Portfolio Selection for all

Investors
Chapter 8
Charles P. Jones, Investments:
Principles and Concepts,
Eleventh Edition, John Wiley & Sons
 Overview
• Having learned about the importance of diversification,
it seems logical that there are limits to its use.
• How many stocks are enough? How can you know if you
have chosen the right portfolio?
• We know that return and risk are the key parameters to
consider, but how do we balance them against each
other?
• It seems prudent at this point to learn about optimal
portfolios, and in fact the basic principles about optimal
portfolios can now be readily understood, given what we
have learned so far.
 Overview
• It is time to consider asset allocation, one of the most
important decisions when it comes to investing (Risk
tolerance).
• Closely related to the principle of diversification is the
concept of asset allocation.
• This involves the choices the investor makes among
asset classes, such as stocks, bonds, and cash
equivalents.
• The asset allocation decision is the most important
single decision made by investors in terms of the impact
on the performance of their portfolios.
Building a Portfolio Using the Markowitz
Solution
 Markowitz model
• In finance, the Markowitz model ─ put forward by
Harry Markowitz in 1952 ─ is a portfolio optimization
model; it assists in the selection of the most efficient
portfolio by analyzing various possible portfolios of
the given securities.
 Optimal Portfolio of Financial Assets using
the Markowitz Principles
• To select an optimal portfolio of financial assets using the
Markowitz analysis, investors should:
• Step 1:Identify optimal risk-return combinations (the
efficient set) available from the set of risky assets being
considered by using the Markowitz efficient frontier
analysis.
• This step uses the inputs from Chapter 7, the expected
returns, variances and covariance for a set of securities.
• Step 2: Select the optimal portfolio from among those in
the efficient set based on an investor’s preferences using
indifference curves.
Identify Optimal Risk-Return Combinations

• As we saw in Chapter 7, even if portfolios are

selected arbitrarily, some diversification benefits are
gained. This results in a reduction of portfolio risk.
• However, to take the full information set into
account, we use portfolio theory as developed by
Markowitz.
 Identify Optimal Risk-Return Combinations
• Portfolio theory is normative, meaning that it tells investors how
they should act to diversify optimally. It is based on a small set of
assumptions, including
• 1. A single investment period; for example, one year.
• 2. Liquidity of positions; for example, there are no transaction
costs.
• 3. Investor preferences based only on a portfolio’s expected
return and risk, as measured by variance or standard deviation.
• Since, random diversification won’t lead to an efficient
diversification we will start to apply another approach which is
based on the MPT called “ Market efficient frontier analysis”
THE ATTAINABLE SET OF PORTFOLIOS
 The Attainable Set of Portfolios
Step 1-How to Identify optimal risk-return
combinations?
• Markowitz’s approach to portfolio selection is that an
investor should evaluate portfolios on the basis of
their expected returns and risk as measured by the
standard deviation.
• Therefore, we must first determine the risk-return
opportunities available to an investor from a given
set of securities.
The Attainable Set of Portfolios
• B
• x

• E(R)
• A

• y
• C

• Risk = 
 The Attainable Set of Portfolios
• The attainable set is the entire set of all portfolios
that could be found from a group of n securities.
• However, risk-averse investors should be interested
only in those portfolios with the lowest possible risk
for any given level of return.
 Efficient Portfolios
• Markowitz was the first to derive the concept of an
efficient portfolio, defined as one that has the
smallest portfolio risk for a given level of expected
return or the largest expected return for a given level
of risk.
 Efficient Portfolios
• By specifying an expected portfolio return and
minimizing the portfolio risk at this level of return.
• Alternatively, they can specify a portfolio risk level
they are willing to assume and maximize the
expected return on the portfolio for this level of risk.
• Rational investors will seek efficient portfolios,
because these portfolios are optimized on the basis
of the two dimensions of most importance to
investors, expected return and risk.
 Efficient Portfolios
• Using the inputs described earlier—expected returns,
variances, and covariance—we can calculate the
portfolio with the smallest variance, or risk, for a
given level of expected return based on these inputs.
 Efficient Portfolios
The Attainable Set of Portfolios
• Point A represents the global minimum variance portfolio
because no other minimum-variance portfolio has a
smaller risk.
• Efficient frontier or Efficient set (curved line from A to B)
• The bottom segment of the minimum-variance frontier,
AC, is dominated by portfolios on the upper segment, AB.
• For example, since portfolio X has a larger return than
portfolio Y for the same level of risk, investors would not
want to own portfolio Y.
 The Efficient Set Frontier-AB
• The segment of the minimum-variance frontier
above the global minimum-variance portfolio, AB,
offers the best risk-return combinations available to
investors from this particular set of inputs.
• This segment is referred to as the efficient set or
efficient frontier of portfolios.
• The efficient set is determined by the principle of
dominance—portfolio X dominates portfolio Y if it
has the same level of risk but a larger expected
return, or the same expected return but a lower risk.
Understanding the Markowitz Solution
• It’s all about the portfolio weights and the
percentage of invested funds in each security.
• Because the expected returns, standard deviations,
and correlation coefficients for the securities being
considered are inputs in the Markowitz analysis, the
portfolio weights are the only variable that can be
manipulated to solve the portfolio problem of
determining efficient portfolios.
Understanding the Markowitz Solution
• The inputs are obtained and a level of desired expected return for
a portfolio is specified, for example,10 percent. Then all
combinations of securities that can be combined to form a
portfolio with an expected return of 10 percent are determined,
and the one with the smallest variance of return is selected as the
efficient portfolio.
• Next, a new level of portfolio expected return is specified—for
example, 11 percent—and the process is repeated. This continues
until the feasible range of expected returns is processed.
• Of course, the problem could be solved by specifying levels of
portfolio risk and choosing that portfolio with the largest expected
return for the specified level of risk.
SELECTING AN OPTIMAL PORTFOLIO OF
RISKY ASSETS
 Selecting an Optimal Portfolio of Risky
Assets/Step 2
• Once the efficient set of portfolios is determined
using the Markowitz model, investors must select
from this set the portfolio most appropriate for them.
• The Markowitz model does not specify one optimum
portfolio.
• Rather, it generates the efficient set of portfolios, all
of which, by definition, are optimal portfolios (for a
given level of expected return or risk).
• From this efficient set an investor chooses the
portfolio that is optimal for him or her.
 Indifference Curves
• Curves describing investor preferences for risk and
return.
• Each indifference curve represents the combinations
of risk and ER that are equally desirable to a
particular investor.
• Curves can’t intersect
• Investors have infinite number of IC’s
• Higher IC’s are more desirable than lower ones
 Selecting the Optimal Portfolio
• The optimal portfolio for a risk-averse investor is the
one on the efficient frontier tangent to the investor’s
highest indifference curve.
• In Figure8-3 this occurs at point 0. This portfolio
maximizes investor utility because the indifference
curves reflect investor preferences, while the efficient
set represents portfolio possibilities.
 Some Important Conclusions about
the Markowitz Model
• 1. Markowitz portfolio theory is referred to as a two-
parameter model because investors are assumed to
make decisions on the basis of two parameters,
expected return and risk. Thus, it is sometimes
referred to as the mean-variance model.
• 2. The Markowitz analysis generates an entire set, or
frontier, of efficient portfolios, all of which are
equally “good.” No portfolio on the efficient frontier,
as generated, dominates any other portfolio on the
efficient frontier.
 Some Important Conclusions about
the Markowitz Model
• The Markowitz model does not address the issue of
investors using borrowed money along with their
own portfolio funds to purchase a portfolio of risky
assets; that is, investors are not allowed to use
leverage.
• As we shall see in Chapter 9, allowing investors to
purchase a risk-free asset increases investor utility
and leads to a different efficient set on what is called
the capital market line.
 Example
• Problem (8-1), (8-2), (8-3) page 226.