FIN3024 Lecture 3
FIN3024 Lecture 3
Portfolio
Management
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What is Portfolio Management??
The art and science of making decisions about
investment mix and policy, matching
investments to objectives, asset allocation
(diversification) for individuals and institutions,
and balancing risk against performance.
To optimize the risk/return tradeoff!
Question:
How do you design/construct your portfolio of
securities?
Main concept of portfolio: Diversification – to
reduce risk!
By adding different financial assets to the
portfolio, investor benefits from
diversification. He is avoiding excessive
exposure to any one source of risk. Eg. If one
stock falls, he has other stocks to rely on and
does not lose everything.
The benefit of diversification is that the unique
risk of all the assets in the portfolio can be
eliminated, leaving only the market risk.
It has been shown from actual financial data,
that a portfolio of 10 to 30 stocks is enough to
eliminate almost all of the unique risk. This is
why it is called diversifiable risk.
The market risk is non-diversifiable.
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Nondiversifiable risk
Portfolio Returns- two
Asset Portfolio
The expected return of the portfolio is
simply the weighted average of the returns
on the individual assets:
E(rP) = wXE(rX) + wYE(rY)
where wX and wY are the weights of the
assets.
The portfolio return will always be between
the two individual returns.
Example: Suppose E(rX) = 12% and E(rY) =
20%.
If you want a portfolio with 25% in asset X
and 75% in asset Y, the expected return on
the portfolio would be:
E(RP) = 0.25(0.12) + 0.75(0.2) = 0.18 = 18%
How to Calculate Portfolio Risk ?
Covariance
+ (0.7)(0.1-0.148)(0.05-0.079)
+ (0.1)(0.08-0.148)(0.2-0.079) = 0.001808
Corelation
The correlation is a standardized measure of
covariance. The symbol for correlation is ρ (rho).
σX = 0.1012
σY = 0.0489
ρXY = 0.001808 /(0.1012)(0.0489) = 0.366
σP = 0.0774 = 7.74%
The risks of the individual assets were σX =
10.12% and σY = 4.89% but the risk of the
combined portfolio is to 7.74%.
The expected return on the portfolio is:
0.7(0.148) + 0.3(0.079) = 12.73%
“
The Importance of
Diversification – Why should I
diversify risk?
● In order to reduce risk one just need to
be very conservative,
● risk-averse investor, you decide to
invest all of your money in a bond
mutual fund. Very conservative,
indeed?
Uh, is this decision a wise one?
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Should I add
on HIGHER
risky
securities in
my portfolio
even if I am
risk averse?
Consider
For simplicity, let’s consider 2 fund portfolios.
Stocks
Bonds
Expected Return 12% 6%
Standard Deviation 15% 10%
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2 low correlated (or –ve correlated) assets
Markowitz Model
“Father of the Modern Portfolio Theory”
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Asset Allocation (investing in different asset classes – easier to find low
or –ve correlation between assets from different asset classes)
We can illustrate the importance of asset allocation with 3 assets.
How? Suppose we invest in three mutual funds:
One that contains Foreign Stocks, F
One that contains U.S. Stocks, S
One that contains U.S. Bonds, B
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Risk & Return With Multiple Assets
Asset Allocation or Security
Selection?
Is asset allocation or security selection more
important to the success of a portfolio?
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Asset Allocation
Empirical evidence suggests that we can reduce the risk on portfolios by
combining several different asset classes than to just rely on a single asset
class.
Traditionally, can be a basket of:
Or you can just invest into mutual funds in that asset class.
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Portfolio Return Attributors
Next Question is...
Which combination is the
best for (all of) you in the
investment opportunity set
(regardless of individual
investor’s risk profile?
Sharpe
Ratio
Sharpe Ratio
William F. Sharpe
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Capital Allocation Line
The investor can allocate his investment between the risk-free
asset and P.
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The optimal risky portfolio, P
• The steeper the CAL, the better. You get more return
for the given risk – invest in more diverse assets
• The CAL that just touches the opportunity set
indicates the optimal P at the point of tangency.
• Any other CAL that cuts the curve would have a
lower slope, meaning that there is less return. This is
not optimal.
• At point P
– E(r) = 11%
– σ = 14.20%
Capital Market Line
The capital market line (CML) is similar to the
capital allocation line (CAL) that we just analysed.
The two components of the CAL are rf and P.
When we substitute
the return on a 30-day T-bill as the risk-free
rate
the market portfolio as the risky portfolio
the CAL is transformed into the CML.
The market portfolio, M, is a broad index
represents the stocks in the market.
The CML is seen as representing a passive
strategy
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Next Week
Topic 4 –
Investment & Risk
Management