portfolio

 Portfolio:
 A group of investment assets.
A group of securities held by an individual or
institutional investor,
which may contain a variety of common and
preferred stocks, corporate and municipal bonds
, certificates of deposit, and treasury bills-that
is, appropriate selections from the equity,
capital, and money markets.
 Risk and Return of a portfolio

Portfolio theory:
- Originally developed by Harry Markowitz
- Theory shows that portfolio risk is more than a
simple aggregation of the risks of individual assets
- Risk depends on the interplay between the return on
assets comprising the portfolio
- An investors construct a portfolio of investment
rather than invest in a single asset
 Portfolio weight

 A percentage of a portfolio’s total value that is in particular asset

 We call these percentages the portfolio weights
for example

We have BR.50/- in one asset and BR.150 in another asset , then our
total portfolio is BR.200/-

The percentage of our portfolio in the first asset is 50/200 = 0.25

The percentage of our portfolio in the second asset is
150/200 = 0.75
The portfolio weights are 0.25 and 0.75 respectively
Note: Portfolio weights have add up to 1
 Portfolio Return
- The expected rate of return on a portfolio is the weighted
average of the expected rate of return on assets comprising the
portfolio
- Two determinants of portfolio return
- Expected rate of return on each asset/ security
- Relative share of each asset/ security in the portfolio
( portfolio weight)

Erp = expected rate of return from a portfolio

Wi = proportion of investment on Asset I
Eri = Expected return on asset I
n = number of assets in a portfolio
 For instance
 Expected return on two assets L and H are 12 and 16
percentages respectively
 If the corresponding weights are 0.65 and 0.35 in the
portfolio
 The expected rate of return of the portfolio
= 0.65X0.12+0.35X0.16
= 7.8+5.6
= 13.4
 Portfolio Risk
 Total risk is measured in terms of variance ( sigma square)
 Standard deviation of returns( Sigma)
 Portfolio variance is not the weighted average of variance of returns on
individual assets in the portfolio
 The overall risk of the portfolio includes the interactive risk of an asset relative
to others, measured by Co-variance of returns
 The Co-variance, in turn, depends on the Correlation between returns on assets in
the portfolio
 Significance of Covariance
 An absolute measure of the degree of
association between the returns for a pair of
securities.
 The extent to which and the direction in which
two variables co-vary over time
 Example:
 Co-variance
 It measures two assets co-movement of returns
Steps involved to measure co-variance:
1) Determine expected return on assets
2) Determine deviations of possible returns from
the expected return
3) Determine the product of deviation of assets
4) Productive of deviations multiplied by respective
probability
5) Calculate sum of the product , it is known as co-
variance
 Different possible co-variances
 Positive co-variance:
Two assets returns could be above their average rate of return at the same
time
Alternatively:
Two assets return could be below their average rate of return at the same
time
 Negative co-variance:
 One Asset Average rate of return above its average rate of return, another
asset average rate of return is below its average rate of return
 Zero co-variance:
Returns on two assets could not show any pattern
 Correlation
 It is a measure of the linear relationship between two variables
 The value of correlation called as correlation coefficient
 The correlation could be positive, Negative or Zero
 The correlation coefficient always ranges between -1 and +1
 Why Correlation?
To understand the relationship between to assets returns
 Perfect positive correlation
 The returns have a perfect direct linear relationship
 Knowing what the return on one security will do allows an investor
to forecast perfectly what the other will do
 Perfect negative correlation
 Perfect inverse linear relationship
 Zero correlation
 No relationship between the returns on two securities
 Why Correlation?
 Combining securities with perfect positive correlation
or high positive correlation does not reduce risk in the
portfolio
 Combining two securities with zero correlation,
portfolio risk cannot be eliminated
 Combining two securities with perfect negative
correlation could eliminate risk altogether
 Diversification
 The process of spreading an investment across assets is called
diversification
Principle of diversification:
 Spreading an investment across no.of assets will eliminate some, but not
all, of the risk
Diversifying:
 Constructing a Portfolio in such as way as to reduced portfolio risk without
sacrificing return
Questions for Diversification:
1.Diversified by including assets across all asset classes
(stocks, Bonds and real estate)
what is proportion of these assets,
which specific stocks, Bonds and real assets should investor will select
2. Focus only one asset Class : which stocks/Bonds selected?
 Markowitz contribution on diversification
 He demonstrated that a diversification strategy should
take into account the degree of co-variance or
correlation between assets return in a portfolio
 The co-variance or correlation of asset returns is the
measure of the degree to which the returns two assets
vary or change together
 Markowitz diversification/Mean variance
diversification
 It is the formulation of a security’s risk in terms of a Portfolio
of securities , rather than the risk of an individual security
 It seems to combine securities in a portfolio with returns that
are less than perfectly positively correlated in an effort to
lower portfolio risk ( variance) without sacrificing return
 Principle of Markowitz diversification
 It states that as the correlation ( co-variance) between the returns for assets
that are combined in a portfolio decreases
 The variance of the return of portfolio less than the variance of individual
assets ( provided the correlation is less than perfectly correlated)
 The good News:
Investor can maintain expected portfolio return and lower portfolio risk by
combining assets with lower correlations
 The Bad News:
very few assets have small to negative correlations with other assets.
The Problem, then, becomes one of searching among large no. of assets in an
effort to discover the portfolio with minimum risk at a given level of
expected return or
The highest expected return at given level of risk
 Diversification
Can eliminate some risk
Unsystematic risk tends to disappear in a large
portfolio
Systematic risk never disappears
 Diversification
 Investing in more than one security to
reduce risk
 If two stocks are perfectly positively
correlated, diversification has no effect on
risk
 If two stocks are perfectly negatively
correlated, the portfolio is perfectly
diversified
 Why do people invest?
 Investment positions are undertaken with the goal of earning some
expected return. Investors seek to minimize inefficient deviations
from the expected rate of return
 Diversification is essential to the creation of an
efficient investment, because it can reduce the
variability of returns around the expected return.
 A single asset or portfolio of assets is considered to be
efficient if no other asset or portfolio of assets offers
higher expected return with the same (or lower) risk,
or lower risk with the same (or higher) expected
return.
 Will diversification
eliminate all our risk?
 It reduces risk to an undiversifiable level.
 It eliminates only company-specific risk.
 Simple diversification—randomly selected stocks,
equally weighted investments
 Diversification across industries—investing in stock
across different industries such transportation,
utilities, energy, consumer electronics, airlines,
computer hardware, computer software, etc.
 Systematic and Unsystematic Risk
 A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
 William Sharpe defined:
 Portion of an asset’s variability that can be attributes to a
common factor
 It is called undiversifible/market risk/Systematic risk
 It is the minimum level of risk that can be attained for a
portfolio by means of diversification across large no. of
randomly chosen assets
 Systematic risk is that which results from general market and
economic conditions that can not diversified away.
 Examples of systematic risk include uncertainty about general
economic conditions, such as GNP, interest rates or inflation.
 Systematic and Unsystematic Risk
 An unsystematic risk is a risk that specifically affects a single
asset.
 William Sharpe defined:
‘The portion of asset’s variability that can be diversified
away’
 Unsystematic risk also known as
diversifiable/unique/residual/company specific/Idiosyncratic
risk
 On the other hand, announcements specific to a company, such
as a gold mining company striking gold, are examples of
unsystematic risk.
 Market Risk
 Unexpected changes in interest rates.
 Unexpected changes in cash flows due
to tax rate changes, foreign
competition, and the overall business
cycle.
 Firm-Specific Risk
 A company’s labor force goes on
strike.
 A company’s top management dies in a
plane crash.
 A huge oil tank bursts and floods a
company’s production area.
 As you add stocks to your
portfolio, firm-specific risk is
reduced.
 B. Diversification
 1. Normal Diversification
 This occurs when the investor combines more than
one (1) asset in a portfolio

Risk

Unsystematic 75% of Co.

Risk Total Risk

Systematic Risk 25% of Co.

Total Risk
1 5 10 20 30 # of Assets
 Risk: Systematic and Unsystematic
We can break down the risk, U, of holding a stock into two
components: systematic risk and unsystematic risk:

Total risk;

Nonsystematic Risk;

Systematic Risk;

n
 Systematic Risk and Betas
 The beta coefficient, , tells us the response of the stock’s
return to a systematic risk.
 In the CAPM,  measured the responsiveness of a security’s
return to a specific risk factor, the return on the market
portfolio.

Cov( Ri , RM )
i 
 ( RM )
2

• We shall now consider many types of systematic risk.

 Note
As we know, the market compensates
investors for accepting risk - but
only for Market risk,
Firm-specific risk can and should be
diversified away.

So - we need to be able to measure

market risk.
 This is why we have BETA.

 Beta: A Measure of Market risk

 Specifically, it is a measure of how an individual

stock’s returns vary with market returns

It’s a measure of the Sensitivity of an individual
stock’s returns to changes in the market.
 The market’s beta is 1

 A firm that has a beta =1has average market risk.

The stock is no more or less volatile than the
market.
 A firm with a beta >1 is more volatile than the
market (ex: computer firms).
 A firm with a Beta <1 is less volatile than the
market (ex: utilities).
 Beta and its significance
 Negative beta - A beta less than 0 - which would
indicate an inverse relation to the market - is possible
but highly unlikely. Some investors used to believe
that gold and gold stocks should have negative betas
because they tended to do better when the stock
market declined, but this hasn't proved to be true over
the long term.
Beta of 0 - Basically, cash has a beta of 0. In other
words, regardless of which way the market moves,
the value of cash remains unchanged (given no
inflation).
 Portfolio Analysis
 Job of a portfolio manager is to use these risk and
return statistics in choosing/combining assets in such
a way that will result in minimum risk at a given level
of return, also called efficient portfolios
 Select investment weights in such a manner that it
results in a portfolio that has minimum risk at a
desired level of return, i.e., efficient portfolios
 As we change desired level of return, our efficient
combination of securities in the portfolio will change
 Therefore, we can get more than one efficient
portfolio at different risk-return combinations
 The concept of “Efficient Frontier”
 Efficient Frontier
 Is the focus of points in risk-return space having the
maximum return at each risk level or the least possible
risk at each level of desired return
 Presents a set of portfolios that have the the maximum
return for every given level of risk or the minimum risk
for a given level of return
 As an investor you will target a point along the efficient
frontier based on your utility function and your attitude
towards risk.
 Can a portfolio on the efficient frontier dominate any
other portfolio on the efficient frontier?
 Examples
 The Efficient Frontier and Investor Utility

 The slope of the efficient frontier curve decreases steadily as

we move upward (from left to right) on the efficient frontier
 What does this decline in slope means?
 Adding equal increments of risk gives you diminishing increments of
expected return
 An individual investor’s utility curves specify the trade-offs
investor is willing to make between expected return and risk
 In conjunction with the efficient frontier, these utility curves
determine which particular portfolio on the efficient frontier
best suits an individual investor.
 Can two investors will choose the same
portfolio from the efficient set?
 Only if their utility curves are identical
 Which portfolio is the optimal portfolio for a
given investor?
 One which has the highest utility for a given investor
given by the tangency between the efficient frontier and
the curve with highest possible utility
 Beta and its significance
 Beta between 0 and 1 - Companies with
volatilities lower than the market have a
beta of less than 1 (but more than 0). As we
mentioned earlier, many utilities fall in this
range.
Beta of 1 - A beta of 1 represents the volatility
of the given index used to represent the overall
market, against