OPTIMAL PORTFOLIO

SELECTION
PORTFOLIO
• It is a collection
or combination of
financial assets.
• It can also be
called collection
of Physical Assets
PORTFOLIO SELECTION
• Diversification is key to optimal risk management
• Analysis required because of the infinite number of
portfolios of risky assets
• How should investors select the best risky portfolio?
• How could riskless assets be used?
• Investors can invest in both risky and riskless assets
and buy assets on margin or with borrowed funds
BUILDING A PORTFOLIO

Step 1: Use the Markowitz portfolio selection model to

identify optimal combinations

Step 2: Consider borrowing and lending possibilities

Step 3: Choose the final portfolio based on your

preferences for return relative to risk
PORTFOLIO OPTIMIZATION

Portfolio optimization is the process

of structuring an investment
portfolio to achieve the optimal
balance between risk and return
based on an investor’s objectives
and constraints.
THE MODERN PORTFOLIO THEORY
(MPT)
MPT, developed by Harry Markowitz, is a
framework that provides a mathematical
approach to portfolio optimization. It
suggests that investors can construct
efficient portfolios by combining assets
with different risk-return characteristics.
PORTFOLIO THEORY
• Optimal diversification takes into account all available
information (as opposed to random diversification)
Assumptions in portfolio theory:
• A single investment period (e.g., one year)
• Liquid position (e.g., no transaction costs)
• Preferences based only on a portfolio's expected return
and risk
AN EFFICIENT PORTFOLIO
• Smallest portfolio risk for a given level of expected
return
• Largest expected return for a given level of portfolio
risk
• Only locate and analyze the subset known as the
• From the setset.
efficient of all possible portfolio

• Lowest risk for given level of

return
AN EFFICIENT PORTFOLIO
• All other portfolios in attainable set are dominated by
efficient set
• Global minimum variance portfolio. Smallest risk of the
efficient set of portfolios
• Efficient set (frontier)
• Segment of the minimum variance frontier above the global
minimum variance portfolio
• The set of efficient portfolios composed entirely of risky
securities generated by the Markowitz portfolio model
EFFICIENT PORTFOLIOS
• Efficient frontier
or Efficient set
(curved line
from A to B)
• Global minimum
variance
portfolio
(represented by
point A)
SELECTING AN OPTIMAL PORTFOLIO OF RISKY
ASSETS
Markowitz portfolio selection
model
• Generates a frontier of efficient portfolios which are equally
good
• Does not address the issue of riskless borrowing or lending
(investors are not allowed to use leverage)
• Different investors will estimate the efficient frontier differently
(this results from estimating the inputs to the Markowitz model
differently)
• Element of uncertainty in application (i.e., uncertainty is
inherent in security analysis)
ALTERNATIVE METHODS OF OBTAINING
THE EFFICIENT FRONTIER
For a portfolio of n
securities:
• The full variance-covariance model of Markowitz
requires [n (n + 3)] / 2 estimates
• The single-index model requires (3n + 2) estimates
• Example: calculate the required number of estimates
needed by both models for a portfolio of 250 securities
SELECTING OPTIMAL ASSET CLASSES
Another way to use the Markowitz model is with asset
• Allocation of portfolio assets to broad asset categories (i.e.,
classes
how much of the portfolio's assets are to be invested in
stocks, bonds, money market securities, etc.)
• Asset class rather than individual security decisions
most important for investors

• The rationale behind the asset allocation approach is that different

asset classes offer various returns and levels of risk

• Correlation coefficients may be quite

low
EXAMPLE: SELECTING OPTIMAL ASSET CLASSES
• Consider the performance of two Canadian portfolio
managers, A and B, between 1999 and 2003.
• Manager A maintained an equally weighted portfolio with
respect to T-bills, long-term government bonds, and
common stocks.
• Manager B was more conservative and allocated 20% of
funds to each stocks and bonds, with the remaining 60%
to T-bills.
• Assume each manager matched the risk-return
performance on the relevant asset class benchmark index
for the proportion of their portfolio invested in each of the
three asset classes.
EXAMPLE: SELECTING OPTIMAL ASSET CLASSES
• Over the period, the average annual return and
standard deviation for the asset classes were:
• T-bills: 4.01% & 1.29%
• Government bonds: 5.6% & 7.96%
• Common stocks: 7.68% & 20.42%
• Calculate the annual return earned by
managers A & B and the standard deviations of
their portfolios.
OPTIMAL RISKY PORTFOLIOS
 2- Borrowing and Lending Possibilities

Risk-free
• assets
Certain-to-be-earned expected return (this is nominal return and
not real return which is uncertain since inflation is uncertain)
• Zero variance
• No covariance or correlation with risky assets (p RF = 0 since the
risk-free rate is a constant which by nature has no correlation
with the changing returns on risky securities)
• Usually proxied by a Treasury Bill
• Amount to be received at maturity is free of default risk,
known with certainty
 Risk-Free Lending

• Riskless assets can be

combined with any
portfolio in the efficient
set AB (comprised only
of risky assets)
• Z implies lending
• Set of portfolios on line
RF to T dominates all
portfolios below it
 Impact of Risk-Free Lending

• Expected portfolio
return

• Risk of the portfolio (correlation and covariance for the risk-free asset is
zero)

• Expected return and risk of the portfolio with lending is a weighted

average
 Example: Impact of Risk-Free Lending

• Assume that portfolio X has an expected return

of 15% with a standard deviation of 30%, and
that the risk-free security has an expected return
of 3%.
• If 60% of investable funds is placed in RF and
40% in portfolio X, calculate the expected return
and standard deviation of the resulting portfolio.
 Implications of Portfolio Selection

Investors should focus on risk that cannot be

managed by diversification

Total risk = Systematic (non-diversifiable) risk +

Non-systematic (diversifiable) risk
 SYSTEMATIC RISK

• Systematic risk (unavoidable)

• Variability in a security's total returns directly
associated with economy-wide events
• Common to virtually all securities
• E.g., interest rate risk, market risk, and inflation risk
 NON - SYSTEMATIC RISK

• Non-Systematic
Risk
• Variability of a security's total return not related to
general market variability
• Diversification decreases this risk

• The relevant risk of an individual stock is its contribution to

the riskiness of a well-diversified portfolio

Portfolios rather than individual assets most important.

Recent Canadian research suggests that 70 or more stocks
are required to obtain a well diversified portfolio
Portfolio Risk and Diversification
CAPITAL ASSET PRICING MODEL (CAPM)

The Capital Asset Pricing Model (CAPM) is a

model that describes the relationship
between the expected return and risk of
investing in a security. It shows that the
expected return on a security is equal to the
risk-free return plus a risk premium, which is
based on the beta of that security.
Below is an illustration of the CAPM
concept. CAPM is calculated
according to the following
formula:

Where:

Ra = Expected return on a
security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the
“Risk
market Premium” = (Rm –
Rrf)
CAPM Example - Calculation of Expected Return
Let's calculate the expected return on a stock, using the Capital Asset Pricing Model
(CAPM) formula.
Given Solution
• It: trades on the NYSE and its
:
• Expected return = Risk
operations are based in the United
Free Rate + [Beta x
States
Market Return Premium]
• Current yield on a U.S. 10-year
• Expected return = 2.5%
treasury is 2.5%
+ [1.25 × 7.5%]
• The average excess historical
• Expected return = 11.9%
annual return for U.S. stocks is
7.5%
• The beta of the stock is 1.25
(meaning its average return is
1.25x as volatile as the S&P500
The CAPM formula shows that the expected return on an
investment is determined by two factors:

Time Value of Money

• The risk-free rate accounts for the opportunity cost of
investing, i.e., the return you could have earned by investing
in a risk-free asset.

Risk Premium
• The beta multiplied by the market risk premium represents
the compensation for taking on systematic risk. The higher the
beta, the greater the systematic risk, and therefore, the higher
the expected return.
LIMITATIONS OF MODERN
PORTFOLIO THEORY

1.Risk aversion
assumptions
2.Equating risk as
volatility
3.Historical data
 ASSUMPTIONS OF MODERN
PORTFOLIO THEORY
1. Investors are rational and risk-averse
2. Markets are efficient
3. Assets are priced correctly
4. Investors have access to all information
THANK YOU!