PORTFOLIO THEORY (Brigham

ch8, Firer Ch13)

 INTRODUCTION

Portfolio
Portfolio Expected Return
Portfolio Risk
Capital Asset Pricing Model(CAPM)
Beta Concept
Security Market Line (SML)
Concerns about CAPM
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 Portfolio

A portfolio is a collection of assets

An asset’s risk and return is important in how it
affects the risk and return of the portfolio
 Expected return of a portfolio is a weighted
average of each of the component assets of the
portfolio
 Standard deviation is a little more tricky and
requires that a new probability distribution for
the portfolio returns be devised.
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 Portfolio

• Of significance in Portfolio evaluation is the

degree of effect that an individual security has on
the overall portfolio’s performance
• A portfolio investor is primarily interested in the
performance of the portfolio, rather than the
stand-alone risk and return measures of each
security

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 Calculating portfolio expected
return

• The expected return of a portfolio is the weighted

average of the expected returns for each asset in
the portfolio
• Two computations are required:
– The expected return for each stock
– Weight of each security in the portfolio, being the
proportion of the amount invested in the security vis-à-
vis the total investment amount

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 Calculating portfolio expected
return

^
where k p is the Portfolio Expected Return
w i is the weight of investment in a security
^
k i is the expected return of a security

^ n ^
kp   wi ki
i 1

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 Example 1

Share Investment( Weight Returns WiKi

Pula) (Wi) (Ki)
Barclays 40 000 15%

Stanbic 80 000 10%

FNB 80 000 25%

  200 000 K^P=

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 What is the expected portfolio return
assuming an equally weighted portfolio?
 Portfolio expected return

Economy Prob. HT Coll Port.

Recession 0.1 -27.0% 27.0% 0.0%
Below avg 0.2 -7.0% 13.0% 3.0%
Average 0.4 15.0% 0.0% 7.5%
Above avg 0.2 30.0% -11.0% 9.5%
Boom 0.1 45.0% -21.0% 12.0%
^
r p  0.10 (0.0%)  0.20 (3.0%)  0.40 (7.5%)
 0.20 (9.5%)  0.10 (12.0%)  6.7%
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 Portfolio Risk

 Portfolio risk is the probability that the portfolio

investment’s realised returns will not be at a level
initially expected
 Portfolio risk is NOT the weighted average of the
standard deviations of the individual securities held
in a portfolio
 Portfolio risk is usually smaller than the weighted
average of the standard deviation of individual
securities 10
 Calculating portfolio standard
deviation and CV
1
 0.10 (0.0 - 6.7) 
2 2

 2 
 0.20 (3.0 - 6.7) 
 p   0.40 (7.5 - 6.7)2   3.4%
 
 0.20 (9.5 - 6.7)2 
 2

 0.10 (12.0 - 6.7) 

3.4%
CVp   0.51
6.7%
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 Portfolio Risk

 Theoretically, it is possible to combine two

individually very risky securities to form a riskless
portfolio, a phenomenon termed risk diversification

 Risk diversification largely depends on the

relationship (correlation) in the behavioural patterns
between securities
 Correlation coefficient is denoted ρ “rho”)
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 Correlation
• Two key concepts that measure how two
random variables are related are: Covariance &
Correlation coefficient
• Covariance (Cov)
 Covariance is a statistical or absolute measure
of the relationship between two random
variables.
 It is a measure of how two random variables
such as the returns on two securities move
together and to what magnitude 13
 Correlation Coefficient (ρ)
• The correlation coefficient provides a standardized
measure of a co-movement between two securities.
• Correlation coefficient always lies between -1 and +1.
• A value of -1 represents perfect negative correlation
and a value of +1 represent perfect positive correlation
• ρ=CovAB/σAσB
Where; σA is standard deviations of stock A
σB is standard deviation for stock B

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 Calculation of Correlation
Coefficient
• ρ=CovAB/σAσB

• Given; σA=0.42 and σB=0.19 and Cov(ab) = 0.04541

• Correlation Coefficient=0.04541/(0.42)(0.19)
= 0.04541/0.0798
=0.57
The two stocks are partially positively correlated

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 ρ= -1

• Perfectly negative correlation

• The returns of the two securities move in a perfectly
countercyclical way, i.e. investment in heating and
refrigeration industries
• The portfolio’s risk would be equal to zero
• Conclusion: Absolute risk diversification can be
achieved by holding a portfolio of stocks that are
perfectly negatively correlated
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 Returns distribution for two perfectly negatively
correlated stocks (r = -1.0)

Stock W Stock M Portfolio WM

25 25 25

15 15 15

0 0 0

-10 -10 -10

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 ρ = 1.0

• The returns move up and down together

and by the same magnitude, e.g.
investment in chainsaw and lumber
industries
• The portfolio risk would be equal to the risk
(σ) of one security in the portfolio
• Conclusion: Diversification does nothing to
reduce risk if the portfolio consists of
perfectly positively correlated securities
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 Returns distribution for two perfectly positively
correlated stocks (ρ = 1.0)

Stock M Stock M’ Portfolio MM’

25 25 25

15 15 15

0 0 0

-10 -10 -10

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 ρ=0

• No correlation
• The movement in their returns is strictly random
e.g. performances in mining and fashion sectors
• Conclusion: The magnitude of risk diversification is
unpredictable, although it can be said with certainty
that some degree of diversification will be achieved

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 Market Realities
• The correlation coefficient between securities in
the markets normally range between +0.5 and
+0.7, meaning:

• Combining stocks into a portfolio reduces, but

does not completely eliminate risk

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 Creating a portfolio:

• The riskiness of a portfolio will decline as partially

correlated securities are added
• But the decline in the portfolio risk will eventually
reach a limit
• The magnitude of this limit will be determined by
the nature and degree of correlation among
securities
Conclusion: there is diversifiable and non-
diversifiable risk to a security risk 22
 Illustrating diversification effects of a stock
portfolio

sp (%)
Diversifiable Risk
35

Portfolio Risk, sp

20
Market Risk

0
10 20 30 40 2,000+
# Stocks in Portfolio
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 Illustration from Diagram

• The standard deviation (risk) of a single stock

averages at about 35%
• Initial increase in portfolio size sharply reduces
portfolio standard deviation from 35%
• Subsequent increases in portfolio size reduce
portfolio risk at a decreasing rate
• The rate of risk reduction slows drastically as the
portfolio size exceeds 10
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 Illustration from Diagram

• At 40+ stocks, portfolio risk approaches 20%, and

does not fall further - the Market or Systematic Risk
• That part of the risk which can be eliminated is
called Diversifiable Risk (35% - 20%)
Conclusion: almost half of the riskiness inherent in an
average individual security can be eliminated if the stock is
held in a reasonably well-diversified portfolio, i.e.
containing 40+ stocks

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If all points are perfectly on this line, you have a perfect correlation.

         
If these points are spread far from
this line, the absolute value of your
correlation coefficient is low.
 Breaking down types of risk

Total Risk = Market risk + Diversifiable risk

• Market risk – portion of a security’s stand-alone risk

that cannot be eliminated through diversification,
and is measured by Beta.
• Diversifiable risk– portion of a security’s stand-alone
risk that can be eliminated through proper
diversification.

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 Diversifiable risk

Diversifiable or Specific risk and is attributable to

random (off-setting) events peculiar to a firm:
• Law suits
• Strikes
• Marketing strategies
• Winning or losing major contracts
 

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 Non-Diversifiable Risk

Market Risk is attributable to macro-economic factors

that systematically affect most (all) firms in an
economy:
• War
• Inflation
• Recessions
• High interest rates
The is inherent in all financial assets hence non-
diversifiable 30
 Failure to diversify

If an investor chooses to hold a one-stock portfolio (hence

exposed to more risk than a diversified investor), should
he be compensated for the total risk?
– NO!
– Stand-alone risk is not important to a well-diversified investor.
– Rational, risk-averse investors are concerned with σp, which is
based upon market risk.
– There can be only one price (the market return) for a given
security.
– No compensation should be earned for holding unnecessary,
diversifiable risk.
– Compensation is for the Relevant Risk

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 Capital Asset Pricing Model
(CAPM)

A model based on concept that:

 a stock’s required rate of return should be primarily
determined by the appropriate relevant/non-
diversifiable risk

 Relevant risk is measured using the concept of Beta

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 Beta

• Is a measure of a security’s degree of volatility in

response to market movements, as compared to
the market portfolio’s degree of volatility
• Market portfolio movement is indicated by share
market index, e.g. Dow Jones, FTSE, Nikkei, etc.

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 Calculating betas
• Run a regression of past returns of a security
against past returns on the market.
• The slope of the regression line (sometimes
called the security’s characteristic line) is
defined as the beta coefficient (bi) for the
security.

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 Illustrating the calculation of beta

_
ki
. Year kM ki
20
15
. 1
2
15%
-5
18%
-10
10 3 12 16
5
_
-5 0 5 10 15 20
kM
-5 Regression line:
. -10
^
ki = -2.59 + 1.44 ^
kM

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 Comments on beta

b = 1 (average security)
The share moves up and down in the same direction and by the same
magnitude as the market, e.g. if the market moves up by 5%, the stock will
also gain 5%.
Conclusion: The share is as risky as the market.

b = 0.5
The share is half as volatile as the market. It will rise and fall only by as
much as half the market, e.g. a 8% decline in the market will generate a 4%
decline in the share
Conclusion: The share is only half as risky as the market.

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 Comments on beta

b =2.0
• The share is twice as volatile as the market. It will rise or fall by as
much as twice the market movement, e.g. a 3% increase in the
market will generate a 6% increase in the share
Conclusion: The share is twice as risky as the market

Note: Most stocks have betas in the range of 0.5 to 1.5

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 Can the beta of a security be negative?

• Yes, if the correlation between Stock i and the

market is negative (i.e., ρi,m < 0).
• If the correlation is negative, the regression
line would slope downward, and the beta
would be negative.
• However, a negative beta is highly unlikely.

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 Comparing expected return and beta coefficients

Security Exp. Ret. Beta

HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87

Point to note: Riskier (high beta) securities have

higher returns

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 Beta coefficients for
HT, Coll, and T-Bills

_
ki HT: β = 1.30
40

20

T-bills: β = 0
_
-20 0 20 40 kM

Coll: β = -0.87

-20
40
 Risk and return in Portfolio Context: The
Security Market Line (SML)

KRF =Risk-free rate of return 

bi=Beta coefficient of a security in a portfolio
KM=Required rate of return on a market portfolio, i.e.
a portfolio constituting of all shares in a market

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 Risk and return in Portfolio Context: The Security
Market Line (SML)

RPM = KM – KRF = Risk premium on a market portfolio.

That premium on returns, over and above the risk-
free return, rewarded for investing in a market
portfolio or an average stock (b=1.0)
RPi = (KM – KRF)bi = Risk premium of a security
Therefore: Ki = KRF + (KM – KRF)bi

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 Calculating required rates of
return
 rHT = 5.5% + (10.5 -5.5%)(1.32)
= 5.5% + 6.6% = 12.10%
 rM = 5.5% + (5.0%)(1.00) = 10.50%
 rUSR = 5.5% + (5.0%)(0.88) = 9.90%
 rT-bill = 5.5% + (5.0%)(0.00) = 5.50%
 rColl = 5.5% + (5.0%)(-0.87) = 1.15%

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Expected vs. Required returns

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 Illustrating the
Security Market Line

SML: ri = 5.5% + (5.0%) bi

ri (%) SML

HT
.. .
rM = 10.5

rRF = 5.5 . T-bills USR

-1
. Risk, bi
Coll.0 1 2

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 SML: Points to note

• The risk free rate always accounts for inflationary

adjustments (rRF =r* + IP);real return +Inflation premium
• The SML originates from the Risk Free Rate, where the beta
coefficient would be zero, hence zero risk
• The required rate of return for any given security increases
proportional to the increase in the security’s risk (beta)
• The slope of the SML reflects the risk aversion in the
economy, i.e. the steeper the slope of the line, the greater
the average investor’s risk

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Portfolio Beta Coefficient

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 An Example: Portfolio Beta
• Create a portfolio with 50% invested in HT and
50% invested in Collections.
• The beta of a portfolio is the weighted average
of each of the stock’s betas.

bP = wHT bHT + wColl bColl

bP = 0.5 (1.32) + 0.5 (-0.87)
bP = 0.225

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 An example: Portfolio Beta

If you now remove low beta Collections stock and replace it with a high
beta stock(USR) , what is the new portfolio beta

bP = wHT bHT + wUSR bUSR

bP = 0.5 (1.32) + 0.5 (0.89)
bP = 1.2774

Conclusion: Adding a high-beta stock to a low beta portfolio increases

that portfolio’s beta, hence the portfolio’s riskiness. The reverse holds
true

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 Calculating Portfolio Required
Returns
The required return of a portfolio is the weighted average of
each of the stock’s required returns.
rP = wHT rHT + wColl rColl
rP = 0.5 (12.10%) + 0.5 (1.15%)
rP = 6.63%

Or, using the portfolio’s beta, CAPM can be used to solve for
expected return.
rP = rRF + (RPM) bP
rP = 5.5% + (5.0%) (0.225)
rP = 6.63%

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 Factors that change the
SML:Inflation
51

What if investors raise inflation expectations by 3%, what would

happen to the SML?
New rRF=8% +3%=11%

ki (%)
D I = 3% SML2
18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5
 Factors that change the SML:Risk
Aversion
52

What if investors’ risk aversion increased, causing the

market risk premium to increase by 3%, what would
happen to the SML?
ki (%) SML2
D RPM = 3%

18 SML1
15
11
8
Risk, βi
0 0.5 1.0 1.5
 Concerns about CAPM
 The CAPM has not been verified completely.
 Statistical tests have problems that make
verification almost impossible.
 Some argue that there are additional risk
factors, other than the market risk
premium, that must be considered.

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 Concerns about CAPM

 Investors seem to be concerned with both market risk and

total risk. Therefore, the SML may not produce a correct
estimate of ri.
ri = rRF + (rM – rRF) bi + ???

 CAPM/SML concepts are based upon expectations, but

betas are calculated using historical data. A company’s
historical data may not reflect investors’ expectations
about future riskiness.

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 Exercises

1. According to the CAPM, the required return on a risky asset depends on three
components. Describe each component, and explain its role in determining required
return.

2. Explain what we mean when we say all assets have the same reward-to-risk ratio.
What does this mean for investors?

3. We routinely assume that investors are risk-averse return-seekers; i.e., they

like returns and dislike risk. If so, why do we contend that only systematic risk
and not total risk is important?

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4. Jane holds a P13 000 portfolio consisting of P5 500 invested in Sechaba
and the rest in Stanbic.
(a)What is her portfolio beta given that Sechaba has a b = 0.80 and Stanbic
beta is 1.12 ?

(b) If she substitutes the Sechaba shares with Metsef, which has a beta of 1.5,
what effect does this action have on the portfolio’s riskiness?

(c)Later, she decides to replace Stanbic shares with those of MedRescue and
her portfolio’s beta moves to 1.36. (i)What is the beta of MedRescue?
(ii) What conclusion can you make?

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