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The Mathematics of Diversification

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O! This learning, what a thing it is!

- William Shakespeare
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Outline
Introduction
Linear combinations
Single-index model
Multi-index model
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Introduction
The reason for portfolio theory
mathematics:
To show why diversification is a good idea

To show why diversification makes sense
logically
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Introduction (contd)
Harry Markowitzs efficient portfolios:
Those portfolios providing the maximum return
for their level of risk

Those portfolios providing the minimum risk
for a certain level of return
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Linear Combinations
Introduction
Return
Variance
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Introduction
A portfolios performance is the result of
the performance of its components
The return realized on a portfolio is a linear
combination of the returns on the individual
investments

The variance of the portfolio is not a linear
combination of component variances
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Return
The expected return of a portfolio is a
weighted average of the expected returns of
the components:

1
1
( ) ( )
where proportion of portfolio
invested in security and
1
n
p i i
i
i
n
i
i
E R x E R
x
i
x
=
=
(
=

=
=

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Variance
Introduction
Two-security case
Minimum variance portfolio
Correlation and risk reduction
The n-security case
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Introduction
Understanding portfolio variance is the
essence of understanding the mathematics
of diversification
The variance of a linear combination of random
variables is not a weighted average of the
component variances
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Introduction (contd)
For an n-security portfolio, the portfolio
variance is:

2
1 1
where proportion of total investment in Security
correlation coefficient between
Security and Security
n n
p i j ij i j
i j
i
ij
x x
x i
i j
o o o

= =
=
=
=

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Two-Security Case
For a two-security portfolio containing
Stock A and Stock B, the variance is:

2 2 2 2 2
2
p A A B B A B AB A B
x x x x o o o o o = + +
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Two Security Case (contd)
Example

Assume the following statistics for Stock A and Stock B:







Stock A Stock B
Expected return .015 .020
Variance .050 .060
Standard deviation .224 .245
Weight 40% 60%
Correlation coefficient .50
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Two Security Case (contd)
Example (contd)

What is the expected return and variance of this two-
security portfolio?







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Two Security Case (contd)
Example (contd)

Solution: The expected return of this two-security
portfolio is:








| | | |
1
( ) ( )
( ) ( )
0.4(0.015) 0.6(0.020)
0.018 1.80%
n
p i i
i
A A B B
E R x E R
x E R x E R
=
(
=

( (
= +

= +
= =

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Two Security Case (contd)
Example (contd)

Solution (contd): The variance of this two-security
portfolio is:








2 2 2 2 2
2 2
2
(.4) (.05) (.6) (.06) 2(.4)(.6)(.5)(.224)(.245)
.0080 .0216 .0132
.0428
p A A B B A B AB A B
x x x x o o o o o = + +
= + +
= + +
=
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Minimum Variance Portfolio
The minimum variance portfolio is the
particular combination of securities that will
result in the least possible variance

Solving for the minimum variance portfolio
requires basic calculus
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Minimum Variance
Portfolio (contd)
For a two-security minimum variance
portfolio, the proportions invested in stocks
A and B are:

2
2 2
2
1
B A B AB
A
A B A B AB
B A
x
x x
o o o
o o o o

=
+
=
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Minimum Variance
Portfolio (contd)
Example (contd)

Assume the same statistics for Stocks A and B as in the
previous example. What are the weights of the minimum
variance portfolio in this case?







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Minimum Variance
Portfolio (contd)
Example (contd)

Solution: The weights of the minimum variance portfolios
in this case are:







2
2 2
.06 (.224)(.245)(.5)
59.07%
2 .05 .06 2(.224)(.245)(.5)
1 1 .5907 40.93%
B A B AB
A
A B A B AB
B A
x
x x
o o o
o o o o

= = =
+ +
= = =
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Minimum Variance
Portfolio (contd)
Example (contd)









0
0.2
0.4
0.6
0.8
1
1.2
0 0.01 0.02 0.03 0.04 0.05 0.06
W
e
i
g
h
t

A

Portfolio Variance
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Correlation and
Risk Reduction
Portfolio risk decreases as the correlation
coefficient in the returns of two securities
decreases
Risk reduction is greatest when the
securities are perfectly negatively correlated
If the securities are perfectly positively
correlated, there is no risk reduction
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The n-Security Case
For an n-security portfolio, the variance is:
2
1 1
where proportion of total investment in Security
correlation coefficient between
Security and Security
n n
p i j ij i j
i j
i
ij
x x
x i
i j
o o o

= =
=
=
=

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The n-Security Case (contd)
The equation includes the correlation
coefficient (or covariance) between all pairs
of securities in the portfolio
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The n-Security Case (contd)
A covariance matrix is a tabular
presentation of the pairwise combinations of
all portfolio components
The required number of covariances to compute
a portfolio variance is (n
2
n)/2

Any portfolio construction technique using the
full covariance matrix is called a Markowitz
model
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Single-Index Model
Computational advantages
Portfolio statistics with the single-index
model
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Computational Advantages
The single-index model compares all
securities to a single benchmark
An alternative to comparing a security to each
of the others

By observing how two independent securities
behave relative to a third value, we learn
something about how the securities are likely to
behave relative to each other
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Computational
Advantages (contd)
A single index drastically reduces the
number of computations needed to
determine portfolio variance
A securitys beta is an example:

2
2
( , )
where return on the market index
variance of the market returns
return on Security
i m
i
m
m
m
i
COV R R
R
R i
|
o
o
=
=
=
=
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Portfolio Statistics With the
Single-Index Model
Beta of a portfolio:


Variance of a portfolio:

1
n
p i i
i
x | |
=
=

2 2 2 2
2 2
p p m ep
p m
o | o o
| o
= +
~
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Portfolio Statistics With the
Single-Index Model (contd)
Variance of a portfolio component:


Covariance of two portfolio components:

2 2 2 2
i i m ei
o | o o = +
2
AB A B m
o | | o =
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Multi-Index Model
A multi-index model considers independent
variables other than the performance of an
overall market index
Of particular interest are industry effects
Factors associated with a particular line of business

E.g., the performance of grocery stores vs. steel
companies in a recession
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Multi-Index Model (contd)
The general form of a multi-index model:

1 1 2 2
...
where constant
return on the market index
return on an industry index
Security 's beta for industry index
Security 's market beta
retur
i i im m i i in n
i
m
j
ij
im
i
R a I I I I
a
I
I
i j
i
R
| | | |
|
|
= + + + + +
=
=
=
=
=
= n on Security i