Part Two

Portfolio Theory

Lecture 5. Efficient Diversification

This is based on Ch.6 of the textbook of this course: “Essentials of Invest-

ments,” written by Bodie/Kane/Marcus. Don't circulate it.
2 Contents

1. Principle of Diversification.
2. Systematic Risk and Unsystematic Risk.
3. Optimal CAL with two risky Assets.
4. Optimal CAL with many Risky Assets.
5. Capital Asset Pricing Model.
 The Principle of Diversification
3

 Diversification
The process of spreading an investment across
assets (and thereby forming a portfolio)
 The principle of diversification
Diversification will eliminate some of the risk
4 Ex 8) in Lecture 3
Stock A Stock B
State of Economy Probability HPR ProbabilityHPR HPR ProbabilityHPR
1 0.3 0.08 0.024 0.05 0.015
2 0.4 0.04 0.016 0.06 0.024
3 0.3 0 0 -0.01 -0.003
Expected return 0.04 Expected return 0.036

Stock A
Probability
State of Economy Probability HPR Deviation Square of deviation
Square of deviation
1 0.3 0.08 0.04 0.0016 0.00048
2 0.4 0.04 0 0 0
3 0.3 0 -0.04 0.0016 0.00048
Variance 0.00096
Standard deviation 0.030983867

Stock B
Probability
State of Economy Probability HPR Deviation Square of deviation
Square of deviation
1 0.3 0.05 0.014 0.000196 0.0000588
2 0.4 0.06 0.024 0.000576 0.0002304
3 0.3 -0.01 -0.046 0.002116 0.0006348
Variance 0.000924
Standard deviation 0.030397368
5 Ex 10) in Lecture 3
Stock A Stock B Portfolio
Invest-
$500 $500 $1000
ment
weight 0.5 0.5 1
State of Probability HPR of
Probability HPR
Economy the portfolio
1 0.3 0.08 0.05 0.065 0.0195
2 0.4 0.04 0.06 0.05 0.02
3 0.3 0 -0.01 -0.005 -0.0015
Expected return of
0.038
the portfolio

Portfolio
State of Square of devia- Probability Square of
Probability HPR Deviation
Economy tion deviation
1 0.3 0.065 0.027 0.000729 0.0002187

2 0.4 0.05 0.012 0.000144 0.0000576

3 0.3 -0.005 -0.043 0.001849 0.0005547

Variance 0.000831
Standard devia-
0.028827071
tion
 Remark
6

 Diversification will eliminate some of the risk,

even while maintaining the expected return
7 Example
 Let the rates of return on the stocks 1, 2, 3 be , , ,
respectively. The expected return and the variance
of the return on each stock, and the covariance be-
tween returns on each pair of the stocks are as fol-
lows

 Let be the rate of return on a portfolio with equal

amounts invested in each of the three stocks
8 Example - continued
 If you invest only in Stock 1, then the expected
return is
 The expected return on the portfolio is also
9 Example - continued
 If you invest only in Stock 1, then the variance of the
return is
 The variance of the portfolio is
 Remark
10

 There is a minimum level of risk that cannot be

eliminated by diversifying
Diversification reduces risk, but only up to a
point
Some risk is diversifiable and some is not
11 Unsystematic Risk
 An unsystematic risk is one that is particular to a sin-
gle asset or, at most, a small group
 Ex)
If the asset under consideration is stock in a single com-
pany, the discovery of positive NPV projects such as
successful new products and innovative cost savings will
tend to increase the value of the stock
Unanticipated lawsuits, industrial accidents, strikes, and
similar events will tend to decrease future cash flows
and thereby reduce share values
12 Unsystematic Risk
 Unsystematic risk is essentially eliminated by diversification,
so a portfolio with many assets has almost no unsystematic
risk
 If we held only a single stock, the value of our investment would
fluctuate because of company-specific events
 If we hold a large portfolio, on the other hand, some of the
stocks in the portfolio will go up in value because of positive
company-specific events and some will go down in value be-
cause of negative events. The net effect on the overall value of
the portfolio will be relatively small because these effects will
tend to cancel each other out
 The terms diversifiable risk and unsystematic risk are often
used interchangeably
 Unsystematic risk is also called unique risk or asset-specific
risk
13 Systematic Risk

 A systematic risk is one that affects almost all assets

to some degree
 No matter how many assets we put into a portfolio,
the systematic risk doesn’t go away
 The terms nondiversifiable risk and systematic risk
are used interchangeably
14 Portfolios of Two Risky Assets

 Portfolios of two risky assets (Asset and Asset ) are

relatively easy to analyze, and they illustrate the prin-
ciples and considerations that apply to portfolios of
many assets.
 Both of Asset and Asset may be portfolios on their
own.
15 Portfolios of Two Risky Assets

 A proportion denoted by is invested in Asset , and the

remainder, , denoted , is invested in Asset .
 The rate of return on this portfolio, , will be
𝑅 𝑝=𝑤1 𝑅 1+𝑤2 𝑅2
where is the rate of return on Asset and is the rate
of return on Asset .
16 Portfolios of Two Risky Assets

 Then, we have

𝐸[𝑅¿¿𝑝]=𝑤1 𝐸[𝑅¿¿1]+𝑤2 𝐸[𝑅¿¿2]¿¿¿

17 Portfolios of Two Risky Assets

 As an example, we consider the case where

𝐸 [𝑅¿¿1]=0.08 , 𝐸 [ 𝑅¿¿2]=0.13 , 𝜎 1=0.12 , 𝜎 2=0.20 ,𝜎 12=0.0072 ¿¿

 The table in the next slide shows combinations of

portfolio expected return and standard deviation for
various and ( = ).
18 Portfolios of Two Risky Assets

w_1 w_2 sigma_p E[R_p]

-0.50 1.50 0.28775 0.1550
0.00 1.00 0.20000 0.1300
0.30 0.70 0.15466 0.1150
0.32 0.68 0.15200 0.1140
0.34 0.66 0.14940 0.1130
0.36 0.64 0.14686 0.1120
0.38 0.62 0.14439 0.1110
0.40 0.60 0.14199 0.1100
0.42 0.58 0.13966 0.1090
0.44 0.56 0.13740 0.1080
0.46 0.54 0.13523 0.1070
0.48 0.52 0.13315 0.1060
0.50 0.50 0.13115 0.1050
0.80 0.20 0.11454 0.0900
0.82 0.18 0.11447 0.0890
0.84 0.16 0.11454 0.0880
1.00 0.00 0.12000 0.0800
1.50 -0.50 0.17776 0.0550
19 Portfolios of Two Risky Assets

 The curve in the next slide shows the portfolio opportu-

nity set in the case where
𝐸 [𝑅¿¿1]=0.08 , 𝐸 [ 𝑅¿¿2]=0.13 , 𝜎 1=0.12 , 𝜎 2=0.20 ,𝜎 12=0.0072 ¿¿

 We call it the portfolio opportunity set because it shows

all combinations of portfolio expected return and stan-
dard deviation that can be constructed from the two
available assets.
20 Portfolios of Two Risky Assets

 The portfolio opportunity set

0.18

Asset2 : 𝑤_1=0
(0.2, 0.13)
0.16

0.14

0.12

0.1
E[R_p]

Minimum-variance portfolio: .82

0.08
(0.11447, 0.089)
0.06
Asset1:
0.04
(0.12, 0.08)
0.02

0
0.1 0.12 0.14 0.16 0.18 0.2 0.22 0.24 0.26 0.28 0.3

sigma_p
 The Optimal Risky Portfolio with Two Risky
21
Assets and a Risk-Free Asset

 In Lecture 4:
 We have developed the CAL, the graph of all feasible risk-re-
turn combinations available from allocating the complete port-
folio between a risky portfolio and a risk-free asset.
 An investor confronting the CAL chooses the optimal combina-
tion from the set of all feasible choices to maximize his utility.
 That is, we found the optimal complete portfolio given a risky
portfolio and the CAL generated by a combination of this risky
portfolio and the risk-free asset,
 The maximum utility, , an investor achieves in the optimiza-
tion problem is an increasing function of the Sharpe ratio of
the risky portfolio.
 The Optimal Risky Portfolio with Two Risky
22
Assets and a Risk-Free Asset

 Therefore, the optimal risky portfolio is the risky port-

folio with the highest Sharpe ratio.
 That is, to construct the optimal risky portfolio with
two risky assets is to find the weights and that result
in the highest slope of the CAL.
 The Optimal Risky Portfolio with Two Risky
23
Assets and a Risk-Free Asset

 We consider the case where

𝐸 [𝑅¿¿1]=0.08 , 𝐸 [ 𝑅¿¿2]=0.13 , 𝜎 1=0.12 , 𝜎 2=0.20 ,𝜎 12=0.0072 ¿¿

and
𝑟 𝑓 =0.05

 The table in the next slide shows combinations of

portfolio expected return and standard deviation, and
the corresponding Sharpe ratios for various and
( = ).
 The Optimal Risky Portfolio with Two Risky
24
Assets and a Risk-Free Asset

w_1 w_2 sigma_p E[R_p] Sharpe ratio

-0.50 1.50 0.28775 0.1550 0.3649
0.00 1.00 0.20000 0.1300 0.4000
0.30 0.70 0.15466 0.1150 0.4203
0.32 0.68 0.15200 0.1140 0.4211
0.34 0.66 0.14940 0.1130 0.4217
0.36 0.64 0.14686 0.1120 0.4222
0.38 0.62 0.14439 0.1110 0.4225
0.40 0.60 0.14199 0.1100 0.4226
0.42 0.58 0.13966 0.1090 0.4225
0.44 0.56 0.13740 0.1080 0.4221
0.46 0.54 0.13523 0.1070 0.4215
0.48 0.52 0.13315 0.1060 0.4206
0.50 0.50 0.13115 0.1050 0.4194
0.80 0.20 0.11454 0.0900 0.3492
0.82 0.18 0.11447 0.0890 0.3407
0.84 0.16 0.11454 0.0880 0.3318
1.00 0.00 0.12000 0.0800 0.2500
1.50 -0.50 0.17776 0.0550 0.0281
 The Optimal Risky Portfolio with Two
25
Risky Assets and a Risk-Free Asset

 The optimal risky portfolio

The optimal risky portfolio:

(0.14199, 0.11), =0.4226
0.18 CAL()
Asset2 : 𝑤_1=0
(0.2, 0.13), S=0.4
0.16

0.14

0.12
Expected return

0.1
Minimum-variance portfolio: .82
0.08
(0.11447, 0.089), S=0.3407
0.06
Asset1:
0.04
(0.12, 0.08),
0.02 S=0.25

0
0.1 0.12 0.14 0.16 0.18 0.2 0.22 0.24 0.26 0.28 0.3

Standard deviation
 An Investor’s Optimal Complete Portfolio
26
with Two Risky Assets and a Risk-Free Asset

 Now that we have constructed the optimal risky portfo-

lio , we can use the individual investor’s degree of risk
aversion to calculate the optimal proportion of the
complete portfolio to invest in the risky component.
 We still consider the case where
,

 In this case, we consider an investor with a coefficient of

risk aversion .
 An Investor’s Optimal Complete Portfolio
27
with Two Risky Assets and a Risk-Free Asset

 Then, the investor’s capital allocation problem is

to choose a risk-return combination to maximize
his utility subject to for .
 The solution to the optimization problem.
 The optimal combination:
 The optimal capital allocation:
 The maximum utility:
 An Investor’s Optimal Complete Portfolio
28
with Two Risky Assets and a Risk-Free
Asset

0.18
The optimal complete CAL()
0.16
portfolio
0.14

0.12
Expected return

0.1

0.08

0.06

0.04

0.02

0
0.1 0.12 0.14 0.16 0.18 0.2 0.22 0.24 0.26 0.28 0.3

Standard deviation
 An Investor’s Optimal Complete Portfolio
29
with Two Risky Assets and a Risk-Free Asset

 Thus, the investor will invest 74.40% of his wealth in

the optimal risky portfolio and 25.60% in the risk-free
asset.
 That is, the return of the optimal complete portfolio,
in this case, can be expressed as
 An Investor’s Optimal Complete Portfolio
30
with Two Risky Assets and a Risk-Free Asset

 The optimal risky portfolio consists of 40% in Asset1,

so the fraction of wealth in Asset1 will be , or 29.76%.
 Similarly, the fraction of wealth in Asset2 will be , or
44.64%.
31
Asset Allocation with Stocks, Bonds, and
Bills
 The construction of the optimal complete portfolio with two
risky assets and a risk-free asset is an asset allocation decision
across three key asset classes of stocks, bonds, and safe as-
sets if Asset1 is a bond portfolio (fund) and Asset2 is a stock
portfolio (fund).
 This is because it involves making an optimal decision about the al-
location of risky portfolios between the stock and bond markets, as
well as investment in Treasury bills.
 Most investment professionals recognize that “the really critical de-
cision is how to divvy up your money among stocks, bonds and su-
persafe investments such as Treasury bills.”
32
Efficient Diversification with Many Risky As-
sets
 We extend the two-risky-assets portfolio methodology to in-
clude multiple risky assets (security selection) in three
steps.
First, we generalize the opportunity set for multiple risky as-
sets, beyond just two.
Next, we determine the optimal risky portfolio that supports
the steepest capital allocation line (CAL), aiming to maximize
the Sharpe ratio.
Finally, we construct a complete portfolio on the steepest CAL
by mixing the risk-free asset with the optimal risky portfolio,
taking into consideration the investor's risk aversion.
33
Efficient Diversification with Many Risky As-
sets
 To get a sense of how additional risky assets can improve investment oppor-
tunities, look at the figure in the next slide.
 Points A, B, C represent the expected returns and standard deviations of three
stocks.
 The curve passing through A and B shows the risk-return combinations of portfo-
lios formed from those two stocks.
 Similarly, the curve passing through B and C shows portfolios formed from those
two stocks.
 Now observe point E on the AB curve and point F on the BC curve.
 These two points represent two portfolios chosen from the set of AB and BC combina-
tions, respectively.
 The curve that passes through E and F in turn represents portfolios constructed
from portfolios E and F.
 Since E and F are themselves constructed from A, B, and C, this curve shows some of
the portfolios constructed from these three stocks.
 Notice that the curve EF extends the investment opportunity set to the north-
west, which is the desired direction.
34
Efficient Diversification with Many Risky As-
sets

F C

E B
Expected return

Standard deviation
35
Efficient Diversification with Many Risky As-
sets
 Now we can continue to take other points (each representing port-
folios) from these three curves and further combine them into new
portfolios, thus shifting the opportunity set even farther to the
northwest.
 You can see that this process would work even better with more
stocks.
 Thus, we determine the risk-return opportunity set.
 The inputs are the expected returns and standard deviations of each
asset in the universe, along with the covariances between each pair
assets.
 These data come from security analysis.
 See the figure in the next slide where the yellow region including the
boundary represents the risk-return opportunities available to the in-
vestor.
36
Efficient Diversification with Many Risky As-
sets

Efficient Fron-
tier
Expected return

Individual
Global assets
Minimum-
Variance Minimum-Variance Frontier
Portfolio

Standard deviation
37
Efficient Diversification with Many Risky As-
sets
 The minimum-variance frontier is the graph representing
risk-return opportunities with the lowest possible standard
deviation that can be attained for each expected return of
the portfolio.
Given the input data for expected returns, variances, and co-
variances, we can calculate the minimum-variance portfolio
for any targeted expected return.
 The (global) minimum-variance portfolio is the point repre-
senting the risk-return combination of a portfolio that has
the minimum variance among all the portfolios available to
the investor.
38
Efficient Diversification with Many Risky As-
sets
 The part of the minimum-variance frontier that lies above the
global minimum-variance portfolio is called the efficient fron-
tier of risky assets.
 It represents the set of portfolios that offers the highest possible
expected return for each level of portfolio standard deviation
 These portfolios may be viewed as efficiently diversified and thus
are candidates for the optimal risky portfolio.
 For any portfolio on the risk-return opportunity set except for
the portfolios that lie on the efficient frontier, there is a portfo-
lio with the same standard deviation and a greater expected
return positioned directly above it.
 Hence the portfolios on the risk-return opportunity set except for
the portfolios that lie on the efficient frontier are inefficient.
39
Efficient Diversification with Many Risky As-
sets
 Choosing the optimal risky portfolio
Using the current risk-free rate, we search for the CAL with the
steepest slope.
That is, we search for the CAL generated from the risk-free as-
set and the risky portfolio with the highest Sharpe ratio among
the portfolios that lie on the efficient frontier of risky assets.
The CAL formed from the optimal risky portfolio will be tangent
to the efficient frontier
40
Efficient Diversification with Many Risky As-
sets
 An investor’s optimal complete portfolio
The optimal combination:
The optimal capital allocation:
The maximum utility:
41
Efficient Diversification with Many Risky As-
sets
 A portfolio manager will offer the same risky portfolio (the optimal
risky portfolio) to all clients, no matter what their degrees of risk
aversion.
 Regardless of risk aversion, all clients will confront the same CAL.
 Risk aversion comes into play only when clients select their de-
sired point on the CAL.
 Separation property is that portfolio choice can be separated into
two independent tasks.
 The first task, to determine the optimal risky portfolio, is purely tech-
nical. Given the input data, the best risky portfolio is the same for all
clients regardless of risk aversion.
 The second task, construction of the complete portfolio from bills and
the optimal risky portfolio, is personal and depends on risk aversion.
Here the client is the decision maker.
42 Systematic Risk Principle
 There is a reward, on average, for bearing risk
 The market does not reward risks that are borne unnecessarily
 Because unsystematic risk can be eliminated at virtually no cost
(by diversifying), there is no reward for bearing it
 Thus, the reward for bearing risk depends only on the systematic
risk of an investment
 We can observe this in the figure in Slide 36.
 Systematic risk principle
 The expected rate of return on an asset depends only on that as-
set’s systematic risk
 That is, the risk premium on an asset depends only on that asset’s
systematic risk
 All of the risk for a portfolios that lies on the efficient frontier is
systematic and rewarded
43
Market Portfolio
 The market portfolio is the risky portfolio for which every se-
curity is held in proportion to its total market value.
 The proportion of investment in each risky asset is the ratio
of the total market value of each risky asset to that of all
risky assets present in the market
44
Market Portfolio
 We may regard the market portfolio as the optimal risky
portfolio if we assume the collective wisdom and actions of
all market participants choose the risky assets optimally.
Then, all of the risk for the market portfolio is systematic and
rewarded.
 We call the capital allocation line provided by the risk-free
asset and the market portfolio the capital market line (CML).
45
Market Portfolio
 The rate of return on a representative index of common
stocks such as S&P 500 is often used as a proxy of that on
the market portfolio
 Market index funds or exchange-traded funds (ETFs) are de-
signed to replicate the performance of such an index
46
Passive Strategies and the Capital Market Line
 A passive strategy is based on the premise that securities
are fairly priced, and it avoids the costs involved in under-
taking security analysis.
Passive investment strategies may make sense for many in-
vestors.
 To avoid the costs of acquiring information on any individual
stock or group of stocks, a passive strategy uses a broad
stock market index as the risky portfolio to generate the
CML
To implement the stock market index, a passive strategy uses a
broad index fund or ETF.
47 Capital Asset Pricing Model
 Let be the number of risky assets present in the mar-
ket (Asset , Asset , …, Asset ). Let be the total market
value of Asset and let be the total market value of all
risky assets in the market. Let be the proportion in-
vested in Asset . Then, we have and

 Let be the rate of return on Asset for , and let be the rate
of return on the market portfolio. Then, we have
48 Capital Asset Pricing Model
 Expected rate of return on the market portfolio

 Risk premium for the market portfolio (Market risk pre-

mium)

)
49 The Variance of ()
50 Summary
 Market risk premium

 The variance of
51 Capital Asset Pricing Model: CAPM

 Capital Asset Pricing Model

 , where
 , called the beta coefficient for Asset , is a measure of
systematic risk
 The line in the above describing the relationship be-
tween systematic risk and expected rate of return in the
financial market is usually called the security market line
(SML)
 The risk-free asset also satisfies the relationship of SML
 , where
52

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