual percentage return

realized on an investment, which is adjusted for changes
in prices due to inflation or other external effects. This
A nominal rate of return is the amount of money generated by method expresses the nominal rate of return in real
an investment before factoring in expenses such as taxes, terms, which keeps the purchasing power of a given
investment fees and inflation. level of capital constant over time.

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Risk of Major Asset Classes
• Exhibit 1 (1926–2017) - Risk for Major Asset Classes in the United States:
• US small company stocks had the highest risk at 31.7 percent.
• US large company stocks followed with a risk of 19.8 percent.
• Long-term government bonds had a risk of 9.9 percent.
• Long-term corporate bonds had a risk of 8.3 percent.
• Treasury bills had the lowest risk at approximately 3.1 percent.
• Exhibit 3 (1900–2017) - Risk for Major Asset Classes Worldwide: 6. World stocks had a risk of 17.4
percent.
• World bonds had a risk of 11.0 percent.
• The world excluding the United States had risks of 18.9 percent for stocks and 14.4 percent for bonds.
• Diversification Effect: 9. Diversification is evident when comparing world risk to US risk and world
excluding US risk.
• US stocks had a risk of 20.0 percent, while world excluding US stocks had a risk of 18.9 percent.
• However, when combined, the risk for world stocks was reduced to only 17.4 percent, illustrating the
benefits of diversifying across different regions and asset classes.
Risk–Return Trade-of
Asset Classes in the United Risk and Return for Stocks vs.
Risk-Return Trade-Off:
States: Bonds:
• The risk-return trade-off • Small company stocks had • Stocks exhibited higher risk and
signifies the positive higher risk and return return compared to bonds in
relationship between expected compared to large company the United States, worldwide,
risk and return in financial stocks. and globally excluding the
markets. • Large company stocks had United States.
• It implies that achieving higher higher returns and risk than
returns typically requires long-term corporate bonds and
accepting higher levels of risk. government bonds.
• Bonds had higher returns and
risk than Treasury bills.
• Long-term government bonds
had higher total risk than long-
term corporate bonds, despite
slightly higher returns.
Risk–Return Trade-of
Cumulative Returns in Real
Risk Premium: Long-Term Perspective:
Terms:
• The risk premium is the extra • T-bills had the least volatile • Over extended periods, it
return investors can expect cumulative returns, with an becomes evident that higher
after adjusting for the risk- average real return of 0.8 risk is associated with higher
free interest rate. percent per year, adjusted for mean returns, supporting the
• Higher-risk investments yield inflation. notion that market prices
higher nominal and real risk • Bonds were more volatile reward risk-averse investors
premiums. than T-bills but less so than with higher returns over
• Equities outperformed bonds stocks. time.
due to their higher risk, • Stocks, including dividends
leading to higher returns for and capital gains, had the
equity investors. highest total return, growing
$1 to $1,654 since 1900, with
an annualized real return of
6.5 percent.
OTHER INVESTMENT CHARACTERISTICS
Distributional Characteristics
• Mean and median are equal.
• Defined by two parameters: mean and variance.
Normal Distribution • Symmetric around the mean.
Characteristics: • 68% of observations within ±1σ of the mean.
• 95% of observations within ±2σ of the mean.
• 99% of observations within ±3σ of the mean.

• Returns are not normally distributed.

Inappropriate for • Deviations occur due to skewness (lack of symmetry around the mean).
Evaluating Investments: • Deviations also due to kurtosis or "fat tails" (higher probability of
extreme events).

Skewed Returns: • Returns do not exhibit symmetry around the mean.

• Indicates a higher likelihood of extreme events than a normal

Kurtosis or Fat Tails:
distribution suggests.
OTHER INVESTMENT CHARACTERISTICS
Skewness
• Skewness in finance refers to the asymmetry of the
return distribution, indicating that returns are not
evenly distributed around the mean.
• Left skewness (negatively skewed) occurs when the
majority of data points are concentrated to the right
of the mean, while right skewness (positively
skewed) occurs when they are concentrated to the
left.
• Negative skewness is represented in Exhibit 4,
illustrating the left-leaning distribution, and positive
skewness is similarly depicted.
• Exhibit 5 provides an example of negative skewness
in stock returns, displaying a histogram of US large
company stock returns from 1926 to 2017.
OTHER INVESTMENT CHARACTERISTICS
OTHER INVESTMENT CHARACTERISTICS
Kurtosis

• Kurtosis refers to the presence of fat tails or a higher likelihood of extreme returns in a financial
asset.
• It increases the asset's risk beyond what is captured in a mean-variance framework.
• Investors assess kurtosis effects using statistical techniques like value at risk (VaR) and conditional tail
expectations.
• The underestimation of extreme events' probability and magnitude contributed significantly to the
2008 financial crisis.
• Exhibit 5 illustrates the higher likelihood of extreme negative outcomes in stock returns.
OTHER INVESTMENT CHARACTERISTICS
Investment Features

Market characteristics: refers to effects of liquidity, information availability, firm

characteristics, and other external factors that affect the return of an
investment. Out of these, Liquidity is one of the most significant factors as it
affects the price and bid-ask spread of an investment to a large extent.
When two investments have the
same expected return, investors
prefer the lower risk investment

When two investments have the

same risk, investors prefer the
investment with the higher
expected return

Risk aversion means investors

prefer less risk to more risk
Risk Aversion ≠ Minimize Risk.

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Concept of Risk Aversion

Risk Tolerance: willingness of the investor to

tolerate risk to achieve and investment goal. isk
tolerance is the degree of variability in investment
Risk Aversion: Minimize risk returns that an investor is willing to withstand.
for the same amount of
return or Maximize return
for the same amount of risk.

Risk Seeking: Investor

chooses to gamble

Risk Neutral: investor is indifferent to risk

when making an investment decision. He
is the middle of the risk spectrum,
represented by risk-seeking investors at
one end and risk-averse investors at the
other

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Indifference Curves for Various Investors

Indifference curves for various risk averse investors

Moderate Risk
High Risk Aversion
Aversion
Low Risk
Aversion
Expected Return

Risk Neutral

Risk Seeker

Standard Deviation

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Indifference Curves for Various Investors

Indifference Curves for Various Types of Investors

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APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
• Utility theory and risk aversion can be applied to a portfolio of two assets: a risk-free asset with zero
risk and return Rf, and a risky asset with risk σi and expected return E(Ri).
• The portfolio's expected return (E(Rp)) and risk (σp) can be calculated using weights (w1) for the risk-
free and risky assets.
• The formula for E(Rp) is E(Rp) = w1Rf + (1 - w1)E(Ri).
• The formula for σp is σp = (1 - w1)σi.
• The capital allocation line represents portfolios available to an investor and is formed by varying w1
from 0 to 100 percent.
• The equation for the capital allocation line is E(Rp) = Rf + (E(Ri) - Rf)σiσp.
• The capital allocation line has an intercept of Rf and a slope of (E(Ri) - Rf)σi, which is the market price
of risk, representing the additional required return for each increment in risk.
APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
• The capital allocation line is a straight line due to the linear nature of the equation.
• It starts with the risk-free asset, offering zero risk and a return of Rf.
• The portfolio can consist of only the risk-free asset at this point.
• Investing 100 percent in the portfolio of risky assets yields a return of E(Ri) with risk σi.
• Moving along the line, investors can borrow at the risk-free rate to invest in risky assets.
• Borrowing 50 percent at the risk-free rate results in w1 = -0.50, with 150 percent in the risky asset,
providing a return of 1.50E(Ri) - 0.50Rf, which is higher than E(Ri).
• The capital allocation line represents various risk-return pairs or portfolios.
• The optimal portfolio choice for an investor depends on combining indifference curves from utility
theory with the capital allocation line from portfolio theory.
• Utility theory provides the utility function or indifference curves for individual preferences.
• Overlaying an individual's indifference curves on the capital allocation line helps determine the
optimal portfolio for that investor.
APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
• The capital allocation line represents feasible portfolios.
• Points below the capital allocation line are attainable but not preferred, as higher returns are
available with the same risk along the line.
• Points above the line are desirable but not achievable with available assets.
• Three indifference curves (1, 2, and 3) represent an individual's utility.
• Curve 1 is above the capital allocation line, Curve 2 is tangential, and Curve 3 intersects at two
points.
• Curve 1 has the highest utility, Curve 3 has the lowest utility.
• Investors prefer Curve 2 as it's tangential to the capital allocation line.
• The optimal portfolio is where the indifference curve touches the capital allocation line.
• It maximizes return per unit of risk and provides the highest utility for the investor.
• Different investors with varying risk aversion coefficients will have different optimal portfolios.
• A higher risk aversion coefficient indicates a lower tolerance for risk and vice versa.
• The slope of an indifference curve reflects the investor's willingness to accept risk for incremental
return.
APPLICATION OF UTILITY THEORY TO PORTFOLIO
SELECTION
• Exhibit 11 shows optimal portfolios for
two investors, Kelly and Jane, with
different risk aversion coefficients (2 and
4, respectively).
• Kelly's optimal portfolio (Point k) is
different from Jane's (Point j) due to their
differing risk preferences.
• Jane's curve has a steeper slope,
indicating her greater need for higher
returns to accept additional risk
compared to Kelly.
PORTFOLIO RISK & PORTFOLIO OF TWO RISKY ASSETS
Portfolio of Two Risky Assets
Portfolio Return
• Portfolio return is calculated as a weighted average of individual asset returns in the portfolio.
• Each asset's contribution to the portfolio return is determined by multiplying its return by its weight
in the portfolio.
• The sum of the weights of all assets in the portfolio must equal 1 to represent 100% of the
investment.
• This calculation is based on single-period returns with constant weights and no cash flows during the
period.
• For a portfolio with two assets, the return can be calculated using the formula: Rp = w1R1 + (1 −
w1)R2, where Rp is the portfolio return, w1 and w2 are the weights of the two assets, and R1, R2 are
their respective returns.
PORTFOLIO RISK & PORTFOLIO OF TWO RISKY ASSETS
Portfolio Risk
General Simplified Two-Asset
Portfolio Portfolio
Portfolio Portfolio Portfolio
Variance Standard
Variance Variance Variance
Formula: Deviation:
Formula: Formula: Formula:
• Portfolio variance • σP^2 = Var(RP) = • σP^2 = ∑wiwjCov(Ri, • For a two-asset • The standard
(σP^2) represents Var(∑wiRi) for N Rj) for N securities. portfolio, the deviation (σP) of a
the risk of a securities. • Cov(Ri, Rj) is the variance simplifies portfolio is the
portfolio. covariance of to: square root of its
• It can be calculated returns between • σP^2 = w1^2σ1^2 + variance.
as the weighted sum securities Ri and Rj. w2^2σ2^2 + • σP = √(w1^2σ1^2 +
of the variances of • It can be expressed 2w1w2Cov(R1, R2) w2^2σ2^2 +
individual securities, as ρijσiσj, where ρij or σP^2 = w1^2σ1^2 2w1w2Cov(R1, R2))
considering their is the correlation + w2^2σ2^2 + or σP = √(w1^2σ1^2
correlations. coefficient between 2w1w2ρ12σ1σ2. + w2^2σ2^2 +
• The weights (wi) of Ri and Rj. 2w1w2ρ12σ1σ2).
each security must
add up to 1.
PORTFOLIO RISK & PORTFOLIO OF TWO RISKY ASSETS
Relationship between Portfolio Risk and Return
• Two assets, Asset 1 and Asset 2, have different annual returns and risks.
• Asset 1: 7% annual return, 12% annualized risk
• Asset 2: 15% annual return, 25% annualized risk
• Portfolio risk and return depend on portfolio weights and correlation between the assets.
• The text presents a table with portfolio return and risk for various correlation coefficients (-1.0 to
+1.0) and 11 different weight combinations (0% to 100%).
• Portfolio return varies with the weights assigned to the assets but is not influenced by the correlation
coefficient.
• Portfolio risk decreases as the correlation coefficient decreases, with the lowest risk when the
correlation is -1.0.
• When the correlation is +1.0, the risk-return relationship is a straight line.
• The curvilinear nature of a portfolio of assets is evident in all investment opportunity sets except when
the correlation is at the extremes (-1.0 or +1.0).
PORTFOLIO RISK & PORTFOLIO OF TWO RISKY ASSETS
PORTFOLIO OF MANY RISKY ASSETS
Correlation Impact on • Correlation between assets influences portfolio risk.
Portfolio Risk: • Lower correlation results in reduced portfolio risk.

• Portfolio return (E(Rp)) and variance (σP^2) equations for N risky assets:
Extension to Multiple • E(Rp) = ∑wiE(Ri)
Assets (N): • σP^2 = ∑wi^2σi^2 + ∑wiwjCov(i,j)
• ∑wi = 1
Equal Weighted Portfolio • Assume equal weights (1/N) for N assets.
with Average
Variance/Covariance: • Assume average variance (σ^2) and average covariance (‾Cov).

Portfolio Variance • Portfolio variance with equal weights and average variance/covariance:
Simplification: • σP^2 = (σ^2 / N) + ((N - 1) / N) * ‾Cov

• As N increases:
Impact of Increasing N: • Contribution of one asset's variance to portfolio variance diminishes.
• Covariance among assets becomes the dominant factor in portfolio risk.
Importance of Correlation in a Portfolio of Many Assets
• The analysis becomes more insightful and engaging when assuming that all
Portfolio Analysis
assets in the portfolio have the same variance and the same correlation
Assumptions:
among them.

• In this scenario, the portfolio risk can be expressed as σp = √(σ²/N + (N - 1) *

ρ * σ² / N), where σp is the portfolio risk, σ² is the variance of individual
Portfolio Risk Formula:
assets, N is the number of assets, and ρ is the correlation coefficient among
assets.

• As the number of assets in the portfolio increases, the first term (variance)
Dominant Factor: under the square root becomes less significant, making the second term
(correlation) the primary determinant of portfolio risk.
• When assets in the portfolio are unrelated (low or zero correlation), the
Diversification Effect: portfolio's overall risk can approach zero. Diversifying by including assets
with low correlation can help reduce portfolio risk.

Portfolio Risk • Understanding the impact of correlation on portfolio risk is crucial for
Management: effective portfolio diversification and risk management.
THE POWER OF DIVERSIFICATION
• Diversification is a crucial concept in investments aimed at reducing risk while maintaining returns.
• Investors are generally risk-averse and seek to minimize risk without sacrificing returns.
• Some investors might accept lower returns in exchange for lower chances of catastrophic losses.
• Correlation and covariance play a significant role in managing risk through diversification.
• This section will explore various methods of risk diversification using these concepts.
• The text starts with a simple and intuitive example to illustrate the principles of risk diversification.
Example
Diversification with Rain and Shine
Assume a company Beachwear rents beach equipment. The annual return from the company’s
operations is 20 percent in years with many sunny days but falls to 0 percent in rainy years with few
sunny days. The probabilities of a sunny year and a rainy year are equal at 50 percent. Thus, the average
return is 10 percent, with a 50 percent chance of 20 percent return and a 50 percent chance of 0
percent return. Because Beachwear can earn a return of 20 percent or 0 percent, its average return of
10 percent is risky.
You are excited about investing in Beachwear but do not like the risk. Having heard about
diversification, you decide to add another business to the portfolio to reduce your investment risk.
• There is a snack shop on the beach that sells all the healthy food you like. You estimate that the
annual return from the Snackshop is also 20 percent in years with many sunny days and 0 percent in
other years. As with the Beachwear shop, the average return is 10 percent.
Example
Diversification with Rain and Shine
You decide to invest 50 percent each in Snackshop and Beachwear. The average return is still 10
percent, with 50 percent of 10 percent from Snackshop and 50 percent of 10 percent from Beachwear.
In a sunny year, you would earn 20 percent (= 50% of 20% from Beachwear + 50% of 20% from
Snackshop). In a rainy year, you would earn 0 percent (=50% of 0% from Beachwear + 50% of 0% from
Snackshop). The results are tabulated in Exhibit 15.
Example
These results seem counterintuitive. You thought that
by adding another business you would be able to
diversify and reduce your risk, but the risk is exactly the
same as before. What went wrong? Note that both
businesses do well when it is sunny and both
businesses do poorly when it rains. The correlation
between the two businesses is +1.0. No reduction in
risk occurs when the correlation is +1.0.
• To reduce risk, you must consider a business that
does well in a rainy year. You find a company that
rents DVDs. DVDrental company is similar to the
Beachwear company, except that its annual return is
20 percent in a rainy year and 0 percent in a sunny
year, with an average return of 10 percent.
DVDrental’s 10 percent return is also risky just like
Beachwear’s return.
Example
If you invest 50 percent each in DVD rental and
Beachwear, then the average return is still 10
percent, with 50 percent of 10 percent from DVD
rental and 50 percent of 10 percent from
Beachwear. In a sunny year, you would earn 10
percent (= 50% of 20% from Beachwear + 50% of
0% from DVD rental). In a rainy year also, you
would earn 10 percent (=50% of 0% from
Beachwear + 50% of 20% from DVD rental). You
have no risk because you earn 10 percent in both
sunny and rainy years. Thus, by adding DVD
rental to Beachwear, you have reduced
(eliminated) your risk without affecting your
return. The results are tabulated in Exhibit 16.
Correlation and Risk Diversification
• Correlation is a crucial factor in diversifying risk in a portfolio.
• Beachwear and DVD rental are two assets that consistently move in opposite directions,
demonstrating a negative correlation of -1.0.
• Adding assets to a portfolio that do not behave like others can reduce overall risk.
• Even in larger portfolios with multiple assets, the correlation among assets remains a primary
determinant of portfolio risk.
• Lower correlations between assets are associated with lower portfolio risk.
• The challenge in diversifying risk is to identify assets with correlations significantly lower than +1.0, as
most assets tend to have high positive correlations.
Historical Risk and Correlation
• Historical returns and expected future returns should be distinguished because past performance may
not predict future performance due to varying levels of risk.
• Returns for large US company stocks were high in the 1990s but low in the 2000s, highlighting the
variability in historical returns.
• Asset class risk tends to be relatively stable over time, with stocks generally being riskier than T-bills,
regardless of return levels.
• Bonds have exhibited higher risk in recent decades compared to earlier ones.
• Historical risk can serve as a reasonable proxy for future risk, especially within the same asset class.
• Correlations between assets from the same country tend to be stable, while intercountry correlations
have increased due to globalization.
• A correlation above 0.90 is considered high and limits diversification opportunities, while correlations
below 0.50 are desirable for portfolio diversification.
Historical Correlation among Asset Classes

Correlations among major US asset classes Correlations between international stocks

and international stocks from 1970 to 2017: and other asset classes:
• Highest correlation: US large company stocks and US • Correlation with US small company stocks: 50%.
small company stocks at approximately 70%. • Correlations between stocks and bonds are generally
• Second-highest correlation: US large company stocks low, with some being negative, like US small company
and international stocks at around 66%. stocks and US long-term government bonds.
• These high correlations still provide diversification • Correlation between T-bills (Treasury bills) and stocks
benefits as they are less than 100%. is close to zero.
Historical Correlation among Asset Classes

• Low correlations between stocks and bonds are beneficial for portfolio diversification.
• Including international securities in a portfolio can help manage portfolio risk.
• Diversified investor portfolios typically consist of domestic stocks, domestic bonds, foreign stocks,
foreign bonds, real estate, cash, and other asset classes.
Avenues for Diversification
Purpose of Diversification:
• Diversification reduces short-term volatility.
• It ensures steady long-term growth.
• A diversified portfolio is more resilient to
market fluctuations.

Importance of Diversification:
• It's a fundamental principle of investing.
• Many investors remain improperly
diversified.
Avenues for Diversification

Diversify Using Different Asset Classes: Diversify with Index Funds:

• Major asset classes generally have low • Direct diversification can be costly due to the
correlations. number of securities needed.
• Examples of asset classes: • For instance, diversifying in domestic large
• Domestic large caps, small caps. company asset class may require at least 30
• Growth and value stocks. stocks.
• Different bond types, like domestic corporate • Diversifying across 10 asset classes might
bonds, long-term government bonds. demand 300 securities.
• Cash equivalents, like Treasury bills. • Exchange-traded funds (ETFs) or mutual funds
tracking indexes can help reduce costs.
• Emerging and developed market stocks and
bonds. • Index funds offer a cost-effective way for
investors to achieve diversification compared to
• Real estate, gold, and other commodities.
buying individual securities.
• Diversification across sectors, e.g., energy stocks
vs. health care stocks, can also be beneficial.
 Avenues for Diversification
Diversification Among Countries: Avoid Owning Your Employer's Stock:

• Countries differ in industry focus, economic • Companies encourage employees to invest in

policies, and political climates. company stock.
• The US emphasizes financial and technical • Evaluate your employer's stock as you would any
services, while China and India focus on other investment.
manufacturing. • Consider your nonfinancial investments, such as
• European Union countries are vibrant human capital.
democracies, while East Asian countries are • Working for your employer already heavily
experimenting with democracy. invests you in their success.
• Different currencies can impact returns when • Further investments in your employer
investing in foreign countries. concentrate your wealth and reduce
• Currency returns are uncorrelated with stock diversification.
returns, reducing risk in foreign investments.
• Investing in foreign countries is crucial for a well-
diversified portfolio.
Avenues for Diversification
Costs of Diversification:
• Acknowledge the costs associated with diversification, including trading costs and the challenges
of tracking a larger portfolio.

Evaluation Rule:
• Assess the risk–return trade-off using the formula:

Sharpe Ratio Rule:

• Alternatively, evaluate based on Sharpe ratios:

• If the Sharpe ratio of the new asset exceeds the Sharpe ratio of the current portfolio times the
correlation coefficient, consider adding the new asset.
Avenues for Diversification
Insurance as an Negative Correlation Risk Reduction
Investment: Investments: Strategies:

• Recognize insurance as an • Consider investments with • Use options like buying put
investment asset with a negative correlations, such options to hedge against
negative correlation to as gold historically having a catastrophic losses, given
other assets. negative correlation with their negative correlation
• Despite a negative average stocks. with falling asset values.
return, insurance provides • These investments, • Acknowledge that such
a positive return when although potentially risk reduction strategies
other assets decline, offering small or negative come with costs, and the
reducing exposure to returns, can be included to expected return may be
extreme losses. reduce overall portfolio minimal or marginally
risk, including currency negative.
and inflation risks.
Minimum-variance & Efficient Frontier

Minimum-variance frontier is a graph that represents the minimum-variance portfolios, i.e.

portfolio of risky assets with lowest variance (A, B, C, D).

The portfolio (B) of the left-most corner of the frontier, with the least variance or risk is termed
as the Global minimum-variance portfolio.

All portfolios that lie above and to the right of global minimum-variance portfolio make up the
Markowitz efficient frontier (maximum return for a given level of risk).

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Optimal Risky Portfolio for an investor

Capital Allocation Line (CAL):

❑ straight line (linear relationship) obtained when risk-free asset is combined with the
risky assets on the efficient frontier
❑ tangent to the efficient frontier.

The point of tangency (C) is termed as the optimal risky portfolio.

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The Two-Fund Separation Theorem

Investment
Decision

Optimal Investor
Portfolio

Financing
Decision

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Optimal Investor Portfolio

CAL(P)
E(R p)
Given the
Indifference curve
investor’s
Efficient frontier
of risky assets
indifference
curve, portfolio

Expected return (%)

C P
A Optimal risky
portfolio
C on CAL(P) is
the optimal
portfolio.
Rf Optimal investor
portfolio

0 σp
Standard deviation (%)

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Holding Period Return

A holding period return is the return from holding an asset for a single
specified period of time.

Pt − Pt−1 + Dt = Pt −Pt + Dt
R= −1
Pt −1 Pt −1 Pt −1
= Capital gain + Dividend yield
105 −100 2
R= + = 5% + 2% = 7%
100 100

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Holding Period Returns

What is the 3-year holding period return if the annual returns are 7%,
9%, and –5%?

R = (1 + R1 ) (1 + R2 ) (1 + R3 )−1
= (1+ .07)(1+ .09)(1+ −.05)−1  .1080 = 10.80%

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Average Returns

Arithmetic or mean return

Average returns Geometric mean return

Money-weighted return

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Arithmetic or Mean Return

The arithmetic or mean return is the simple

average of all holding period returns.

Ri1 + Ri 2 + + RiT −1 + R
=  Rit
1 T
Ri = iT

T T t =1

− 50% + 35% + 27%

Ri = = 4%
3

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Geometric Mean Return

The geometric mean return accounts for the

compounding of returns.

RGi = T (1+ Ri1)(1+ Ri2 ) (1+ RiT−1)(1+ RiT )−1

T
= T (1+ Rit )−1
t =1

RGi = 3 (1− .50)  (1+ .35)  (1+ .27) −1  −5.0%

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Money-Weighted Return
Year 1 2 3
Balance from previous year €0 €50 €1,000
New investment by the investor (cash 100 950 0
A money-weighted rate of inflow for the mutual fund) at the start of
return is a measure of the the year
rate of return for an asset Net balance at the beginning of year 100 1,000 1,000
or portfolio of assets. It is Investment return for the year –50% 35% 27%
calculated by finding the Investment gain (loss) –50 350 270
rate of return that will set
Withdrawal by the investor (cash 0 –350 0
the present values of all
cash flows and terminal outflow for the mutual fund) at the end
values equal to the value of the year
of the initial investment. Balance at the end of year €50 €1,000 €1,270
CF0 CF1 CF2 CF3
0
+ 1
+ 2
+ 3
=0
(1+ IRR) (1+ IRR) (1+ IRR) (1+ IRR)
-100 - 950 + 350 +1270
+ + + =0
1 2 3
1 (1+ IRR) (1+ IRR) (1+ IRR)
IRR = 26.11%
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Annualized Return
)c
rannual = (1+ rperiod −1
c : number of periods in a year
Weekly return of 0.20%:

rannual = (1+ 0.002)52 −1 = .1095 = 10.95%

18-month return of 20%:

2
rannual = (1+ 0.20) 3 −1 = 0.1292 = 12.92%

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Gross and Net Returns

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Pre-Tax and After-Tax Nominal Return

Pre-tax nominal After-tax

Taxes nominal
return
return

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Variance and Standard Deviation of a Single Asset

Population Sample

T T

 (R −)  (R − R )
2 2
t t
2 = t =1
s2 = t =1
T T −1
= 2 s = s2

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Portfolio Mean

Expected return (Mean) of portfolio of assets is the sum of weighted

returns of the individual assets in the portfolio

E(Rp) = w1E(R1) + w2E(R2) + w3E(R3)…………….+ wNE(RN)

where, ‘wi’ is weight of individual asset

18
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Mean-Variance of a Portfolio

Variance of a portfolio is the sum of two main components;

❑ the weighted average of variance of individual securities, and
❑ the co-variance between securities based on their individual weights

So for a 2 asset portfolio, risk of the portfolio is:

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Important Assumptions of Mean-Variance Analysis

Returns are
normally
distributed

Markets are
informational
ly and
operationally Mean-
efficient
variance
analysis

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Variance and Covariance

Example:
❑ Mr. X has invested in two asset portfolios – A and B
❑ Portfolio weights are 75% and 25% respectively
❑ Portfolio A - Expected Returns = 10%, std dev = 14
❑ Portfolio B - Expected Returns = 12%, std dev = 20
❑ Covariance between A and B = 0.5%
Calculate:
❑ Returns and risk of Mr. X’s portfolio

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Covariance and Correlation

Covariance measures the degree to which returns on two assets move together.
❑ Positive covariance implies returns move in the same direction.
❑ Negative covariance implies the returns of the assets are inversely related.
❑ Zero covariance implies there is no relation between the returns of the assets.

Correlation coefficient addresses the limitation of covariance

❑ It measures the strength of dependence, i.e. how much is one asset dependent on the other
❑ Ranges from -1 to +1.

Strong +ve correlation Strong -ve correlation Moderate correlation

Weak +ve correlation Weak -ve correlation No correlation

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Correlation and Portfolio Risk

Correlation
between assets
in the portfolio Portfolio risk

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Portfolio Risks – How Correlation Affects it?

Correlation and Diversification:

𝜌 = +1, then no
diversification is
achieved
𝜌 = -1, greatest
diversification is
achieved

As correlation between assets ⇩ benefits of diversification ⇧

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Portfolio Risks – How Correlation Affects it?...

Weight Portfoli Portfolio Risk with Correlation of

in o 1.0 0.5 0.2 –1.0
Asset 1 Return
0% 15.0 25.0 25.0 25.0 25.0
ρ = .2
10% 14.2 23.7 23.1 22.8 21.3 14

20% 13.4 22.4 21.3 20.6 17.6

Expected Portfolio Return E (Rp)

ρ = −1
30% 12.6 21.1 19.6 18.6 13.9
11 ρ=1
40% 11.8 19.8 17.9 16.6 10.2
50% 11.0 18.5 16.3 14.9 6.5 ρ = .5
60% 10.2 17.2 15.0 13.4 2.8 8

70% 9.4 15.9 13.8 12.3 0.9

80% 8.6 14.6 12.9 11.7 4.6
5 10 15 20 25
90% 7.8 13.3 12.2 11.6 8.3
Standard Deviation of Portfolio p
100% 7.0 12.0 12.0 12.0 12.0
As evident above, a diversified portfolio with inverse correlation tends to reduce the
portfolio risk. (Refer 50%-60% weight in asset 1)

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Portfolio Choices Based On Indifference Curve

The ideal portfolio for an investor who prefer to keep a mix of both risky and risk
free assets, will lie between optimal risky portfolio and Rf.

Investor A is more risk averse than Investor B (steeper indifference curves)

Investor A selects a less-risky optimal portfolio (portfolio that maximizes
investor’s expected utility

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Histogram of U.S. Large Company Stock Returns, 1926-2008

2006
Violations of the 2004
2000 2007 1988 2003 1997
normality assumption: 1990 2005 1986 1999 1995
skewness and kurtosis. 1981
1977
1994
1993
1979
1972
1998
1996
1991
1989
1969 1992 1971 1983 1985
1962 1987 1968 1982 1980
1953 1984 1965 1976 1975
1946 1978 1964 1967 1955
2001 1940 1970 1959 1963 1950
1973 1939 1960 1952 1961 1945
2002 1966 1934 1956 1949 1951 1938 1958
2008 1974 1957 1932 1948 1944 1943 1936 1935 1954
1931 1937 1939 1941 1929 1947 1926 1942 1927 1928 1933

–60 –50 –40 –30 –20 –10 0 10 20 30 40 50 60 70

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Utility Theory

Expected Variance or risk

return

1
U = E (r) − A  2
2
Utility of an Measure of risk
investment tolerance or risk
aversion
A theory used in economics that holds the belief that an item or service's utility is a
measure of the satisfaction that the consumer will derive from the consumption of
that particular good or service.

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Portfolio Expected Return and Risk Assuming a Risk-Free Asset

Assume a portfolio of two assets, a risk-free asset and a risky asset. Expected
return and risk for that portfolio can be determined using the following
formulas:

E(RP )= w1Rf + (1− w1 )E(Ri )

2P= w22
1 f+ (
1− w )12
i
2
+ 2w1(1− w1 )
fi f i

= (1− w1 )2 i2
 P = (1− w1 )  i2 = (1− w1 ) i
2

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The Capital Allocation Line (CAL)

E(Rp)
CAL

E(Ri)

Equation of the CAL :

E( Ri ) − R f
E (R P ) = R f + P
i
Rf

σp
σi

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Portfolio Selection for Two Investors with Various
Levels of Risk Aversion
E(Rp) Indifference Curves

Capital Allocation
Portfolio Return

A=2 Line
x
k

A=4
x
j

0 σp
Portfolio Standard Deviation

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Avenues for Diversification

Diversify with asset classes

Diversify with index funds

Diversify among countries

Evaluate assets

Buy insurance

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Minimum-Variance Frontier

E(Rp) Efficient Frontier

X A B
D
Portfolio Expected Return

C Minimum-Variance
Frontier
Global
Minimum-
Variance
Portfolio (Z)

0 σ
Portfolio Standard Deviation

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Capital Allocation Line and Optimal Risky Portfolio

CAL(P) is
CAL(P)
Y Efficient Frontier
the optimal
X CAL(A) of Risky Assets capital
allocation
P
line and
E(Rp)

Optimal Risky portfolio P

A Portfolio
is the
optimal
Rf
risky
σp
portfolio.
Portfolio Standard Deviation

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Practice Question

1. Which of the following return calculating methods is best for evaluating the annualized returns of a buy-
and-hold strategy of an investor who has made annual deposits to an account for each of the last five
years?
A. Geometric mean return.
B. Arithmetic mean return.
C. Money-weighted return.

2. With respect to capital market theory, which of the following asset characteristics is least likely to impact
the variance of an investor’s equally weighted portfolio?
A. Return on the asset.
B. Standard deviation of the asset.
C. Covariance of the asset with the other assets in the portfolio.

3. With respect to trading costs, liquidity is least likely to impact the:

A. stock price.
B. bid–ask spreads.
C. brokerage commissions.
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Practice Question

4. Evidence of risk aversion is best illustrated by a risk–return relationship that is:

A. negative.
B. neutral.
C. positive.

5. With respect to risk-averse investors, a risk-free asset will generate a numerical utility that is:
A. the same for all individuals.
B. positive for risk-averse investors.
C. equal to zero for risk seeking investors.

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Solution

1. A is correct. The geometric mean return compounds the returns instead of the amount invested.
2. A is correct. The asset’s returns are not used to calculate the portfolio’s variance [only the assets’ weights,
standard deviations (or variances), and covariance (or correlations) are used].
3. C is correct. Brokerage commissions are negotiated with the brokerage firm. A security’s liquidity impacts
the operational efficiency of trading costs. Specifically, liquidity impacts the bid–ask spread and can
impact the stock price (if the ability to sell the stock is impaired by the uncertainty associated with being
able to sell the stock).
4. C is correct. Historical data over long periods of time indicate that there exists a positive risk–return
relationship, which is a reflection of an investor’s risk aversion.
5. A is correct. A risk-free asset has a variance of zero and is not dependent on whether the investor is risk
neutral, risk seeking or risk averse. That is, given that the utility function of an investment is expressed as
U = E ( r ) − 0.5× A × variance , where A is the measure of risk aversion, then the sign of A is irrelevant if
the variance is zero (like that of a risk-free asset).

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