CHAPTER 4
PORTFOLIO
MANAGEMENT
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LEARNING OBJECTIVES
After working through this chapter, you should be able to:
Explain the impact of diversification on the expected return
and risk of a portfolio of shares.
Calculate the following indicators of risk and expected return
on a portfolio of shares:
expected return on a two-asset portfolio
risk of a two-asset portfolio using covariance
expected return on a multi-share portfolio
beta of a portfolio
expected return on a leveraged portfolio
standard deviation of a leveraged portfolio
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Diversification
Why is diversification important?
As future returns are uncertain, investors
should not place all their funds in one
investment.
Profitable investments should more than
compensate for investments that fail.
Diversification – what is the effect on
returns and risk?
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TWO-ASSET PORTFOLIO
RISK AND RETURN
The holding of more than one asset is often
referred to the holding a portfolio of assets.
Example 4.3
An investor decides to invest R10 000 in a portfolio
which may consist of any combination of shares in
Plasco Ltd and Quinco Ltd.
The following summary statistics are available for the
two companies:
Plasco Re = 30%; = 13.5% and;
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Quinco Re = 20%; = 11%
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Portfolio Return
Expected return on a portfolio = the weighted
average return, weighted according to the weights
used in the portfolio.
RP= ∑ (W1R1 + W2R2 + ...+ WnRn)
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Portfolio Risk
The risk of a portfolio depends not only on
the riskiness of the individual shares, which
comprise the portfolio, but also on the
relationship between their returns.
Portfolio risk is NOT a weighted average of
the risk of the individual shares in a
portfolio.
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Example
Assume an investment manager has created a
portfolio with the Stock A and Stock B. Stock A
has an expected return of 20% and a weight of
30% in the portfolio. Stock B has an expected
return of 15% and a weight of 70%.
What is the expected return of the portfolio?
E(R) = (0.30)(20%) + (0.70)(15%)
= 6% + 10.5% = 16.5%
The expected return of the portfolio is 16.5%
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TWO-ASSET PORTFOLIO RISK AND
RETURN
TABLE 4.1
EXPECTED returns for various portfolio's of P and Q
THE
PRINCIPLE
A B C Notice that each
% Investment in P Ltd % Investment in Q Ltd Expected return on portfolio return
Return = 30% Return = 20% the portfolio is the weighted
1
2 0% 100% 20.0% average
3 25% 75% 22.5%
4 50% 50% 25.0%
5 75% 25% 27.5%
6 100% 0% 30.0%
7 Example of Workings: (25% x 30%) + (75% x 20%) = 22.5%
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TWO-ASSET PORTFOLIO RISK
AND RETURN
TABLE 4.2
PAST
Year P Q PQ
performance
of shares P 1 40% 32% 36%
and Q and an 2 16% 8% 12%
equally 3 44% 30% 37%
weighted 4 20% 14% 17%
portfolio PQ 5 44% 30% 37%
6 16% 6% 11%
THE OBSERVATION 7 42% 28% 35%
In years when P performs 8 18% 12% 15%
well, so does Q
In years when P performs Std. Dev. 12.6% 10.3% 11.4%
poorly, so does Q Std. Dev.(sample) 13.5% 11.0% 12.2%
Covariance of P & Q 0.0127
0.9783
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What is relevant here?
P has a higher variability in returns than Q and this is indicated by the
individual standard deviations.
P and Q are highly correlated as their returns move in similar directions
from one year to the next.
The covariance and correlation coefficient measures the extent to
which the shares move together. A correlation coefficient of 1, means
that the share movements will be perfectly related to each other.
The correlation coefficient of P and Q is 0.978 which reflects a very
high level of correlation
As the shares are highly correlated, the risk of the portfolio in this case
will be close to the weighted average of the individual shares.
Although we may have invested in more than one share and the risk of
losing our money may have been reduced, the variability of portfolio
returns is similar to the individual shares. The construction of our
portfolio has not resulted in a reduction of risk (as measured by
variability of returns) as compared to the individual shares.
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TWO-ASSET PORTFOLIO: NEAR
PERFECT UNISON
50
40
PERCENTAGE RETURN
30
20
P LTD
PORTFOLIO PQ
Q LTD
10
0
1 2 3 4 5 6 7 8
YEAR IN WHICH RETURN WAS ACHIEVED
THE PRINCIPLE
These two shares have a high positive correlation.
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There will NOT BE much risk reducing benefit
Portfolio Risk
Assume that the returns for Q are the same
but occur in different years.
The Standard deviations for P and Q
remain the same, yet the portfolio risk has
been significantly reduced.
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Portfolio Risk
TABLE 4.2
PAST performance of shares P and Q and an
equally weighted portfolio PQ
Year P Q PQ
1 40% 12% 26%
2 16% 32% 24%
3 44% 8% 26%
THE 4 20% 30% 25%
OBSERVATION 5 44% 14% 29%
In years when P 6 16% 30% 23% Note how
performs well, Q 7 42% 6% 24% stable the
combined
performs poorly 8 18% 28% 23% return is
Std. Dev. 12.6% 10.3% 1.9%
In years when P Std. Dev.(sample) 13.5% 11.0% 2.0%
performs poorly, Q Covariance of P & Q - 0.0126
Correlation Coefficient - 0.9667
performs well
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TWO-ASSET PORTFOLIO: NEAR
PERFECT NEGATIVE CORRELATION
The AVERAGE
return each year
is very stable.
The portfolio will
have a very low
standard
deviation and
therefore very
low risk.
THE PRINCIPLE:
These two shares have a high NEGATIVE correlation.
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There WILL BE much risk reducing benefit.
FREQUENCY DISTRIBUTION OF TWO INDIVIDUAL
SHARES
AND THE PORTFOLIO OF THE TWO SHARES P and Q
THE PRINCIPLE
The expected return on
the portfolio is the
weighted average, but
the risk is considerably
less than the weighted
average
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What is required to reduce
portfolio risk?
Perfectly negatively correlated firms are
hard to find.
Yet, if shares are less than perfectly
correlated, then the portfolio risk will be
LESS than the weighted average of the
individual shares.
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Example. 4.2 Analyses the Risk of two shares, B&G
Returns
Year Benix Genhold
1 26% 24%
2 20% 35%
3 22% 22%
4 23% 37%
5 29% 32%
Stats
B G BG
Average return 24.00% 30.00% 27.00%
Standard deviation 3.16% 5.97% 3.18%
Co-variance -0.026%
Compare portfolio standard deviation to weighted average of
4.56%. We can increase our return with hardly any increase in risk
Correlation Coefficient
Slightly negative
correlation B&G
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Variance of the Portfolio
The variance of a portfolio may be determined
by applying the following formula;
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Variance
Assume a portfolio of 25% B and 75% G
Formula for the portfolio variance can also be
stated as follows;
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Using Excel
Weighted Average Return and Standard Deviation
A B C D E F G H
15 Portfolio Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Avg Return Stdev (σ)
16 BG 24.5% 31.3% 22.0% 33.5% 31.3% 29% 4.44%
17 Portfolio = 25% of B and 75% of G
We work out the weighted average return per
portfolio of 25% B & 75% G
Ex. Yr 1 = 25% x 26% + 75% x 24% = 24.5%
Then we can compute the average return for the
portfolio and the standard deviation of the
portfolio’s returns
No complex formulae required
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EFFECT OF DIVERSIFICATION ON
PORTFOLIO RISK
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Assumptions of MPT
All investors are rational and prefer less risk
rather than more for a given rate of return.
All investors have full and equal access to all
available information which results in similar
expectations.
There are no transaction costs such as brokerage;
the markets are perfectly competitive; and all
financial assets are divisible.
There is no taxation.
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The Introduction of a Risk-Free
Asset
What is the effect of being able to invest and
borrow at a risk-free rate, such as a Treasury
Bill rate?
This results in a capital market line which is
tangent to the efficient frontier and begins at
the risk-free rate.
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THE CAPITAL MARKET LINE
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What if the investor borrows at
the risk-free rate?
Assume that an investor borrows at a risk-free
rate of 12% and the market premium is 22%.
Expected return is;
Assume the investor invests R10 000 and
borrows R5 000.
R = (-5 x 0.12) + (1.5 x 0.22) = 27%
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Portfolio Risk with a Risk-Free
Asset
What is the risk of a portfolio that includes a risk-
free asset?
The standard deviation of the risk-free investment
is zero and so Formula 4.5 loses two of its terms.
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GRAPIC REPRESENTATION OF
BETA
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THE SECURITIES MARKET LINE
EXPECTED SECURITIES
RETURN
MARKET
EXPECTED LINE
18%
MARKET [SML]
RETURN
16%
M
14%
CORRECTLY
12% PRICED
MARKET SECURITY
10%
PORTFOLIO
THE RISK MARKET
8%
FREE RATE BETA
0%
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0
RISK
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Risk
Total Risk = Systematic (market) Risk +
Unsystematic (specific) Risk
Beta of a Portfolio = weighted average of betas
of shares in the portfolio
The required return on a share is as follows;
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REGRESSION ANALYSIS TO
ESTABLISH THE MARKET RISK
(BETA) OF A SHARE
THE PRINCIPLE
This share is less
volatile than the
market as a whole.
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Determining Beta
Returns
12.0%
10.0%
8.0%
Excess Company Return
6.0%
4.0%
y = 1.6338x - 0.0081
R2 = 0.8282
2.0%
0.0%
-3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%
-2.0%
-4.0%
-6.0%
Excess Market Return
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Betas Company in Betas
Sector
2010 the Sector 2010
Betas
RESOURCES 1.31
JSE:BASIC MATERIALS 1.31
JSE:GOLD MINING 0.65 Harmony 0.69
JSE:PLATINUM MINING 1.56 Angloplat 1.62
2010 JSE:GENERAL MINING 1.42 Anglo American 1.62
JSE:FORESTRY & PAPER 1.34 Sappi 1.40
JSE:INDUSTRIAL METALS & MINING 1.39 Arcelor Mittal SA 1.41
JSE:CHEMICALS 0.69 AECI 0.73
JSE:OIL & GAS 1.09 Sasol 1.11
INDUSTRIALS 0.76
JSE:CONSTRUCTION & MATERIALS 0.84 PPC 0.51
JSE:INDUSTRIAL TRANSPORTATION 0.98 Grindrod 1.19
JSE:SUPPORT SERVICES 0.75 Bidvest 0.77
JSE:GENERAL INDUSTRIALS 0.62 Barloworld 1.12
JSE:ELECTRONIC & ELECTRICAL EQUIP. 0.66 Reunert 0.56
JSE:INDUSTRIAL ENGINEERING 0.91 Hudaco 0.70
FINANCIALS 0.71
JSE:BANKS 0.76 ABSA 0.54
JSE:INSURANCE 0.39 Santam 0.43
JSE:LIFE ASSURANCE 0.88 Old Mutual 1.19
JSE:REAL ESTATE INVEST. & SERVICES 0.35 Growthpoint 0.34
JSE:GENERAL FINANCIAL 0.86 PSG 0.75
CONSUMER GOODS 0.70
JSE:BEVERAGES 0.69 SABMiller 0.69
JSE:FOOD PRODUCERS 0.50 Tiger Brands 0.47
JSE:AUTOMOBILES & PARTS 0.71 Metair 0.84
JSE:HOUSEHOLD GOODS 0.92 Steinhoff 1.01
CONSUMER SERVICES 0.68
JSE:GENERAL RETAILERS 0.58 Woolworths 0.70
JSE:FOOD & DRUG RETAILERS 0.42 Pick n Pay 0.45
JSE:TRAVEL & LEISURE 0.62 Sun International 0.67
JSE:MEDIA & ENTERTAINMENT 0.91 Naspers 0.94
HEALTH CARE 0.56
JSE:HEALTH CARE EQUIP. & SERVICES 0.64 Medi Clinic 0.43
JSE:PHARMACEUTICALS & BIOTECH 0.45 Aspen 0.54
TECHNOLOGY 0.80
JSE:TECHNOLOGY HARDWARE N/A Pinnacle 0.96
JSE:SOFTWARE & COMPUTER SERVICES 0.82 Gijima AST 1.40
TELECOMMUNICATIONS 0.77
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Source: Cadiz Financial Risk Service - June 2010
Efficient Market Hypothesis
EMH
Weak form
Semi-strong form
Strong form
What is the current state of play? Are
markets efficient?
Market anomalies such as the January
effect
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