CHAPTER 6

Efficient Diversification

McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

6.1 DIVERSIFICATION AND
PORTFOLIO RISK

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Diversification and Portfolio Risk

Market risk
– Systematic or Nondiversifiable
Firm-specific risk
– Diversifiable or nonsystematic

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 Figure 6.1 Portfolio Risk as a
Function of the Number of Stocks

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 Figure 6.2 Portfolio Risk as a
Function of Number of Securities

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6.2 ASSET ALLOCATION WITH
TWO RISKY ASSETS

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 Covariance and Correlation

Portfolio risk depends on the correlation

between the returns of the assets in the
portfolio
Covariance and the correlation coefficient
provide a measure of the returns on two
assets to vary

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 Two Asset Portfolio
Return – Stock and Bond

rp  w r w r
B B S S

rP  Portfolio Return
wB  Bond Weight
rB  Bond Return
wS  Stock Weig ht
rS  Stock Return

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Covariance and Correlation Coefficient

Covariance:
S
Cov(rS , rB )   p (i )  rS (i )  rS   rB (i )  rB 
i 1

Correlation
Coefficient:
Cov(rS , rB )
 SB 
 S B
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 Correlation Coefficients:
Possible Values
Range of values for  1,2
-1.0 < < 1.0
If = 1.0, the securities would be
perfectly positively correlated
If = - 1.0, the securities would be
perfectly negatively correlated

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Two Asset Portfolio St Dev –
Stock and Bond

  w   w   2w w   
2 2 2 2 2
p B B S S B S S B B,S

  Portfolio Variance
2
p

  Portfolio Standard Deviation

2
p

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In General, For an n-Security Portfolio:

rp = Weighted average of the

n securities
p2 = (Consider all pair-wise
covariance measures)

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Three Rules of Two-Risky-Asset Portfolios

Rate of return on the portfolio:

rP  wB rB  wS rS
Expected rate of return on the portfolio:

E (rP )  wB E (rB )  wS E (rS )

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Three Rules of Two-Risky-Asset Portfolios

Variance of the rate of return on the portfolio:

 P2  ( wB B ) 2  ( wS S ) 2  2( wB B )( wS S )  BS

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Numerical Text Example: Bond and Stock
Returns (Page 169)

Returns
Bond = 6% Stock = 10%
Standard Deviation
Bond = 12% Stock = 25%
Weights
Bond = .5 Stock = .5
Correlation Coefficient
(Bonds and Stock) = 0

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Numerical Text Example: Bond and Stock
Returns (Page 169)

Return = 8%
.5(6) + .5 (10)

Standard Deviation = 13.87%

[(.5)2 (12)2 + (.5)2 (25)2 + …
2 (.5) (.5) (12) (25) (0)] ½
[192.25] ½ = 13.87

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Figure 6.3 Investment Opportunity
Set for Stocks and Bonds

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 Figure 6.4 Investment Opportunity Set for
Stocks and Bonds with Various Correlations

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6.3 THE OPTIMAL RISKY PORTFOLIO
WITH A RISK-FREE ASSET

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Extending to Include Riskless Asset

The optimal combination becomes linear

A single combination of risky and riskless
assets will dominate

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 Figure 6.5 Opportunity Set Using Stocks
and Bonds and Two Capital Allocation Lines

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 Dominant CAL with a Risk-Free
Investment (F)
CAL(O) dominates other lines -- it has the best
risk/return or the largest slope

Slope = E (rA )  rf
A

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 Dominant CAL with a Risk-Free
Investment (F)

E (rP )  rf E (rA )  rf

P A

Regardless of risk preferences, combinations of

O & F dominate

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Figure 6.6 Optimal Capital Allocation Line
for Bonds, Stocks and T-Bills

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Figure 6.7 The Complete Portfolio

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 Figure 6.8 The Complete Portfolio –
Solution to the Asset Allocation Problem

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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS

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Extending Concepts to All Securities

The optimal combinations result in lowest

level of risk for a given return
The optimal trade-off is described as the
efficient frontier
These portfolios are dominant

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Figure 6.9 Portfolios Constructed from
Three Stocks A, B and C

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Figure 6.10 The Efficient Frontier of Risky
Assets and Individual Assets

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6.5 A SINGLE-FACTOR ASSET MARKET

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 Single Factor Model

Ri  E ( Ri )  i M  ei
βi = index of a securities’ particular return to the
factor
M = unanticipated movement commonly related to
security returns
Ei = unexpected event relevant only to this
security
Assumption: a broad market index like the
S&P500 is the common factor

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Specification of a Single-Index Model of
Security Returns
Use the S&P 500 as a market proxy
Excess return can now be stated as:

Ri     i RM  e
– This specifies the both market and firm risk

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Figure 6.11 Scatter Diagram for Dell

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Figure 6.12 Various Scatter Diagrams

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 Components of Risk

Market or systematic risk: risk related to the

macro economic factor or market index
Unsystematic or firm specific risk: risk not
related to the macro factor or market index
Total risk = Systematic + Unsystematic

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 Measuring Components of Risk

i2 = i2 m2 + 2(ei)

where;
i2 = total variance
i2 m2 = systematic variance
2(ei) = unsystematic variance

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Examining Percentage of Variance

Total Risk = Systematic Risk + Unsystematic

Risk
Systematic Risk/Total Risk = 2
ßi2  m2 / 2 = 2
i2 m2 / i2 m2 + 2(ei) = 2

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Advantages of the Single Index Model

Reduces the number of inputs for

diversification
Easier for security analysts to specialize

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6.6 RISK OF LONG-TERM INVESTMENTS

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Are Stock Returns Less Risky in the Long
Run?
Consider a 2-year investment

Var (2-year total return) = Var ( r1  r2

 Var (r1 )  Var (r2 )  2Cov(r1 , r2 )
  2  2  0
 2 2 and standard deviation of the return is  2

Variance of the 2-year return is double of that of the

one-year return and σ is higher by a multiple of the
square root of 2

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Are Stock Returns Less Risky in the Long
Run?

Generalizing to an investment horizon of n

years and then annualizing:

Var(n-year total return) = n 2

Standard deviation (n-year total return) = n
1 
 (annualized for an n - year investment) =  n 
n n

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The Fly in the ‘Time Diversification’
Ointment

Annualized standard deviation is only appropriate

for short-term portfolios
Variance grows linearly with the number of years
Standard deviation grows in proportion to n

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The Fly in the ‘Time Diversification’
Ointment
To compare investments in two different
time periods:
– Risk of the total (end of horizon) rate of return
– Accounts for magnitudes and probabilities

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