CHAPTER 7

Optimal Risky Portfolios

(Markowitz procedure to select optimal risky portfolio)
 The Investment Decision

Top-down process with 3 steps:

1. Capital allocation between the risky portfolio and
risk-free asset.
2. Asset allocation across broad asset classes of
risky assets.
3. Security selection of individual assets within each
risky asset class.
Note that both asset allocation and security
selection aim at identifying the optimal risky
portfolio.

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Diversification and Portfolio Risk
• Diversification: Risk reduction achieved by investing in
multiple assets rather than a single asset.
• Market risk (Systematic/Nondiversifiable)
The risk that comes from general conditions in
the economy, e.g., business cycle, inflation, interest
rates, exchange rates, oil price shocks.
• Firm-specific risk (Nonsystematic/Diversifiable)
These risk sources are independent across firms.
Results from, for example, success or failure in
research and development, personnel changes,
workers’ unrest, accidents.

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Figure 7.1 Portfolio Risk as a Function of the
Number of Stocks in the Portfolio

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Figure 7.2 Portfolio Diversification

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 Covariance and Correlation
• Portfolio risk depends on the correlation
between the returns of the assets in the
portfolio.

• Covariance and the correlation coefficient

provide a measure of the way returns of two
assets vary.

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 Efficient Diversification
• Efficient diversification: Constructing risky portfolios
that provide the lowest possible risk for any given
level of expected returns.
• For simplicity, we illustrate the concept with
portfolios of 2 risky assets (2 risky mutual funds)
having the following risk-return properties:

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Two-Security Portfolio: Return

rp  wr
D D
 wE r E
rP  Portfolio Return
wD  Bond Weight
rD  Bond Return
wE  Equity Weight
rE  Equity Return

E (rp )  wD E (rD )  wE E (rE )

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 Two-Security Portfolio: Risk

  w   w   2 wD wE CovrD , rE 
2
p
2
D
2
D
2
E
2
E

2
 = Variance of Security D
D

2
 E = Variance of Security E

CovrD , rE  = Covariance of returns for

Security D and Security E

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 Portfolio Variance from the Covariance Matrix
• Another way to express variance of the
portfolio:
 P2  wD wD Cov(rD , rD )  wE wE Cov( rE , rE )  2 wD wE Cov(rD , rE )

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 Three-Asset Portfolio

E (rp )  w1 E (r1 )  w2 E (r2 )  w3 E (r3 )

2 2 2 2 2 2 2
 w  w  w 
p 1 1 2 2 3 3

 2w1w2 1, 2  2w1w3 1,3  2w2 w3 2,3

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 Covariance
Cov(rD,rE) = rDEDE

rD,E = Correlation coefficient of

returns

D = Standard deviation of
returns for Security D

E = Standard deviation of
returns for Security E

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Correlation Coefficients: Possible Values

Range of values for r1,2

+ 1.0 > r > -1.0

If r = 1.0, the securities are perfectly positively
correlated
If r = - 1.0, the securities are perfectly negatively
correlated

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 Correlation Coefficients
• When ρDE = 1, there is no diversification

 P  wE E  wD D

• When ρDE = -1, a perfect hedge is possible

D
wE   1  wD
 D  E

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and as changes

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Figure 7.3 Portfolio Expected Return as a
Function of Investment Proportions

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Figure 7.4 Portfolio Standard Deviation as a
Function of Investment Proportions

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 The Minimum Variance Portfolio
• The minimum variance • When correlation is less
portfolio is the portfolio than +1, the portfolio
composed of the risky standard deviation may
assets that has the be smaller than that of
either of the individual
smallest standard component assets.
deviation, the portfolio
with least risk.
• When correlation is -1,
the standard deviation of
the minimum variance
 E2  Cov(rD , rE ) portfolio is zero.
wmin ( D)  2
 D   E2  2Cov(rD , rE )

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Figure 7.5 Portfolio Expected Return as a
Function of Standard Deviation
Portfolio Opportunity Set
shows all combinations of
portfolio expected returns and
standard deviations that can
be achieved from the available
risky assets (here we have only
2 risky assets) .

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 Correlation Effects
• The amount of possible risk reduction through
diversification depends on the correlation.
• The risk reduction potential increases as the
correlation approaches -1.
– If r = +1.0, no risk reduction is possible.
– If r = 0, σP may be less than the standard deviation
of either component asset.
– If r = -1.0, a riskless hedge is possible.

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 Finding Optimal Portfolio from the
Opportunity Set
• The determination of optimal portfolio from an
opportunity set depends on investor’s risk
preference.

MaxU  E ( rP )  1 2 A P2
E (rD )  E (rE )  A( E2   D E r DE )
wD 
A( D2   E2  2 D E r DE )
wE  1  wD

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 Optimal Risky Portfolio when there is a
Risk-free Asset
• POS provides obtainable risk-return combinations from a
set of risky assets. Which particular combination should a
rational investor choose if a risk-free asset is also made
available for investment?
E (rP )  rf
Max S P 
wi P
E ( RD ) E2  E ( RE )Cov( RD , RE )
wD 
E ( RD ) E2  E ( RE ) D2   E ( RD )  E ( RE )  Cov( RD , RE )
wE  1  wD Note that R denotes excess returns, not total returns, r.
• Refer to textbook Example 7.2 (p.217).

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Figure 7.6 The Opportunity Set of the Debt and Equity Funds and
Two Feasible CALs

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Figure 7.7 The Opportunity Set of the Debt and Equity Funds with
the Optimal CAL and the Optimal Risky Portfolio

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 Determination of the Optimal Overall Portfolio

• Recall from Chapter 6 that the optimal allocation of

capital between a risky portfolio (P) and a risk-free
portfolio is given by

E (rP )  rf
y* 
A P2
• Refer to textbook Example 7.3 (p.218).

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Figure 7.8 Determination of the Optimal Overall
Portfolio

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Figure 7.9 The Proportions of the Optimal
Overall Portfolio

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 Markowitz Portfolio Selection Model
• Security Selection
– The first step is to determine the risk-return
opportunities available.
– All portfolios that lie on the minimum-
variance frontier from the global minimum-
variance portfolio and upward provide the
best risk-return combinations – the efficient
frontier.

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Figure 7.10 The Minimum-Variance Frontier
of Risky Assets

Efficient Frontier:
Part of the minimum
variance frontier
that lies above the
global minimum-
variance portfolio.*

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 Markowitz Portfolio Selection Model

• We now search for the CAL with the highest

reward-to-variability ratio.

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Markowitz Portfolio Selection Model
• Portfolio choice problem then has 2 independent parts.
• Everyone invests in P, regardless of their degree of risk
aversion. Therefore, security selection (asset allocation) is a
purely technical job. Given the manager’s input lists, the
best risky portfolio is the same for all clients!
• Capital allocation, on the other hand, depends on client’s
personal preference. More risk averse investors put more in
the risk-free asset; and less risk averse investors put more in
P.

These results are collectively known as the Separation Theorem.

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 The Power of Diversification
n n
• We know, 2
   wi wj Cov(ri , rj )
P
i 1 j 1
1
• Assume a naïve diversification strategy, wi 
n
21 n 1 2 n n 1
    i  2 Cov(ri , rj )
P
n i1 n j 1 i 1 n
j i
• There are n variance and n(n-1) covariance terms, hence
21 n 2 1 n n
   i and Cov   Cov(ri , rj )
n i 1 n(n  1) j 1 i 1
j i

• Therefore, we obtain
1 n 1
 p2   2  Cov
n n
• Further assuming all securities to have common standard deviation and
 all security pairs to have common correlation , werobtain
1 n 1
 p2   2  r 2
n n
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Table 7.4 Risk Reduction of Equally Weighted Portfolios
in Correlated and Uncorrelated Universes

The table assumes  to be 50%.

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