Portfolio Selection

for All Investors

Chapter 8
Charles P. Jones, Investments: Principles and Concepts,
Eleventh Edition, John Wiley & Sons

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Portfolio Selection
 Diversification is key to optimal risk
management
 Analysis required because of the infinite

number of portfolios of risky assets

 How should investors select the best risky

portfolio?
 How could riskless assets be used?

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Building a Portfolio
 Step 1: Use the Markowitz portfolio selection
model to identify optimal combinations
◦ Estimate expected returns, risk, and each
covariance between returns
 Step 2: Choose the final portfolio based on
your preferences for return relative to risk

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Portfolio Theory
 Optimal diversification takes into account all
available information
 Assumptions in portfolio theory

◦ A single investment period (one year)

◦ Liquid position (no transaction costs)
◦ Preferences based only on a portfolio’s expected
return and risk

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An Efficient Portfolio
 Smallest portfolio risk for a given level of
expected return
 Largest expected return for a given level of

portfolio risk
 From the set of all possible portfolios

◦ Only locate and analyze the subset known as the

efficient set
 Lowest risk for given level of return

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Efficient Portfolios
 Efficient frontier or
Efficient set
(curved line from A
B to B)
x
 Global minimum
E(R)
A variance portfolio
(represented by
y point A)
C
Risk = 

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Question CFA 8-21
 Which of the following portfolios cannot lie
on the efficient frontier as described by
Markowitz?
Portfolio Expected Standard
Return Deviation

a. W 9% 21%

b. X 5% 7%

c. Y 15% 36%

d. Z 12% 15%

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Selecting an Optimal Portfolio
of Risky Assets
 Assume investors are risk averse
 Indifference curves help select from efficient

set
◦ Description of preferences for risk and return
◦ Portfolio combinations which are equally desirable
◦ Greater slope implies greater the risk aversion

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 Example:Consider the following two sets of
indifference curves for investors Suliman and Youssef.
Determine whether Suliman or Youssef
 is more risk averse
 Prefer investment A to investment B
 Prefer investment D to investment C

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Answer
 a. Suliman is less risk averse because Suliman 's
indifference curves are less steeply sloped than
are Youssef's.
 b. Suliman is indifferent between investments
A and B because they lie on the same
indifference curve. Youssef, however, prefers
investment A to investment B because it lies on
a higher indifference curve.
 c. Both investors prefer investment D to
investment C because it lies on higher
indifference curve for both of them.

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Selecting an Optimal Portfolio
of Risky Assets
 Markowitz portfolio selection model
◦ The optimal portfolio for a risk - averse investor is
the one on the efficient frontier that is tangent to
an investor ’ s indifference curve that is highest in
return - risk space.

In selecting one portfolio from the efficient frontier,

we are matching investor preferences ( as given by
his or her indifference curves) with portfolio
possibilities ( as given by the efficient frontier).

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The Single Index Model
 Relates returns on each security to the
returns on a common index, such as the S&P
500 Stock Index
 Expressed by the following equation

Ri  α i  βi RM  ei
 Divides return into two components
◦ a unique part, ai
◦ a market-related part, biRM

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Characteristic Line

Variation in Ri explained by the line is the stock’s systematic risk

Variation in Ri unrelated to the market (the line) is unsystematic risk

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What is Beta?
• A measure of systematic risk
• Indicates how the price of a security responds to market forces
• The beta for the market is 1.0
• Stocks may have positive or negative betas. Nearly all are
positive.
• Stocks with betas greater than 1.0 are more risky than the
overall market.
• Stocks with betas less than 1.0 are less risky than the overall
market.

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What is Beta?

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What is Beta?

Interpreting Beta
• Higher stock betas should result in higher expected returns due to
greater risk
• If the market is expected to increase 10%, a stock with a beta of 1.50
is expected to increase 15%
• If the market went down 8%, then a stock with a beta of 0.50 should
only decrease by about 4%
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Comparing Security Characteristic Lines

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Comparing Security Characteristic
Lines
 
Describe

a) 

b) 

c) total risk
 for each

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The answer:
a) Beta, the slope coefficient of the security on the factor : securities R1
to R6 have a positive beta. These securities move, on average, in the
same direction as the market (RM). R1, R2, R6 have large betas, so
they are “aggressive” in that they carry more systematic risk than
R3, R4, R5, which are “defensive.” R7 and R8 have a negative beta.
These are hedge assets that carry negative systematic risk.

b) Intercept, the expected return when the market is neutral: The

estimates show that R1, R4, R8 have a positive intercept, while R2, R3,
R5, R6, R7 have negative intercepts. To the extent that one believes
these intercepts will persist, a positive value is preferred.

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The answer:
c) variance, the nonsystematic risk: R2, R3, R7 have a relatively low
variance. With sufficient diversification, risk eventually will be
eliminated, and hence, the difference in the variance is of little economic
significance.
 
d) Total risk, the sum of systematic and nonsystematic risk: R 3 has a low
beta and low variance, so its total risk will be low. R1, R6 have high betas
and high variance, so their total risk will be high. But R4 has a low beta
and high variance, while R2 has a high beta with a low variance. In sum,
total risk often will misrepresent systematic risk, which is the part that
matters.
 

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Implications of Portfolio Selection
 Investors should focus on risk that cannot be
managed by diversification
 Total risk =systematic (nondiversifiable) risk
+ nonsystematic (diversifiable) risk
◦ Systematic risk
 Variability in a security’s total returns directly
associated with economy-wide events
 Common to virtually all securities
◦ Both risk components can vary over time
 Affects number of securities needed to diversify

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Portfolio Risk and Diversification

sp %
35 Portfolio risk

20
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
Problem 8-1
Given the following information:
Standard deviation for stock X=12%
Standard deviation for stock Y=20%
Expected return for stock X=16%
Expected return for stock Y=22%
Correlation coefficient between X and Y = 0.30
 The covariance between X and Y is

a) 0.48%

b) 0.72%

c) 3.60%

d) 105.6%

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Problem 8-2
 Given the previous information regarding
risk, the expected return for a portfolio
consisting of 50 percent invested in X and 50
percent in Y can be seen to be
a. 19%
b. 16%
c. Less than 16%
d. More than 22%

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Problem 8-3
 Given the previous information form problem 8-1.
Assume that the correlation coefficient between
stocks X and Y is +1.0. Choose the investment
below that represents the minimum-risk portfolio.
a) 100%investment in stock Y.

b) 100%investment in stock X

c) 50%investment in stock Y and 50%investment in

stock X
d) 80%investment in stock Y and 20%investment in
stock X

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