THE IRWIN SERIES IN FINANCE

Stephen A. Ross
Sterling Professor of Economics and Finance
Yale University
Consulting Editor

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BIBLIOTECA
 CHAPTER 5 Risk and Risk Aversion 143

Chapter 5 5.1 RtSK AND RISK AVERSION

Risk and Risk Aversion Risk with Simple Prospects

The presence of risk means that mor~ ~han. _ ()n_e ?_u_tc_()ID(! Js._poss.ibl_e._ A simple prosvect
iSall-'lllVesfinent-oppürtüriity in whiCh-- a -c-ert3h1-ínltla1~~~&fu:.iici~~~cÍ at psk, and there
are-only two possible ouiccimes:-Füftiie sake-of simplicity, it is useful to begin-our
~ and elucidate sorne basic concepts using simple prospects. 1
Take__a~_an <_OJ<a_01ple initial wealth, W,_Qf_$JQQ,ü.DQ, and assume two possible results.
With-a_p~obafull~y,p:-_;;,_=:-(,tlÍefavorable outcmne 'Nill Qc;pur,Jeading to final \>{ealth,
W1 =o $12_0,0!J!l, Qtherwise, with próba5lliiYI - p =o A, aless favoralil_e outcome,

T IIE INVESTMENT PROCESS CONSISTS OF T\VO BROAD ll\SKS.

.ttfZ_".'_~80cOO.CJ.,_~.ll-ºccur. We can represent the simple prospect using an event tree:

W 1 = $150,000
One task is security and market analysis, by which we assess the risk p = .6
and expected-retum attributes of the entire set of possible investment ) w= $100,000~ 1
vehicles. The second task is the formation of an optima! portfolio of
assets. This task involves the determination of the best risk-retum
p .4
W2
= = $80,000
Suppose that '1Jl_in1Cestor, Susan, is offered an investment portfolio with a payoff
opportunities available from feasible investment portfolios and the in one year that is described by suclÍ a simple prospect. How can she evaluate this
choice of the best portfolio from the feasible set. We start our formal portfolio?
First, she could try to summarize it using descriptive statistics. Por instance, ·her
analysis of investments with this latter task, called portfolio theory.
mean or expected end-of-year wealth, denoted E(W), is
We return to the security analysis task in later chapters.
E(W) = pW1 + (! - p)W2
This chapter introduces three themes in portfolio theory, ali center-
= .6 X 150,000 + .4 X 80,000
ing on risk. The first is the basic tenet that investors avoid risk and demand a reward = $122,000
for engaging in risky investments. The reward is taken as a risk premium, an expected
The expected profit on the $100,000 investment portfolio is $22,000: 122,000 -
rate of return higher than that available on alternative risk-free investments. 100,000. The variance, cr2 , of the portfolio's payoff is calculated as the expected value
The second theme allows us to summarize and quantify investors' personal trade- of the squared deviations of each possible outcome from the mean:
offs between portfolio risk and expected return. To do this we introduce the utility cr2 = p[W¡ - E(W)]2 + (1 - p) [W2 - E(W)]2
function, which assumes that investors can assign a welfare, or "utility," score to any = .6 (150,000 - 122,000)2 + .4(80,000 - 122,000)2
investment portfolio depending on its risk and retum.
Finally, the third fundamental principie is that we cannot evaluate the risk of an
I = l,176,000,000

The standard deviation, cr, which is the square root of the variance, is therefore
asset separate from the portfolio of which it is a part; that is, the proper way to mea- $34,292.86.
(,:learly, this is risky business: the standard deviation ofthe payoff is large, much
sure the risk of an individual asset is to assess its irnpact on the volatility of the entire
larger than-theexpecfü_d_jírofifof$2:i:ooo:-wiletlÍertr11iexpected profit is ]arge enough
portfolio of investments. Taking this approach, we find that seemingly risky securities toj_IJStify_such_risk depends on the altemative portfolios.
rnay be portfolio stabilizers and actually low-risk assets. Let us suppose Treasury bilis are o~e áiterrí_í!t.iyitó Susan's risky portfolio. Suppose
Appendix A to this chapter describes the theory and practice of measuring port- that at the time of tlie decision, a one-year T-bill off.;;.s arate ofretum_of 5-c¡¡;;·_Bill),QQ_o
can beinv~stedt<J_yielda SlJfe l'~C>J'it_of]:;"QQO-.-Wécan nowdr~w Snsan's decision tree.
folio risk by·the variance or standard deviation of returns. We discuss other potential-
ly relevan! characteristics of the probability distribution of portfolio retums, as well
as the circumstances in which variance is sufficient to rneasure risk. Appendix B dis- 1 Chapters 5 through 7 rely on sorne basic results from elementary statistics. For a refresher, see the Quantitative Review in
cusses the classical theory of risk aversion. the Appendix at the end of the book.
144 PART II Portfolio Theory CHAPTER 5 Risk and Risk Aversion 145

the British pound. They may choose to bet on the outcome. Suppose that Paul will pay
Mary $100 if the value of f'.l exceeds $1.70 one year from now, whereas Mary will pay
Paul if the pound is worth less then $1.70. There are only two relevan! outcomes: (1)
$100,000 the pound will exceed $1.70, or (2) it will fall below $1.70. If both Paul and Mary agree
on the probabilities of the two possible outcornes, and if neither party anticipates a loss,
B. Invest in risk-
1 - - - - - - - - p r o f i t = $5,000 '3/, it must be that they assign p = .5 to each outcome. In that case the expected profit to
free T-bill
both is zero and each has entered one side of a gambling prospect.
What is more likely, however, is that the bet results from differences in the proba-
Earlier, we showed the expected profit on the prospect to be $22,000. Therefore the bilities that Paul and Mary assign to the outcome. Mary assigns it p > .5, whereas Paul's
expected marginal, or incremental, profit of the risky portfalio over investing in safe assessment is p < .5. They perceive, subjectively, two different prospects. Economists
T-bills is / ;_ ; ) . call this case of differing beliefs "heterogeneous expectations." In such cases investors
$22,000 - $5,000 = $17,000 on each side of a financial position see themselves as speculating rather than gambling.
Both Paul and Mary should be asking, "Why is the other willing to invest in the side
~_e'filil)g ..that.one c.an eam a risk premium of $17 ,000 as compensation far the risk of of a risky prospect that I believe offers a negative expected profit?" The ideal way to
1the investment.
The question of whether a given risk premium provides adequate cornpensation for
resolve heterogeneous beliefs is far Paul and Mary to "merge their infarmation," that
is, for each party to verify that he or she possesses all relevant information and process-
the investment's risk is age-old. Indeed, one of the central concems of finance theory es the information properly. Of course, the acquisition of infonnation and the extensive
(and much of this text) is the measurement of risk and the determination of the risk pre- communication that is required to eliminate alJ heterogeneity in expectations is costly,
miums that investors can expect of risky assets in well-functioning capital rnarkets. and thus up to a point heterogeneous expectations cannot be taken as irrational. If, how-
ever, Paul and Mary enter such contracts frequently, they would recognize the infor-
CONCEPT CHECK Question l. What is the risk premium of Susan's risky portfolio in terms of rate of mation problem in one of two ways: Either they will realize that they are creating gam-
retum rather than dollars? ·'
1 bles when each wins half of the bets, or the consisten! loser will adrnit that he or she
has been betting on the basis of inferior forecasts.

Risk, Speculation, and Gambling

One definition of speculatiqn is "the assumption of considerabJ~JJJ,ISin_essxiskin_Qb1filQ- CONCEPT CHllCK Question 2. Assume that dollar-denominated T-bills in the United States and pound-
~ ----------·-----·---------- .. ,,,_,

ing commensurate gain." Although this definition is fine linguistically, it is useless denominated bilis in the United Kingdom offer equal yields to maturity. Both are short-
Wiilillut f¡f:Sl:Specifyiiig what is meant by "commensurate gain" and "considerable risk." term assets, and both are free of default risk. Neither offers investors a risk premium.
By "commensurate gain" we mean a positive expected profit beyond the risk-free However, a U.S. investor who holds U.K. bilis is subject to exchange rate risk, because
altematÍve. This is the- nsk Jliemium. In mir exarnple, the dallar risk premium i;¡¡;-~· the pounds earned on the U.K. bilis eventually will be exchanged far dollars at the
profa net of-ilie3J.lernaiíve, which is the sure T-bill profit. J'he ri_sk_p@mium~tlJ<: future exchange rate. Is the U.S. investor engaging in speculation or garnbling?
incremental ex¡:i"ctedgain_fr_om!ajci_n_g_()D the risk. By "co.uBiderable risk" we mean that
¡ the risk Is sufficient to affect the decision~An individual might reject a prospect that has
! a positive risk premium because the added gain is insufficient to make up far the risk Risl{ Aversion and Utility Values
1
involved.
To gamble is "to b~~--qr__wager on an uncertain outcome." If you compare this defin- We have discussed risk with simple prospects and how risk premiums bear on specula-
itioñ1i:i-iliaTof speculation, you will see that the central difference is the lack.oL'.com- tion. A__m:'ospe~tJb--ª!. has a z_g9__ risk_p.r~_l)lium is called a fair game. Investors who are
~surate g¡¡in." Economically speaking{a garnble is the assurnption of i;iskJor _nop1.1r- risk averse reject investment portfolio~--that are J~g3.ffies Üf-·;orse. Risk-averse
pose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the investors are willing to consider only risk-free or speculative prospects. Loosely speak-
fis~- i?vül~·ea. beca_ll_~~- .º~-~_perc~iVbS a favorable risk--ret_~_rn trade-off) To t~;n-ag;:~ble ing, a risk-averse investor "penalizes" the expected rate of retum of a risky portfalio by
inta·a -spec-Uf3.dVé-prospect requires an adequate risk prerillllln for compensation of risk- a certain percentage (or penalizes the expected profit by a dallar arnount) to account far
averse investors for th-e risks that they bear. Hence, _risk aversion and _~peculation are the risk involved. The greater the risk the investor perceives, the larger the penalty. One
not inconsistent. might wonder why we assume risk aversion as fundamental. We believe that most
In sorne cases a gamble may appear to the participants as speculation. Suppose that investors accept this view from simple introspection, but we discuss the question more
two investors disagree sharply about the future exchange rate of the U.S. dallar against fully in Appendix B of this chapter.
146 PART II Portfolio Theory CHAPTER 5 Risk and Risk Aversion 147

We can formalize this notion of a risk-penalty system. To do so, we will assume that I1'igurc 5. t E(r)
each investor can assign a welfare, or utility, score to competing investment portfolios The Trade-off
based on the expected return and risk of those portfolios. The_ utility score mayJie · between risk and
viewed ªs_ameans of ranking portfolios. Higher utility values are as~Ig11edJo portfolli1L retum of a potential 1
Wlth;;-ore attrac:tjve risk-:r~iurn profiles. Portf6lI6SreCeiVe-111gher utility seores for investment portfolio 1
1
liigher expected returns and lower seores for higher volatility. Many particular "scor- 1

ing" systems are legitimate. One reasonable function that is commonly employed by 1

1 II
1
financia! theorists assigns a portfolio with expected return E( r) and variance of returns 1
a2 the following utility score: 1 p

V = E(r) - .005 Aa2 (5.1) E(rp)

]/
---------------------~--------------

where U is the utility value and A is an index of the investor's aversion. (The factor of '
1
lll t IV
.005 is a scaling convention that allows us to express the expected return and standard 1

deviation in equation 5.1 as percentages rather than decimals.)

CTp
Equation 5.1 is consisten! with the notion that utility is enhanced by high expected
returns and diminished by high risk. (Whether variance is an adequate measure of port-
folio risk is discussed in Appendix A.) The extent to which variance lowers utility 1
certainty eguivalent rate of a portfoJJQ..j§_j_h~~ that risk-free investments would
depends on A, the investor's degree of risk aversion. More risk-averse investors (who 1,( need to offer with.=rtainty to be considered as equaÚy attractive as theiisky-portfollO.-
have the larger As) penalize risky investments more severely. Jnvestors choosing among Now we can say that a portfolio is desirabl-e only if Ús certainty equiVafent-·return
competing investment portfolios will select the one providing the highest utility leve!. exceeds that of the risk-free alternative. A sufficiently risk-averse investor may assign
Noticeirl equation 5.1 that the utility provided by a risk-free portfolio is simply the any risky portfolio, even one with a positive risk premium, a certainty equivalent rate
rate of return on the portfolio, because there is no penalization for risk. This provides of retum that is below the risk-free rate. which will cause the investor to reject the port-
us with a convenient benchmark for evaluating portfolios. For examp1e, recall Susan's folio. At the sarne time, a less risk-averse (more risk-tolerant) investor will assign the
investment problem. choosing between a portfolio with an expected retum of 22% and sarne portfolio a certainty equivalen! rate that exceeds the risk-free rate and thus will
a standard deviation a = 34% and T-bills providing a risk-free return of 5%. Although prefer the portfolio to the risk-free alternative. If the risk premium is zero or negative
the risk premium on the risky portfolio is large, 17%, the risk of the project is so great to begin with, any downward adjustment to utility only makes the portfolio look worse.
that Susan does not need to be very risk averse to choose the safe all-bills strategy. Even lts certainty equivalen! rate will be below that of the risk-free altemative for all risk-
for A = 3, a moderate risk-aversion parameter, equation 5.1 shows the risky portfolio'& averse investors.
utility value as 22 - .005 X 3 X 342 = 4.66%, which is slightly lower than the risk- In contrast to ·risk-averse investors, risk-neutral investors judge risky prospects
free rate. In this case, Susan would reject the portfolio in favor of T-bills. solely by their expected rates of retum. The leve! of risk is irrelevant to the risk-neutral
The downward adjustment of the expected return as a penalty for risk is .005 X 3 investor, meaning that there ·is no penalization for risk. For this investor a portfolio's
X 342 = 17.34%. If Susan were less risk averse (more risk toleran!), for exarnple with certainty equivalent rate is simply its expected rate of return.
A = 2, she would adjust the expected rate of retum downward by only 11.56%. In that A risk Iover is willing to engage in fair garnes and garnbles; this investor adjusts the
case the utility leve! of the portfolio would be 10.44%, higher than the risk-free rate, expected return upward to take into account the "fun" of confronting the prospect's risk.
leading her to accept the prospect. Risk lovers will always take a fair game because their upward adjustment of utility for
risk gives the fair game a certainty equivalen! that exceeds the altemative of the risk-
free investment.
CONCllPT CHECK Question 3. A portfolio has an expected rate of retum of 20%, and standard deviation We can depict the individual's trade-offbetween risk and retum by plotting the char-
of 20%. Bilis offer a sure rate of retum of 7%. Which investment altemative will be acteristics of potential investment portfolios that the individual would view as equally
chosen by an investor whoseA = 4? What if A= 8? attractive on a graph with axes measuring the expected value and standard deviation of
portfolio retums. Figure 5.1 plots the characteristics of one portfolio.
Portfolio P, which has expected retum E(rp) and standard deviation O"p, is preferred
Because we can compare utility values to the rate offered on risk-free investments by risk-averse investors to any portfolio in quadrant IV because it has an expected
when choosing between a risky portfolio anda safe one, we may interpreta portfolio"s return egua! to or greater than any portfolio in that quadrant and a standard deviation
utility value as its "certainty equivalent" rate of return -to an investor. That is, the equal to or smaller than any portfolio in that quadrant. Conversely, any portfolio in
 PART Il Portfolio Theory
CHAPTER 5 Risk and Risk Aversion 149
148

Table 5.1 UtilityValues of Possible Portfolios Figure 5.2

The indifference
curve

10°/o 20.0o/o 10- .005 X 4 X 400 =2

25.5 15- .005 X 4 X 650 =2
15
30.0 20-.005x4X900 =2
20
25 33.9 25- .005X4X1,150 = 2

E(rp)

quadrant ¡ is preferable to portfolio P because its expected retum is equal to or greater

than P"s and its standard deviation is equal to or smaller than P"s.
This is the mean-standard deviation, or equivalently, mean-variance (M-\Tl___<:I"i_1!:__
---·--- It can be stated as: A.. -..dominates
rion. B iC
--------~-~----~--
·
E(rA);,, E(r8 )
<Jp
and
~;!A.&!!.s._
and at le~st__omünequalityis.strict (mlesoJ.Jt tl!e equality,) .
. . ¡;; the expected retum-standard deviation graph the preferred direction is northwest,
because in this direction we simultaneously increase the expected return and decrease 5.2 PORTl<'OLIO RISK
the variance of the rate of retum. This means that any portfolio that lies northwest of P
is superior to P. Asset Risk versus Portfolio Risk
What can be said anout portfolios in the quadrants II and III? Their desirability, com-
pared with P, depends on the exact nature of the investor's risk aversion. Suppose an We have focused so far on the return and risk of an individual's overall investment port-
investor identifies all portfolios that are equally attractive as portfolio P. Starting at P, folio. Such portfolios are composed of diverse types of assets. In addition to their direct
an increase in standard deviation lowers utility; it must be compensated for by an investment in financial markets, investors have stakes in pension funds, Iife insurance
increase in expected retum. Thus, point Q is equally desirable to this investor as P. policies with savings components, homes, and not least, the earning power of their
Investors will be equally attracted to portfolios with high risk and high expected retums skills (human capital).
compared with other portfolios with lower risk but lower expected returns. We saw in Chapter 4 that, sometimes, adding a seemingly risky asset to a portfolio
These equally preferred portfolios will lie on a curve in the mean-standard deviation actually reduces the risk of the overa!! portfolio. The example we cited was that of a fire
graph that connects all portfolio points with the sarne utility value (Figure 5.2). This is insurance policy. Although the policy viewed in isolation had a very uncertain and
called the indifference curve. volatile payoff, it clearly was a portfolio risk-reducer because it provided a positive
· To determine sorne of the points that appear on the indifference curve, examine the payoff precisely when another majar part of the portfolio, the investor's house, fared
utility values of severa! possible portfolios for an investor with A = 4, presented in poorly. Investing in an asset with a payoff pattern that offsets your exposure to a par-
Table 5.1. Note that each portfolio offers identical utility, because the high-retum port- ticularsourceüf risk is called hedging. . "---------"·---
folios also have high risk. Although in practice the exact indifference curves of various ·--· -In;ura;;;;;~on't~cts- ar~·-¿bviou-S-hidgini vehicles. In many contexts financial mar-
investorS cannot be known, this analysis can take us a long way in determining appro- kets offer similar, although perhaps less direct, hedging opportunities. For exarnple,
priate principies for portfolio selection ·strategy. consider two firms, one producing suntan lotion, the other producing umbrellas. The
shareholders of each firm face weather risk of an opposite nature. A rainy sumrner
lowers the return on the suntan-lotion firm but raises it on the umbrella firm. Shares of
CONCEPT CHECK Question 4. the umbrella firm actas "weather insurance" for the suntan-lotion finn shareholders in
a. How will the indifference curve of a less risk-averse investor compare to the indif- precisely the same way that fire insurance policies insrue houses. When the lotion firm
ference curve drawn in Figure 5.2? does poorly (bad weather), the "insurance" asset (umbrella shares) provides a high pay-
b. Draw both indifference curves passing through point P. off that offsets the loss.
150 PART JI Portfolio Theory
CHAPTER 5 Risk and RÍsk Aversion
151
Another means to _control portfolio risk is diversification,__ QY,.Jl'.lü9_b__y¿e__._ffik@_fu~t
investments are rnade in a wide variety of assets__ so_ that the expos11re t~--~~~
any particular security is limited. By placing one's eggs in many baskets, overall port-
r Rule 2. The variance of an asset's retums is the expected value of the squared devi-
/ allons from the expected retum. Symbolically,
folio risk actually may be less !han the risk of any componen! security considered in
isolation.
a
2
= :f Pr(s)[r(s) - E(r)] 2 (5.3)
Therefore, in our example
To examine these effects more precisely, and to lay a foundation far the mathemati-
cal properties that will be used in coming chapters, we will consider an example with <T~e" = .5(25 - 10.5) 2 + .3(1 O - 10.5) 2 + .2( - 25 - 10.5)2
Jess than perfect hedging opportunities, and in the process review the statistics under- = 357.25
lying portfolio risk and return characteristics.
r:;
;
The standard deviation of Best's return, which is the square root of the variance, is
357.25 = 18.9%. .
A Review of Portfolio Mathematics
. ·~ Huma~ex _has 50% of its endowment in Best's stock. To reduce the risk of the over-
Consider the problem of Humanex, a nonprofit organization deriving more of its all portfoho, I! could mvest the remainder in T-bills, which yield a sure rate of return of
income from the retum on its endowment. Years ago, the faunders of Best Candy willed 5%. To denve the retum of the overall portfolio, we apply rule 3:
a Jarge block of Best Candy stock to Humanex with the provision that Humanex may
never sell it. This block of shares now comprises 50% of Humanex's endowment. Rule 3. The rat~ of return on a portfolio is a weighted average of the rates of retum of
Humanex has free choice as to where to invest the remainder of its portfolio.2 each asset compnsmg the portfalio, with portfolio proportions as weights. This implies
The value of Best Candy stock is sensitive to the price of sugar. In years when the that the expected rate of retum on a portfolio is a weighted average of the expected rate
Caribbean sugar crop fails, the price of sugar rises significantly and Best Candy suffers of retum on each component asset.
considerable losses. We can describe the fartunes of Best Candy stock using the fol- In this case, the portfolio proportions in each as.set are .5, and the portfolio's ex-
lowing scenario analysis: pected rate of return is

Normal Year for Sugar Abnormal Year E(rHumaneJ = .5E(rBestl + .5rBil!s

= .5 X 10.5 + .5 X 5
Bullish Bearish = 7.75%
Stock Market Stock Market Sugar Crisis
The standard deviation of the portfolio may be derived from the following:
Probability .5 .3 .2
Rate of retu rn 25°/o 1Oo/o -25°/o Rule 4. When a risky asset is combined with a risk-free asset, the portfolio standard
devial!on equals the nsky asset's standard deviation multiplied by the portfolio propor-
To summarize these three possible outcomes using conventional statistics, we review tion 1nvested in the asset.
sorne of the key rules goveming the properties of risky assets and portfolios.
. In this cas_e, the Humanex.portfolio is 50% invested in Best stock and 50% invested
m nsk-free bilis. Therefore
·Rule J. The mean or expected return of an asset is a probability-weighted average of
its return in ali scenarios. Calling Pr(s) the probability of scenario s and r(s) the retum CTHumanex = .So-Best
in scenario s, we may write the expected return, E(r), as = .5 X 18.9
= 9.45%
E(r) = 2.Pr(s)r(s) (5.2)
s
By reducingüs exposure to the risk of Best by half, Humanex reduces its portfolio
Applying this formula to the case at hand, with three possible scenarios, we find that
standard deviallon by half. The cost of this risk reduction, however, is a reduction in
the expected rate of return of Best Candy's stock is
expected return. The expecte_d rate of retum on Best stock is 10.5%. The expected return
E(rBest) = .5 X 25 + .3 X 10 + .2(-25) on the one-halfT-b11l portfoho is 7.75%. This makes the risk premiums over tbe 5% rate
= 10.5% ~n nsk-free bilis 5.5% far Best stock and 2.75% far the halfT-bill portfolio. By reduc-
mg the share of Best stock in the portfolio by one-half, Humanex reduces its portfolio
nsk premmm by one-half, from 5.5% to 2.75%
In an effort to improve the contribution of fue endowment to the operating budget
2 The portfolio is admittedly unusual. We use this example only to illustrate the various strategies that might be used to
control risk and to review sorne useful results from statistics. Humanex 's trustees hire Sally, a recen! MBA, as a consultan!. Investigating the sug..'.
and candy mdustry, Sally discovers, not surprisingly, that during years of sugar crisis in
 PART II Portfolio Theory
CHAPTER 5 Risk and Risk Aversion 153
152

the Caribbean basin, SugarKane, a big Hawaiian sugar company, reaps unusual profits
CONCEPT CHllCK Question 5. Suppose that the stock market offers an expected rate ofreturn of 20%, with
and its stock price soars. A scenario analysis of SugarKane's stock looks like this:
a standard deviation of 15%. Gold has an expected rate of retum of 18%, with astan-
Normal Year for Sugar Abnormal Year dard deviation of 17%. In view of the market's higher expected retum and lower uncer-
tainty, will anyone choose to hold gold in a portfolio?
Bullish Bearish
Stock Market Stock Market Sugar Crisis
To quantify the hedging or diversification potential of an asset, we use the concepts
.5 .3 .2 of covariance and correlation. The covariance measures how rnuch the returns on two
Probability
Rate of return 1o/o -5°!o 35°/o risky assets move in tandem. A positive covariance means that asset retums move
together. A negative covariance meaos that they vary inversely, as in the case of Best
The expected rate of return on SugarKane's stock is 6%, and its standard dev.iation is and SugarKane.
14.73%. Thus, SugarKane is almos! as volatile as Best, yet its expected return is only a To measure covariance, we Iook at return "surprises" or deviations from expected
notch better than the T-bill rate. This cursory analysis makes SugarKane appear to be value in each scenario. Consider the product of each stock's deviation from expected
an unattractive investment. For Humanex, however, the stock holds great promise. _ return in a particular scenario:
SugarKane offers excellent hedging potential for holders of Best stock because its
return is highest precisely when Best's return is lowest----during a Caribbean sugar cn- [rBe't - E(rBe,Jl [rKane - E(rKand]
sis. Consider Humanex's portfolio when it splits its investment evenly between Best This product will be positive if the returns of the two stocks move together across
and SugarKane. The rate of retum for each scenario is the simple average of the rates scenarios, that is, if both retums exceed their expectations or both fall short of those
on Best and SugarKane because the portfolio is split evenly between the two stocks (see expectations in the scenario in question. On the other hand, if one stock's return exceeds
rule 3). its expected value when the other's falls short, the product will be negative. Thus, a
good measure of how much the returns move together is the expected value of this prod-
Normal Year far Sugar Abnormal Year
uct across all scenarios, which is defined as the covariance.
Bullish Bearish (5.4)
Stock Market Stock Market Sugar Crisis
In this example, with E(r8 .,,) = 10.5% and E(rKanel = 6%, and with returns in each
Probability .5 .3 .2 scenario summarized as follows, we compute the covariance by applying equation 5.4 .
Rate of return 13.0o/o 2.5°/o 5.0o/o
Normal Year for Sugar Abnormal Year
The expected rate of retum on Humanex's hedged portfolio is 8.25% with a standard
deviation of 4.83%. Bullish Bearish
Sally now summarizes the reward and risk of the three alternatives: Stock Market Stock Markel Sugar Crisis

Portfolio Expected Return Standard Deviation Probability .5 .3 .2

10.50°/o 18.90°/o Stock

Ali in Best Candy
Half in T-bills 7.575 9.45
Ha:lf in SugarKane 8.25 4.83 Best Candy 25% 1Oo/o -25°/o
SugarKane 1º/o -So/o 35o/o
The numbers speak for themselves. The hedge portfolio including SugarKane clearly The covariance between the two stocks is
dorninates the simple risk-reduction strategy of investing in safe T-bills. It has h1gher Cov(rBe<t ,rKane) = .5(25 - 10.5)(1 - 6)
expected retum and lower standard deviation than the one-half T-bill portfolio. The + .3(10 - 10.5)( - 5 - 6) + .2(- 25 - 10.5)(35 - 6)
point is that, despite SugarKane's large standard deviation of return, it is a risk reducer = - 240.5
for sorne investors-in this case, those holding Best stock.
The risk of the individual assets in the portfolio must be measured in the context of The negative covariance confirms the hedging quality of SugarKane stock relative to
the effect of their return on overall portfolio variability. This example demonstrates that Best Candy. SugarKane's retums move inversely with Best's.
assets with _retllTI1s___tl1_11,t_ª1;"~ inversely ass?ciate_d_~~-t!!_th-~- !!1-i!~ª~~~~y_positi~~-!~~-- An easier statistic to interpret than the covariance is the correlation coefficient,
};?~t p_oW_~rt_ul ¡¡~-k redo:~~~~-------- ---- ------ - which scales the covariance to a value between -1 (perfect negative correlation) and
154 PART 11 Portfolio Theory CHAPTER 5 Risk and Risk Aversion 155

+ 1 (perlect positive correlation). The correlatibn coefficient between two variables a. What would be its correlation with Best?
equals their covariance divided by the product of the standard deviations. Denoting the b. Is SugarKane stock a useful hedge asset now?
correlation by the Greek letter p, we find that c. Calculate the portfolio rate of retum in each scenario and the standard deviation of
the portfolio from the scenario retums. Then evaluate u P using rule 5. ·
Cov[rBest' rsugarKane1
p(Best, SugarKane) = d. Are the two methods of computing portfolio standard deviations consisten!?
uBestCTSugarKane
- 240.5
18.9 X 14.73 SUMilHRY
= - .86 l. Speculation is the undertaking of a risky investment for its risk premium. The
risk premium has to be large enough to cornpensate a risk-averse investor for the risk
This large negative correlation (close to -1) confirms the strong tendency of Best and of the investment.
SugarKane stocks to move inversely, or "out of phase" with one another. 2. A fair game is a risky prospect that has a zero-risk premium. It will not be under-
The impact of the covariance of asset returns on portfolio risk is apparent in the fol- taken by a risk-averse investor.
lowing formula for portfolio variance. 3. Investors' preferences toward the expected return and volatility of a portfolio
may be expressed by a utility function that is higher for higher expected returns and
Rule 5. When two risky assets with variances rr1
and cr~, respectively, are combined lower for higher portfolio variances. More risk-averse in,vestors will apply greater
into a portfolio with portfolio weights w 1 and w2 , respectively, the portfolio variance ai penalties for risk. We can describe these preferences graphically using indifference
curves.
is given by
4. The desirability of a risky portfolio to a risk-averse investor may be summarized
ai = w}a} + w~a~ + 2w1w 2Cov(r1,r2). by the certainty equivalen! value of the portfolio. The certainty equivalen! rate of retum
In this example, with equal weights in Best and SugarKane, w1 = w2 = .5, and with is a value that, if it is received with certainty, would yield the sarne utility as the risky
portfolio.
O"Best = 18.9%, O"Kane = 14.73%, and Cov(rBest' 'Kanel = -240.5, we find that
5. Hedging is the purchase of a risky asset to reduce the risk of a portfolio. The
cri
= .52 X 18.92 + .52 X 14.73 2 + 2 X .5 X .5 X (- 240.5) = 23.3 negative correlation between the hedge asset and the initial portfolio tums the volatility
or that ap = ..J23.3 = 4.83%, precisely the same answer for the standard deviation of of the hedge asset into a risk-reducing feature. When a hedge asset is perfectly nega-
the returns on the hedged portfolio that we derived earlier from the scenario analysis. llvely correlated with the initial portfolio, it serves as a perfect hedge and works like an
Rule 5 for portfolio variance highlights the effect of covariance o.n portfolio risk. A insurance contract on the portfolio.
positive covariance increases portfolio variance, and a negat:ive covariance acts to
l(ey Terms
reduce portfolio variance. This makes sense because retums on negatively correlated
assets tend to be offsetting, which stabilizes portfolio retums. Risk premi urn Hedging
Basically, hedging invol_ves the purchase of a risky asset that is neg_atively_~l"-d Risk averse Diversification
wifu- fue ~~isti~g p~rtf~Ü~. This negative correlatiol1 makes the volatility of the hedge Utility Expected retum
asset a risk:reduCirig-feature. A hedge strategy is a powerful alternative to the simple Certainty equivalen! rate Variance
risk-reduction strategy of including a risk-free asset in the portfolio. Risk neutral Standard deviation
In later chapters we will see that, in a rational equilibrium, hedge assets must offer Risk lover Covariance
relatively low expected rates of return. _Ihe_perfeCt_ he~e,_¡¡ninsurance contrae!, is by Mean-variance (M-V) criterion Correlation coefficient
d~sign_ perf~~t)y_n_~g~-~iY~lX._C.g.g~~~~~~ ~-~-~-~_specifl~~--rj§_lf. _._Af> one would expect in a lndifference curve
"nofreé-lunch" world, the insurance premium-re-ducés the portfolio's expected rate of
return. Selected Readings
A classic work on risk and risk aversion is:
CONCEPT CHECK Question 6. Suppose that the distribution of SugarKane stock is as follows: Arrow, Kenneth, Essays in the Theory of Risk Bearing. Amsterdam: North Holland, 1971.
Some good statistics texts with business applications are:
Bullish Bearish Levy, Hairn; and Moshe Ben-Horim. Statistics: Decisions and Applications in Business and
Stock Market Stock Market Sugar Crisis Economics. New York: Random House, 1984.
Wonnacott, Thornas H., and Ronald J. Wonnacott. lntroductory Statisticsfor Business and
?o/o 20%
Economics. New York: Wi1ey, 1984.
156 PART 11 Portfolio Theory CHAPTER 5 Risk and Risk Aversion 157

Problems a. l.
b. 2.
l. Considera risky portfolio. The end-of-year cash flow derived from the portfolio
c. 3.
will be either $50,000 or $150,000 with equal probabilities of .5. The alterna-

•
d. 4.
tive risk-free investment in T-bills pays 5% per year.
8. Based. on the utility formula above, which investment would you select if you
a. If you require a risk premium of 10%, how much will you be willing to pay
were nsk neutral?*
for the portfolio? a. l.
b. Suppose that the portfolio can be purchased for the arnount you found in
b. 2.
(a). What will be the expected rate of return on the portfolio?
c. 3.
c. Now suppose that you require a risk premium of 15%. What is the price that

•
d. 4.
you will be willing to pay?
9. The variable (A) in the utility formula represents the:*
d. Comparing your answers to (a) and (e), what do you conclude about the
a. investor's return requirement
relationship between the required risk premium on a portfolio and the price
h. investor's aversion to risk
at which the portfolio will sell?
c. certainty-equivalent rate of the portfolio
2. Considera portfolio that offers an expected rate of return of 10% and a standard
d. preference for one unit of return per four units of risk
deviation of 15%. T-bills offer a risk-free 8% rate of retum. What is the maxi-
mum leve! of risk aversion for which the risky portfolio is still preferred to Consid_er historical data showing that the average annual rate of return on the S&P 500
bilis? portfoho over the past 68 years has averaged about 8.5% more !han the Treasury bill
3. Draw the indifference curve in the expected return-standard deviation plan cor- return and that the S&P 500 standard deviation has been about 21 % pet year. Assume
responding to.a utility level of 5o/o for an investor with a risk aversion coeffi- these values ar~ repres~ntative of investors' expectations for future performance and that
cient of 3. (Hint: choose severa! possible standard deviations. ranging from 5% the curren! T-b11l rate 1s 6%. Use these values to answer questions 10 to 12.
to 25 % and find the expected rates of retum providing a utility leve! of 5. Then
10. Calculate the expected return and variance of portfolios invested in T-bills and
plot the expected return-standard deviation points so derived.)
the S&P 500 index with weights as follows:
4. Now draw the indifference curve corresponding to a utility leve! of 4% for an
investor with risk aversion coefficient A = 4. Comparing your answers to ques- wbills Windex
tions 3 and 4, what do you conclude?
5. Draw an indifference curve for a risk-neutral investor providing utility leve! 5%. o 1.0
6. What must be true about the sign of the risk aversion coefficient, A, for a risk 0.2 0.8
0.4 0.6
lover? Draw the indifference curve for a utility leve! of 5% for a risk lover.
0.6 0.4
0.8 0.2
U se the following data in answering questions 7, 8, and 9. 1.0 o
Ulilily Formula Data
11. Calculate the utility levels of each portfolio of question 10 for an investor with
Expected Return Standard A = 3. Wbat do you conclude?
lnvestment f(r) Deviation a '\
u
12. Repeat question 11 for an investor with A = 5. Wbat do you conclude?

1 12o/o 30°/o Reconsider the Best and SugarKane stock market hedging example in the text, but
2 15 50 - / .
·;:__--<
assume for quest10ns 13. to 15 that the probability distribution of the rate of return on
3 21 16 ''(
SugarKane stock 1s as follows:
4 24 21
. s••.16 / Bullish Stock Market Bearish Stock Market Sugar Crisis
U = E(r) - .005 Acr2 where A = 4.

•
Probability .5 .3 .2
7. Based on the utility formula above, which investment would you select if you
Rate of return 10% -5% 20o/o
were risk averse?*

*Reprinted, with permission, from the Leve! J 1991 CFA Study Guide. Copyright 1991, Association for Investment *Reprinted, with pennission, from the Level I 1991 CFA Study Guide. Copyright 1991, Association for Investment
Management and Research, Charlottesville, VA. All rights reserved. Management and Research, Charlottesville, VA. Ali rights reserved.
 PART ll Portfolio Theory CHAPTER 5 Risk and Risk Aversion 159
158

13. If Humanex's portfolio is half Best stock and half SugarKane, what are its ex- ..we now tum to the characterization of the risk implied by the nature of the proba-
pected retum and standard deviation? Calculate the standard deviation from the b1hty distnbutmn. of returns. In general, it is impossible to quantify risk by a single
portfolio retums in each scenario. number. The idea 1s to describe the likelihood and magnitudes of "surprises" (deviations
14. What is the covariance between Best and SugarKane? from the mean) with as small a set of statistics as is needed for accuracy. The easiest
15. Calculate the portfolio standard deviation using rule 5 and show that the result way to accomplish this is to answer a set of questions in order of their informational
is consístent with your answer to question 13. value and to stop at the point where additional questions would not affect our notion of
the risk-retum trade-off.
The first question is, "What is a typical deviation from the expected value?" A nat-
APPENDIX A: A DEFENSE OF MEAN-VARIANCE ANALYSIS ural answer would be, "The expected deviation from the expected value is - - - . "
Unfortunately, this answer is meaningless because it is necessarily zero: Positive devi-
Describing Probability Distributions ations from the mean are offset exactly by negative deviations.
The axiom of risk aversion needs little defense. So far, however, our treatment of risk There are two ways of getting around this problem. The first is to use the expected
has been limiting in that it took the variance (or, equivalently, the standard deviation) absolute value of the deviation. This is known as MAD (mean absolute deviation)
which is given by '
of portfolio returns as an adequate risk measure. In situations in which variance alone
is not adequate to measure risk this assumption is potentially restrictive. Here, we pro- n
_,~
vide sorne justification far mean-variance analysis. 1 Pr(s) X Absolute Value[rs - E(r)J
The basic question is how one can best describe the uncertainty of portfolio rates of
retum. In principie, one could list all possible outcomes for the portfolio over a given The.second is to use the expected squared deviation from the mean, which is simply
the vanance of the probability distribution:
period. If each outcome results in a payoff such as a dallar profit or rate of retum, then
this payoff value is the random variable in question. A list assigning a probability to al! n
possible values of the random variable is called the probability distribution of the ran- a 2 = ,~¡ Pr(s) [r, - E(r)J2
dom variable.
The reward for holding a portfolio is typically measured by the expected rate of Note that the unit of measurement of the variance is "percent squared." To return to our
original units, we compute the standard deviation as the square root of the variance
return across all possible scenarios, which equals
which is measured in percentage terms, as is the expected value. The variance also ¡~
n
E(r) = ,~¡ Pr(s)r,
called the second central moment around the mean, with the expected return itself being
the first mornent.
where s = 1, ... , n are the possible outcomes or scenarios, rs is the rate of return for Alt~ough the variance measures the average squared deviation from the expected
outcome s, and Pr(s) is the probability associated with it. value, 1t .<loes not provide a full description of risk. To see why, consider the two prob-
Actually, the expected value or mean is not the only candidate for the central value ab1hty distr1but10ns for rates of retum on a portfolio, in Figure 5A. l.
of a probability distribution. Other candidates are the median and the mode. A and B are probability dis"tributions with identical expected values and variances.
The median is defined as the outcome value that exceeds the outcome values for half The graphs show that the variances are identical because probability distribution B is
the population and is exceeded by the other half. Whereas the expected rate of retum is the mirror image of A.
a weighted average of the outcomes, the weights being the probabilities, the median is What is the principal difference between A and B? A is characterized by more Iikely
based on the rank arder of the outcomes and takes into account only the order of the but small losses and less likely but extreme gains. This pattern is reversed in B. The dif-
outcome values rather than the values themselves. ference is irnportant. When we talk about risk, we really mean "bad surprises." The
The median differs significantly from the mean in cases where the expected value is "bad surprises" in A, although they are more likely, are small (and Jimited) in magni-
dominated by extreme values. One exarnple is the income (or wealth) distribution in a tude. The "bad surprises" in B could be extreme, indeed unbounded. A risk-averse
population. A relatively small number of households command a disproportionate share investor :Vi~l prefer A to B on these grounds; berree, it is worthwhile to quantify this
of total income (and wealth). The mean income is "pulled up" by these extreme values, character1stlc. The asymrnetry of the distribution is called skewness, which we measure
which makes it nonrepresentative. The median is free of this effect, since it equals the by the third central moment, given by
income leve! that is exceeded by half the population, regardless of by how much. n
Finally, a third candidate for the measure of central value is the mode, which is the M 3 = ,~¡ Pr(s) [r, - E(r)]3
most likely value of the distribution or the outcome with the highest probability.
However, the expected value is by far the most widely used measure of central or aver- Cubing the deviations from expected value preserves their signs, which allows us to 1

age tendency. distinguish good from bad surprises. Because this procedure gives greater weight to
¡,
1

11
 PART II Portfolio Theory CHAPTER 5 Risk and Risk'Aversion 161
160
B l. The importance of ali moments beyond the variance is much smaller than that
A
Pr (r) Pr (r) of the expected value and variance. In other words, disregarding moments
higher than the variance will not affect portfolio choice.
2. The variance is as important as the mean to investor welfare.
Samuelson's proof is the major theoretical justification for mean-variance analysis.
Under the conditions of this proof mean and variance are equally important, and we can
overlook all other moments without harm,
The major assumption that Samuelson makes to arrive at this conclusion concems
the "compactness" of the distribution of stock retums. The distribution of the rate of
return on a portfolio is said to be compact if the risk can be controlled by the investor.
Practically speaking, we test for compactness of the distribution by posing a question:
Will the risk of my position in the portfolio decline if I hold it for a shorter period, or
will the risk approach zero if I hold the risky portfolio for only an instan!? If the answer
Figure 5A.1 is yes, then the distribution is compact.
Skewed probability distributions for rates of return on a portfolio
In general, compactness may be seen as being equivalent to continuity of stock
prices. If stock prices do not take sudden jumps, then the uncertainty of stock retums
over smaller and smaller time periods decreases. Under these circumstances investors
larger deviations, it causes the "long tail" of the distribution to dominat~ the measure .ºf who can rebalance their portfolios frequently will act so as to make higher moments of
skewness. Thus the skewness of the distribution will be positive for a nght-skewed d!S: . the stock return distribution so small as to be unimportant. It is not that skewness, for
tribution such as A and negative for a Jeft-skewed distribution such as B. The asynune- example, does not matter in principie, It is, instead, that the actions of investors in fre-
try is a relevan! characteristic, although it is not as importan! as the magmtude of the quently revising their portfolios will limit higher moments to negligible levels.
standard deviation. · Continuity or compactness is not, however, an innocuous assumption. Portfolio revi-
To summarize, the first moment (expected value) represents the reward. The second sions entail transaction costs, rneaning that rebalancing must of necessity be somewhat
and higher central moments characterize the uncertainty of the reward. All the even limited and that skewness and other higher moments cannot entirely be ignored.
moments (variance, M , etc.) represen! the likelihood of extreme values. Larger values Compactness also rules out such phenomena as the majar stock price jumps that occur
4
for these moments indicate greater uncertainty. The odd moments (M3, M5, etc.) repre- in response to takeover atternpts. It also rules out such drarnatic ev~nts as the 25%
sent measures of asymmetry. Positive numbers are associated with positive skewness one-day decline of the stock market on October 19, 1987. Except for these relatively
and hence are desirable. unusual events, however, rnean-variance analysis is adequate. In rnost cases, ifthe port-
We can characterize the risk aversion of any investor by the preference scheme that folio may be revised frequently, we need to worry about the mean and variance only.
the investor assigns to the various moments of the distribution. In other words, we can Portfolio theory, for the most part, is built on the assumption that the conditions for
write the utility value derived from the probability distribution as mean-variance (or mean-standard deviation) analysis are satisfied. Accordingly, we
typically ignore higher moments.
U= E(r) - b0u 2 + b 1M3 - b2M 4 + b 3M 5 - ···
where the importance of the terms lessens as we proceed to higher moments. Notice that
the "good" (odd) moments have positive coefficients, whereas the "bad" (even) CONCEPT CHECK Question 5A. l. How does the simultaneous popularity of both lotteries and insurance
moments have minus signs in front of the coeffic1ents. policies confirm the notion that individuals prefer positive to negative skewness of
How many moments are needed to describe the investor's asse~sme~t of the proba- portfolio returns?
bility distribution adequately? Samuelson's "Fundamental Approx1ma11on Theorem of
3
Portfolio Analysis in Terms of Means, Variances, and Higher Moments" proves that m
many important circumstances: Normal and Lognormal Distribntions
Modem portfolio theory, for the most par~ assumes that asset retums are normally dis-
tributed. This is a convenient assumption because the normal distribution can be
3 Paul A. Samuelson, "The Fundamental Approximation Theorem of Portfolio Analysis in Terms of Means, Variances, and
described completely by its mean and variance, justifying mean-variance analysis.
Higher Moments," Review of Economic Studies 37 (1970). The argument has been that, even if individual asset returns are not exactly normal, the
162 PART JI Portfolio Theory CHAPTER 5 Risk and Risk,Aversion
163
Table 5A.1 Frequency DisLribution of Rates of Return from a One-Year Investment in Randomly Selected Figure 5A.2 fr(X)
Portfolios from NYSE-Listed Stocks The Lognonnal (J =30%
distribution for
three values of u.
1.2
Source: J. Atchison and
J. A. C. Brown, The
Lognormal Distrihution
Minimum -71.1 NA -12.4 NA 6.5 NA 16.4 NA (New York; Cambridge
5th centile -14.4 -39.2 8.1 4.6 17.4 16.7 22.7 22.6 University Press, 1976).
20th centile -.5 6.3 16.3 16.1 22.2 22.3 25.3 25.3
50th centile 19.6 28.2 26.4 28.2 27.8 28.2 28.1 28.2
70th centile 38.7 49.7 33.8 35.7 31.6 32.9 30.0 30.0 0.8 (J =140%
95th centile 96.3 95.6 54.3 51.8 40.9 39.9 34.1 33.8
Maximum 442.6 NA 136.7 NA 73.7 NA 43.1 NA
Mean 28.2 28.2 28.2 28.2 28.2 28.2 28.2 28.2
Standard deviation 41.0 41.0 14.4 14.4 7.1 7.1 3.4 3.4
Skewness (M3) 255.4 o.o 88.7 O.O 44.5 o.o 17.7 O.O
Sample size 1,227 131,072 32,768 16,384

Source: Lawrence Fisher and James H. Lorie, "Sorne Studies ofVariability of Returns on Investments in Common Stocks," Journal of Business 43 (April
1970).

distribution of returns of a large portfolio will resernble a normal distribution quite

closely. 4
The data support this argument. Table 5A. l shows summaries of the results of one-
year investments in many portfolios selected randomly from NYSE stocks. The port-
folios are listed in order of increasing degrees of diversification; that is, the numbers of
stocks in each portfolio sarnple are 1, 8, 32, and 128. The percentiles of the distribution
becaus.e it allows for any outcome, including the whole range of negative prices.
of retums for each portfolio are compared to what one would have expected from port-
Spec1fically, rates of return lower than -100% are theoretically impossible because
folios identical in mean and variance but drawn from a normal distributivn.
they imply the possibility of negative security prices. The failure of the normal distri-
Looking first at the single stock portfolio (n = 1), the departure of the retum distri-
bution to rule out such outcom~s must be viewed as a shortcoming.
bution from normality is significan!. The mean of the sample is 28.2%, and the standard
An alternative assumption is that the continuously compounded annual rate of return
deviation is 41.0%. In the case of normal distribution with the same mean and standard
is normally distributed. If we call this rate r and we cal] the effective annual rate r then
deviation, we would expect the fifth percentile stock to lose 39.2%, but the fifth per- e'
the re = er - 1, and because er can never be negative, the smallest possible value far
centile stock actually lost 14.4%. In addition, although the normal distribution's mean
re is - 1 or -100%. Thus, this assumption nicely rules out the troublesome possibility
coincides with its median, the actual sample median of the single stock was 19.6%, far
of negative prices while still conveying the advantages of working with normal distri-
below the sarnple mean of 28.2%. butions.
In contrast, the retums of the 128-stock portfolios are virtually identical in distribu-
Under this assumption the distribution of re will be lognormal. This distribution is
tion to the hypothetical normally distributed portfolio. The normal distribution there- depicted in Figure 5A.2.
fore is a pretty good working assumption for well-diversified portfolios. How large a
For short holding periods, that is, where t is small, the approximation of r (t) =
portfolio must be for this result to take hold depends on how far the distribution of the
~rt - 1 by rt is quite accurate and the normal distribution provides a good apprC:xirna-
individual stocks is from normality. It appears that a portfolio typically must include al
t10n to the lognormal. With rt normally distributed, the effective annual retum over
Jeast 32 stocks for the one-year retum to be close to normally distributed.
short time periods may be taken as approximately normally distributed.
There remain theoretical objections to the assumption that individual stock returns
For short holding periods, therefore, the mean and standard deviation of the effec-
are normal!y distributed. Given that a stock price cannot be negative, the normal distri-
tive holding period returns are proportional to the mean and standard deviation of the
bution cannot be truly representative of the behavior of a holding period rate of retum
annual, continuously compounded rate of return on the stock and to the time interval.
164 PART 11 Portfolio Theory CHAPTER 5 Risk and Risk Aversion
165
Therefore, if the standard deviation of the annual continuously compounded rate of Problem: Appendix A
retum on a stock is 40% (cr = .40), then the variance of the holding period retum far
l. The Smartstock investment consulting group prepared the fallowing scenario
one month, for example, is far all practica! purposes
analysis far the end-of-year dividend and stock price of Klink !ne., which is sell-
2 ing now at $12 per share:
cr2(monthly) = " = 1§_ = .0133
12 12
End-of-Year
and the standard deviation is ,,l.0133 = .1155.
Scenario Probabilily Divldend ($) Price ($)
To illustrate this principie, suppose that the Dow Janes Industrials went up one day
by 30 points from 4,200 to 4,230. Is this a "large" move? Looking at annual, continu- .1 o
1 o o
ously compounded rates on the Dow Janes portfolio, we find that the annual standard 2 .20 0.25 2.00
deviation in post-war years has averaged about 16%. Under the assumption that the 3 .40 0.40 14.00
retum on the Dow Janes portfolio is lognormally distributed and that returns between 4 .25 0.60 20.00
5 .05 0.85 30.00
successive subperiods are uncorrelated, the one-day distribution has a standard devia-
tion (based on 250 trading days per year) of Compute the rate of retum for each scenario and
a. The mean, median, and mode
cr(day) = cr(year),,ll/250
b. The standard deviation and mean absolute deviation
. 16
= mo c. The first rnornent, and the second and third moments around the mean .
Is the probability distribution of Klink stock positively skewed?
= .0101
= 1.01 % per day APPENDIX B: RISK AVERSION AND EXPllCTED UrtUTY
Applying this to the opening leve! of the Dow Janes on the trading day, 4,200, we find We digress here to examine the rationale behind our contention that investors are risk
that the daily standard deviation ofthe Dow Janes index is 4,200 X .0101 = 42.4 points averse. Recognition of risk aversion as central in investment decisions goes back at
per day. leas! to 1738. Daniel Bernoulli, one of a farnous Swiss family of distinguished mathe-
Because the daily rate on the Dow Janes portfolio is approximately normal, we know maticians, spent the years 1725 through 1733 in St. Petersburg, where he analyzed the
that in one day out of three, the Dow Janes will move by more than 1% either way. following coin-toss game. To enter the garne one pays an entry fee. Thereafter, a coin
Thus, a move of 30 points is hardly an unusual event. is tossed until the first head appears. The number of tails, denoted by n, that appears
until the first head is tossed is used to compute the payoff, $R, to the participan!, as
CONCEPT CHECK Question 5A.2. Look again at Table 5A.1. Are you surprised that the minimum rates of
R(n) = 2n
retum are less negative for more diversified portfolios? Is your explanation consistent-
with the behavior of the sarnple's maximum rates of retum? The probability of no tails befare the first head (n = O) is Y, and the corresponding
payoff is 2° = $1. The probability of one tail and then heads (n = 1) is Y, x Y, with
1
payoff 2 = $2, the probability of two tails and then heads (n = 2) is Y, X Y, x Y,, and
Summary: Appendix A so forth.
l. The probability distribution of the rate of retum can be characterized by its
moments. The reward from taking the risk is measured by the first moment, which is The following table illustrates the probabilities and payoffs far various outcomes:
the mean of the retum distribution. Higher moments characterize the risk. Even Tails Probabilily Payoff ~ $R(n) Probability x Payoff
moments provide information on the likelihood of extreme values, and odd moments
provide infarmation on the asymmetry of the distribution. o Y, $1 $1/2
2. Investors' risk preferences can be characterized by their preferences for the var-
ious moments of the distribution. The fundamental approximation theorem shows that
X $2 $1/2
2 Ya $4 $1/2
when portfolios are revised often enough, and prices are continuous, the desirability of 3 Y,, $8 $1/2
a portfolio can be measured by its mean and variance alone.
3. The rates of retum on well-diversified portfalios far holding periods that are no!
too long can be approximated by a normal distribution. Far short holding periods (up
to one month), the normal distribution is a good approximation far the lognormal. n (112¡n + 1 $2íl $1/2
The expected payoff is therefore
166 PART II Porifolio Theory
CHAPTER 5 Risk and Risk Aversion
167
Figure 58.1 U(W)
E(R) = ¡ Pr(n)R(n)
Utility of wealth with
n=O
a log utility function
112 + 1/2+ ...
==
The evaluation of this game is called the "St. Petersburg Paradox." Although the ex-
pected payoff is infinite, participants obviously will be willing to purchase tickets to =======================-----~-;-~...-~~-
1
play the game only at a finite, and possibly quite modest, entry fee. 1
1
Bernoulli resolved the paradox by noting that investors do not assign the same value 1
1
per dallar to all payoffs. Specifically, the greater their wealth, the less their "apprecia- 1
1
tion" for each extra dollar. We can make this insight mathematically precise by assign- 1
1
ing a welfare or utility value to any leve! of investor wealth. Our utility function should 1
1
increase as wealth is higher, but each extra dollar of wealth should increase utility by 1
progressively smaller amounts. 4 (M_odem economists would say that investors exhibit 1
1
1
"decreasing marginal utility" from an additional payoff dollar.) One particular function 1
1
that assigns a subjective value to the investor from a payoff of $R, which has a smaller 1
value per dollar the greater the payoff, is the function log(R). If this function measures 1
1
utility values of wealth, the subjective utility value of the game is indeed finite. 5 The 1
1
certain wealth leve! necessary to yield this utility value is $2.38, because log(2.38) = ~~~~~'---'-~~~~~~--'-'~.i_~~~~~~~-w
.866. Hence the certainty equivalen! value of the risky payoff is $2.38, which is the
maximum amount that this investor will pay to play the game.
Von Neumann and Morgenstern adapted this approach to investment theory in a
concave. A simple example is !he log function, familiar from high school mathematics.
complete axiomatic system in 1946. Avoiding unnecessary technical detail, we restrict
~f course, a log function will not fit all investors, but it is consistent with the risk aver-
ourselves here toan intuitive exposition of the rationale for risk aversion. s1on that we assurne for ali investors.

=
Imagine two individuals who are identical twins, except that one of them is less for- Now consider the following simple prospect:
tunate than the other. Peter has only $1,000 to his name while Paul has a net worth of
$200,000. How many hours of work would each twin be willing to offer to eam one $150,000
extra dollar? It is likely that Peter (the poor twin) has more essential uses for the extra =~~~p~=:.21¡~,~~~~
money than does Paul. Therefore, Peter will offer more hours. In other words, Peter $100,000-====
derives a greater personal welfare or assigns a greater "utility" value to the l,OO!st
1 - p = 1/z
$50,000
dollar than Paul does to !he 200,00lst. Figure 5B.l depicts graphically the relationship .
This_ is a fair game in that the expected profit is zero. Suppose, however, that the curve
between the wealth and the utility value of wealth that is consisten! with this notion of
m Figure 5_B.I represents the investor's utility value of wealth, assuming a log utility
decreasing marginal utility.
function. Figure 5B.2 shows this curve w1th the numerical values marked.
Individuals have different rates of decrease in their marginal utility of wealth. What
. Figure 5B.2 shows that the loss in ufüity from losing $50,000 exceeds the gain from
is constant is Íhe principie that per-dollar utility decreases with wealth. Functions that
wmnmg $50,000. Cons1der the gam first. With probability p = .5, wealth goes from
exhibit the property of decreasing per-unit value as the number of units grows are called
$100,000 to $150,000. Usmg the log utility function, utility goes from log(l00,000) =
11.51 to log(150,000) = 11.92, !he distance G on the graph. This gain is G = 11.92 -
11.51 = .41. In expected utility terrns, then, the gain is pG = .5 X .41 = .21.
4 This utility is similar in spirit to the one that assigns a satisfaction leve! to portfolios with given risk-and-retum attributes.
However, the utility function here rcfers not to investor's satisfaction with altemative portfolio choices but only to the sub- Now cons1der the possibility of coming up on !he short end of the prospect. In that 1
jective welfare they derive from different levels of wealth. case, wealth goes from $100,000 to $50,000. The loss in utility, the distance L on the ·'
5 If we substitute the "utility" value, log(R), for the dallar payoff, R, to obtain an cxpected uti\ity value of thc game (rather
graph, is L = log(l00,000) - log(50,000) = 11.51 - 10.82 = .69. Thus, the loss in
.,,,
than expected dallar value), we have, calling V(R) the expected utility. 11
exp_ected utility term_s is O - p)L = .5 X .69 = .35, which exceeds the gain in expected
V(R) = ¡
n=O
Pr(n) log[R(n)) = S
n=O
(Y,)n+1log(2n)"'0.866 ut1hty from the poss1b1hty of wmning the game.
,,li
We compute !he expected utility from !he risky prospect: !!
 CHAPTER 5 Risk and Risk Aversion 169
PART II Portfolio Theory
168
Smith views $86,681.56 far certain as being equal in utility value as $100,000 at
U(W) risk. Therefore, she would be indifferent between the two.
Figure 5B.2
Fair games and ------ --------
expected utility U(lS0.000)= 11.92 G
CoNCEPT CHECK Question 5B. l. Suppose the utility function is U(W) ~ M.
u (100,000) = 11.51 a. What is the utility leve! at wealth levels $50,000 and $150,000?
E[U(W)]= 11.37 L
b. What is expected utility if p still equals .5?
c. What is the certainty equivalen! of the risky prospect?
1
1 d. Does this utility function also display risk aversion?
u (50,000) = 10.82 -----¡----- e. Does this utility function display more or less risk aversion than the lag utility
'
1
1
function?
1
1
1
1
1
Does revealed behavior- of investors demonstrate risk aversion? Looking at prices
1
1
and past rates of retum in financia! markets, we can answer with a resounding "yes."
1 With remarkable consistency, riskier bonds are sold at lower prices than are safer ones
L_~~~~_j_~:c-~J.C---:~(W)-.::-~lO~O~O~O~O~~~w~,:=~1~50~.~ooiillo
W¡ (50,000) WcE E = •
w with otherwise similar characteristics. Riskier stocks also have provided higher average
rates of retum over long periods of time than less risky assets such as T-bills. Far exarn-
ple, over the 1926 to 1993 period, the average rate_ of retum on the S&P 500 portfolio
E[U(W)] = pU(W1) + (l - p)U(Wz) exceeded the T-bill retum by about 8.5% per year.
= Y, log(50,000) + 1!,log(150,000) It is abundantly clear from financia! data that the average, or representative, investor
= 11.37 exhibits substantial risk aversion. Por readers who recognize that financia! .assets are
. . the utilit value of the (sure) $100,000 is log(I00,000) ,,= priced to compensate far risk by providing a risk premium and al the same time feel the
If the prospecl is reiectedf, h f . y e (11 37) Hence the risk-averse investor will urge far sorne garnbling, we have a constructive recommendation: direct your garnbling
11.51, greater than that o t e alf garn · · ' desire to investment in financia! markets. As Van Neumann once said, "The stock mar-
rej~~i:; !~~;:~·investor utility function (such as the lag utility) allows us to ~m­ ket is a casino with the odds in your favor." A small risk-seeking investment may pro-
vide all the excitement you want with a positive expected return to bootl
pute the certainty equivalen! value of the risky prospect :~ ªw~~~nc~::~~:~r~qu:
Smith. This is the amount that, if rece1ved w1th certamty, M y Problems: Appendlx B
attractive as the risky prospect. f t d ealth outcomes then Figure 5B.2 l. Suppose that your wealth is $250,000. You buy a $200,000 house and invest the
If lag utility describes Mary's pre erences owar fwh t we' ask "What sure remainder in a risk-free. asset paying an annual interest rate of 6%. There is a
· f h the dallar value o t e prospec · •
can also tell us what ·~'.r~r v:;~e of 11.37 (which equals the expected utility from the, probability of .001 that your house will bum to the ground and its value be
leve! of w?~'aAlthhha_s a uta!' ;me drawn al the leve! 11.37 intersects the utility curve al the reduced to zero. With a lag utility of end-of-year wealth, how much would you
prospect) . onzon be willing to pay far insurance. (al the beginrr\ng of the year)? (Assume that, if
leve! of wealth WCE" This means that the house does not bum down, its end-of-year value still will be $200,000.)
Jog( W CE) = 11.37 2. If the cost of insuring your house is $1 per $1,000 of value, what will be the cer-
tainty equivalen! of your end-of-year wealth if you insure your house at:
which implies that a. Y; its value.
W = ell.37 b. Its ful! value.
CE
..... = $86,681.86 c. 1Y; times its value .
. . e uivalent of the prospect. The distance y in Figure 5B.2
W CE is therefore ththe cdertamty dqadj"ustment to the expected profit that is attributable to
is the penalty, or e ownwar '
the risk of the prospect.
Y= E(W) - WCE
= $100,000 - $86,681.86
~ $13,318.13
...,,,.
 CHAPTER 6 Capital Allocation between the Risky Assei- and the Risk-Free Asset 171

Chapter 6 determined. For now, however, ,we start our "top-down journey" by asking liow an

Capital Allocation between the Risky investor decides how much ·to invest in the risky versus the risk-Íree asset.
This capital allocation problem may be solved in two stages. First, we determine
Asset and the Risk-Free Asset the risk-return trade-off encountered when choosing between the risky and risk-free
assets. Then, we show how risk avetsion determines the optima! mix of the two
assets. This analysis leads us to examine so-called passive strategies, which call for
allocation of the portfolio between a (risk-free) money market fund andan index fund
of common stocks.

6.1 CAPITAL lhLOCATION ACROSS RISKY AND RISK·FREE PoRn'OLIOS

RRTFOUO MANAGERS SEEK TO ACHIEVE THll BEST POSSIBl,I\ History shows us that Jong-term bonds have been riskier investments than investments
TRADE·OFF BllTWEEN RISK ANO RETURN. A top-down analysis of in Treasury bilis, and that stock investments have been riskier still. On the other hand,
their strategies starts with the broadest details about the exact makeup the riskier investments have offered higher average returns. Investors, of course, do not
make all-or-nothing choices from these investment classes. They can and do construct
of the portfolio.
their portfolios using securities from ali asset classes. Sorne of the portfolio may be in
For example, the capital aUocation decision is the choice of the nsk-free Treasury bilis, and sorne in high-risk stocks.
proportion of the overall portfolio to place in safe but low-return money The most straightforward way to control the risk of the portfolio is through the frac-
market securities versus risky but higher-retum securities like stocks. tion of the portfolio invested in Treasury bills and other safe money market securitie.s
versus risky assets. This capital allocation decision is an examp1e of an asset allocation
The choice of the fraction of funds apportioned to risky investments is
choice-a choice among broad investment classes, rather than among the specific secu-
the first part of the inves.tor's asset allocation decision, which describes the distribu- rities within each asset class. Most investment professionals consider asset allocation
tion of risky investments across broad asset classes like stocks, bonds, r~al estate, for- the most important part of portfolio construction. Consider this statement by John
eign assets, and so on. Finally, the security selection decision describes the choice of Bogle, the chairman of the Vanguard Group of Investment Companies:
which particular securities to hold within each asset class. The most fundamental decision of investing is the allocation of your assets: How much should
The top-down analysis of portfolio construction has much to recommend it. Most you own in stock, How rnuch should you own in bonds? How rnuch should you own in cash
reserves? ... That decision (has been shown to account] for an astonishing 94% of the differ-
institutional investors follow a top-down approach. Capital allocation and asset al- ences in total retums achieved by institutionally managed pension funds ... There is no reason
location decisions will be made at a high organizational level, with the choice of the to believe that the sarne relationship <loes not also hold true far individual investors. I
specific securities to hold within each asset class delegated to particular portfolio Therefore, we Start our discussion of the risk-retum trade-off available to investors by
managers. When investors partake in frequent capital or asset allocation revisions, examining the most basic asset allocation choice: the choice of how much of the port-
they are called market timers. Individual investors typically follow a less-structured folio to place in risk-free money market securities versus in other risky asset classes.
We will denote the investor's portfolio of risky assets as P, and the risk-free asset as
approach to money managernent, but they also typically give priority to broader allo-
F. We will assume for the sake of illustration that the risky component of the investor's
cation issues. Por example, an individual's first decision is usually how rnuch of his overa!] portfolio is comprised of two mutual funds: one invested in stocks and the other
or her wealth rnust be left in a safe bank or money market account. invested in long-term bonds. For now, we take the composition· of the risky portfolio as
This chapter treats the broadest part of the asset allocation decision, capital allo- given and focus only on the allocation between it and risk-free securities. In the next
chapter, we turn to asset allocation and security selection across risky assets.
cation between risk-free assets versus the risky portian of the portfolio. We will take
the composition of the risky portfolio as given and refer to itas "the" risky asset.
In Chapter 7 we will examine how the composition of the risky portfolio rnay best be 1
John C. Bog!e, Bogle on Mutual Funds {Burr Ridge, IL: Irwin Professional Publishing, 1994), p. 235.
 PART II Portfolio Theory
CHAPTER 6 Capital Allocation betvvl'.en the Risky Asset and the Risk-Free Asset 173
172

When we shift wealth from the risky portfolio to the risk-free asset, we do not 113,400 - 22,680
IBM:
change the relative proportions of the various risky assets within the risky portfolio. 210,00Q - 42,000
Rather, we reduce the relative weight of the risky portfolio as a whole in favor of risk- .54
free assets. 96,000 - 19,320
For exarnple, assume that the total market value of an initial portfolio is $300,000, GM: W2 = 210,000 - 42,000
of which $90,000 is invested in the Ready Asset money market fund, a risk-free asset . = .46
for practica! purposes. The remaining $210,000 is invested in risky equity securities-
Rather than thinking of our risky holdings as IBM and GM stock separately, we may
$113,400 in IBM and $96,600 in GM. The IBM and GM holding is "the" risky port-
view our holdings as if they were in a single fund that holds IBM and GM in fixed pro-
folio, 54% in IBM and 46% in GM: portions. In this sense we treat the risky fund as a single risky asset, that asset being a
113,400 particular bundle of securities. As we shift in and out of safe assets, we simply alter our
IBM: w1=
210,000 holdings of that bundle of securities commensurately.
.54 Given this assumption, we can now turn to the desirability of reducing risk by chang-
.'...'\ 96,600 ing the risky/risk-free asset mix, that is, reducing risk by decreasing the proportion y .
GM: Wz =
210,000 As long as we do not alter the weights of each stock within the risky portfolio, the prob-
.46 ability distribution of the rate of return on the risky portfolio remains unchanged by the
asset reallocation. What will change is the probability distribution of the rate of retum
The weight of the risky portfolio, P, in the complete portfolio, including risk-free
on the complete portfolio that consists of the risky asset and the risk-free asset.
investments, is denoted hy y:
210,000
.7 (risky assets) CONCEPT CHECK Question 1. What will be the dallar value of your position in IBM, and its proportion in
y= 300,000
your overall portfolio, ifyou decide to hold 50% of your investment budget in Ready
90,000
1 - y = 300,000 .3 (risk-free assets) Asset?

The weights of each stock in the complete portfolio are as follows:

$113,400 6.2 'i'Hll RISK·F'Rlm ASSET
IBM: .378
$300,000 By virtue of its power to tax and control the money supply, only the government can
$96,600 issue default-free bonds. Even the default-free guarantee by itself is not sufficient to
GM: .322
$300,000 make the bonds risk-free in real terms. The only risk-free asset in real terms would be
Risky portfolio .700 a perfectly price-indexed bond. Moreover, a default-free perfectly indexed bond offers
The risky portfolio is 70% of the complete portfolio. a guaranteed real rate to an investor only if the maturity of the bond is identical to the
Suppose that the owner of this portfolio wishes to decrease risk by reducing the allo- investor's desired holding period,. Even indexed bonds are subject to interest rate ris.k,
cation to the risky portfolio from y = .7 to y = .56. The risky portfolio would total only because real interest rates change unpredicta]>IY.!.hrQJ!&h time. Whenfuture realr;t'es
$168,000 (.56 X $300,000 = $168,000), requiring the sale of $42,000 of the original are uncertain, so is the .future price of ~ectly ind-;;~ed bo~d~~---······ - . --- ·- ..
$210,000 risky holdings, with the proceeds used to purchase more shares in Ready --NevertfieTuSs~·itiS.-common practice to vie~~T;~~SUfY 'bíiiS~J.~ "the'' risk~free asset.
Asset (the money market fund). Total holdings in the risk-free asset will increase to Their short-term nature makes their values insensitive to interest rate fluctuations.
$300,000(1 - .56) = $132,000), or the original holdings plus the new contribution to Indeed, an investor can lock in a short-term nominal return by buying a bill and hold-
the money market fund: ing it to maturity. Moreover, the inflation uncertainty over the course of a few weeks,
or even months, is negligible compared with the uncertainty of stock market retums.
$90,000 + $42,000 = $132,000 In practice, most inveStors use a broader range of money market instruments as a
The key point, however, is that we leave the proportions of each stock in the risky risk-free asset. All the money market instruments are virtually free of interest rate risk
portfolio unchanged. Because the weights of IBM and GM in the risky portfolio are .54 because of their short maturities and are fairly safe in terms of default or credit risk.
and .46, respectively, we sell .54 X $42,0ÓO = $22,680 of IBM and .46 X $42,000 = Most money market funds hold, for the most part, three types of securities-
$19,320 of GM. After the sale, the proportions of each share in the risky portfolio are Treasury bilis, bank certificates of deposit (CDs), and commercial paper (CP)-differ-
in fact unchanged: ing slightly in their default risk. The yields to maturity on CDs and CP for identical
 PART JI Portfolio Theory CHAPTER 6 Capital Allocation benveen the Risky Asset and the Risk-Free Asset, 175
174

Figure 6.1 Percentage

Spread between
Points
5.0 LOCK•IN.·S'focI<-~~~'lf\'.~~~i'~J¡)
-.,.--, -·- . ___ _
three-month CD 4.5
and T-bill rates 4.0
Isiilflati~kt~~~g'U~~~~l• ;;¿1
3.5
3.0 Are·.interest.••rate$• tjiing7 .•
2.5 -5tocks: riSkier·-than ·borids?.: ----~~~::;~~:;;~-

~º :-~~~s:: --:-·:-·-':'_->.:·:·:~:.~,·~:-;'.Y'. ~-:_:_·::-'.;-_.'./·:.-t.;~;,·\~.:·~~\1;'.;\~:.~ÁI'-~·~l;i~}

2.0
= -= ::-
1.5
1.0 __.BH)_ls,_. -' _be_ar~-·.=_~d.:.nerv,OU~-.~~e_I~:í~-~:}~~::'i~riqif. A~~·'}~€~;·~ ·':e_·'·
0.5 niQil ju- the .m_ark{!t~---:and, i?c~.-'}Il_:;Y~.~1q~::~?e-;if:'.:&~~<.:::fo.~~t~·~;o ;./-"
o maprbe )ligher~f()í_ . t.h~= .~~xt -f~ y~_·.;q~~}g~Y-~~~<~:?:f \i·i::r~~:~\:·:/<
Jiciw?.-.:~Y'~ ·?-~Y~.~-~-~g>_i~. :-:Wllni9~g~_:;é.?~~,s~··::~;~f~~-·"'
-·npt(!S, ·ze.~O~c_ou_pon.::T~~.a~,~r~.:bJ~~~§;:,~·~:·:;~~~~;:.~RW~~· ~
c_e.rtifi<:at~,s·. qf <le_p0s~t._'·:~¡~¡?g·:.}11~~~~~'.. f~!e$}~~y,~_:·~ . _.,-.·
r~~~-,--_on. ·th~s~::_·~y~~tm~?~~'.~i~tp.~·me_;.~~·~{.)·f~~r;~f~~~li
adjusted=;_ asJ?nS.:~~-·:~.?;i.,~ºll~t~JO.us~-~~.:-~g~e~;:~~l~~:~.:.;~:::.p.·
maturity, for example, are always somewhat higher than !hose ofT-bills. The pattem of -~;'IS~:·:,ª~:-- ~µ~e.rt.~i~~·. ~-9~14t. '·.~~~t. '.~~~}?F~-;,-pp;. 1.~~,:~~:~;t:.
this yield spread for 90-day CDs is shown in Figure 6.1. r,etilr~~ ,Y9'1·. ~J?io_y:_·P-t~~ty~·.P:i?_.:~·--~W:b:~~;.)!=º~rrr;··.'.?~i;?~·!fp~:~,~)l\::~1·!:
Money market funds have changed their relative holdings of these securities over ~t _th~_ e~d_: Pf ·. ~h_e: p=~~~d~~-.~·~~~Y,$CJi,tTI,: ;!JR~~·~·.~~'.~p,i?t~~ilit!}f=$~}\~.::;;:~si·~+s~s
time but, by and large, T-bills make up only about 15% of their portfolios. Nevertheless, at .'~.~uthold;Gi:~u~·';'-~_j~.~-µ~~:~~~~~:i~,?~~t~-é,~~;:~?~*~~,-~~~:~:>·~
ing- gro,uF ~ íp.~~Wrl~.a~()µ~. ;_ ·.;: :'.'. ·:'.· :_.:·;·: : ;·.~./-·-~.'~ :':.~.:·>~<\;)::;·.~~ . ~:~:::-~tf~;-::_._;.,.~_;t.~: :, .
the risk of such blue-chip short-term investments as CDs and CP is minuscule compared
with that of rnost other assets such as 1ong-term corporate bonds, common stocks, ar )',Iba(~ !lJº'~' ·1hat .~.'fo !e~ .~ill ~tRl>~J>Ji•W~;.i¡j't\t~
·c10'~~:·.t?'.~º~:~tg.~~s~.~}U.::~11?~;:.-~~,~:,~);1.i,Y~r{~J.~9t,%;:~~1S~'/~::i
real estate. Hence, we treat money market funds as the most easily accessible risk-free Research. by Leuthold suggesis 1'.'~t~(h?ll~~ (h~'!~tÍg\••:i,
asset far rnost investors. (er~, 1tis~_ri_'?~-.~~.tµgr9:Il?~l9~ks.:'.i~:,-;f9%¿tl!é.:J7:~,~4~ti~~-::;:}1,~
The notion of a risk-free asset seems straightforward, but nevertheless is the source the _he.~t .de,c~de i_s ·. j~ke_iy . -.~?~ ?~:_ ~-1,o~er~i?·.:~~;~~·. - ~;:,-:; ·;,:.~ :':.~::.;:.ú/;.;T'.:.·:.:·,,.
of surprising amounts of confusion. Consider, far exarnple, the nearby box, which touts ·''Ifyoucimlockjn·7?%.t>fíh"..~\sto1c~Tf~.9~¡(h~'
the possibility of stock-marketlike returns without the risk. The article argues that long- stockmarket'l'i(!i.zippori~k,.\l'J¡af~~tf'pJ?ln&>'l?~?:'.'.•~~·
term bonds can provide returns approximately three-quarters that of stocks with negli- James _WHson. ~ª- ~nanciál_ . plarin_~r:in;. _CQl_llm_bi.~~s~c~~·_.·c ·-
gible risk. This analysis is faulty for severa! reasons.
First, the investment instruments suggested in the article are by no means risk free.
••S•u'<.,rM~a11s;"etJou~~1.~;,~~l~1'4}¡~~4~~iJ~,;Wlti~~
Ail:Rights-Reserved Wotldwide. - ,- -,. ' - " " -,.-
Interest rate fluctuations impart uncertainty to the value of these securities at any time
befare their maturity dates. In fact, we saw in Figure 4.5 of Chapter 4 that the standard
deviation of the rates of return on these long-term fixed-income securities has been
about 8.7% per year.
Second, we have argued that the risk premium is properly viewed as an incremental
6.3 rmnFOLIO§ º"' 01\E RISKY Assm· ANO ONE RISK-FRllll AsSET
rate of return above the risk-free rate. As the rates available on high-quality short-term In this section we examine the risk-return combinations available to investors. This is
instruments rise, so should the expected rate on riskier assets, if their risk premiums are the "technological" part of as;et allocation; it deals with only the opportunities avail-
to be preserved. When the article cites the long-term historical retum on stocks as about able to investors given the features of the broad asset markets in which they can invest.
10%, and notes that fixed-income securities are now providing yields almos! that high, In the next section we address the "personal" part of the problem-the specific
it ignores the fact that the expected rate of retum of the stock market might well have individual's choice of the best risk-return combination from the set of feasible
risen along with the rates available on these securities. combinations.
Finally, the article seems ÍO imply that locking in a norninally risk-free rate for 5 or Suppose that the investor has already decided on the cmnposition of the optima!
1O years avoids risk. Bui, as Robert A. Clarfeld, who is quoted in the mticle, points out, risky portfolio. The investment proportions in all the available risky assets are known.
a fixed nominal return leaves you exposed to opportunity-cost risk, because it is possi- Now the final concern is with the proportion of the investment budget, y, to be allocated
ble that available rates of retum rnight continue to rise, leaving behind a portfolio with to the risky portfolio, P. The remaining proportion, 1 - y, is to be invested in the risk-
fixed payments. free asset, F.
 1 ' - .
176 PART JI Portfolio Theory CHAPTER 6 Capital Allocation between the Risky Asset and the kisk-Free Asset 177

Denote the risky rate of return by r P and denote the expected rate of retum on P Figure 6.2 E(r)
by E(rp) and its standard deviation by ªP· The rate of retum on the risk-free asset is Expected return-
denoted as r¡. In the numerical example we assume that E(rp) = 15%, ap = 22%, standard deviation
and that the risk-free rate is r¡ = 7%. Thus, the risk premium on the risky asset is combinations
E(rp) - r¡ = 8%.
With a proportion, y, in the risky portfolio, and 1 - y in the risk-free asset, the rate E(rp) = 15o/o ---------------;---------_----
of retum on the complete portfolio, denoted C, is re where

rc=yrp+(l-y)r¡

Taking the expectation of this portfolio's rate of return,

r¡= 7% F
E(rc) = yE(rp) + (1 - y)r¡
= r
1
+ y[E(rp) - r¡] (6.1)
= 7 + y(15 - 7)
This result is easily interpreted. The base rate of return for any p~rtfolio is the risk- 22%
free rate. In addition, the portfolio is expected to eam a risk premium that depends on
the risk premium of the risky portfolio, E(rp) - r , and the investor's exposure to the
1
nsky asset, denoted by y. Investors are assumed to be risk averse and thus unwilling to To derive the exact equation for the straight line between F and P, we rearrange
take on a risky position without a positive risk premium. equation 6.2 to find that y = a¿aP• and substitute for y in equation 6.1 to describe the
As we noted in Chapter 5, when we combine a risky asset and a risk-free asset in a expected retum-standard deviation trade-off:
portfolio, the standard deviation of that portfolio is the standard deviation of the risky
asset multiplied by the weight of the risky asset in that portfolio. In our case, the com- E[rc(y)] = r¡ + y[E(rp) - r¡]
plete portfolio consists of the risky asset and the risk- free asset. Because the standard = lj' + ªe
- [E(rp) - r¡]
Up
deviation ofthe risky portfolio is ap = 22%,
8
(6.2) = 7 + 22 ªe

Thus, the expected return of the portfolio as a function of its standard deviation is a
which makes sense because the standard deviation of the portfolio is proportional to straight line, with intercept r¡ and slope as follows:
both the standard deviation of the risk asset and the proportion invested in it. In sum,
the rate of retum of the complete portfolio will have expected retum E(rel = r¡ + S = E(rp) - r¡
Up
y[E(rp) - r1] = 7 + 8y and standard deviat10n ªe= 22y.
8
The next step is to plot the portfolio characteristics (as a function of y) in the ex-
22
pected retum-standard deviation plane. This is done in Figure 6.2. The expected
return~standard deviation combination for the risk-free asset, F, appears ~n the vertical Figure 6.3 graphs the investrnent opportunity set, which is.the set of feasible ex-
axis because the standard deviation is zero. The risky asset, P, is plotted with a standard pected re.tum and standard deviation pairs of ali portfolios resulting from different
deviation, a p = 22% and expected return of 15%. If an investor chooses to invest solely values of y. The graph is a straight line originating at r and going through the point
1
in the risky asset, then y = 1.0, and the resulting portfolio is P. If the chosen position labeled P.
is y = O, then 1 - y = 1.0, and the resulting portfolio is the risk-free portfolio F. This straight line is called the capital allocation line (CAL). It depicts ali the.risk-
What about the more interesting rnidrange portfolios where y lies between zero and retum combinations available to investors. The slope of the CAL, S, equals the increase
1? These portfolios will graph on the straight line connecting points F and P. The slope in the expected retum of the ch osen portfolio per unit of additi.onal standard deviation-
of that line is simply [E(rp) - r¡]la P ( or rise/run), in this case, 8/22. in other words, the measure of extra retum per extra risk. For this reason, the slope also
The conclusion is straightforward. Increasing the fraction of the overa!! portfolio is called the reward-to-variability ratio.
invested in the risky asset increases the expected retum by the risk premium of equa- A portfolio equally divided between the risky asset and the risk-free asset, that is,
tion 6.1~ which is 8%. It also increases portfolio standard deviation accordi.ng to equa- where y = .5, will have an expected rate of retum of E(r el = 7 + .5 X 8 = 11 %,
tion 6.2 at the rate 22%. The extra return per extra risk is thus 8/22 = .36. implying a risk premium of 4%, and a standard deviation of a e = .5 X 22 = 11 %.
178 PART 11 Portfolio Theory CHAPTER 6
'
Capital Allocatioii between the Risky Asset and the Risk-Free Asset 179

Figure 6.3 Figure 6.4 E(r)

The investment The opportunity set
opportunity set with a with differential
risky asset and a borrowing and
risk-free asset lending rates

CAL= Capital
allocation
CAL
line

E(rp) = 15% E(rp) = 15o/o

r¡=7ºlo F
--- __S_=_8!
22
___________ i} E(rp)- r¡= 8% rf=9%

r¡=7%

CTp = 22% CTp = 22o/o

It will plot on the line FP midway between F and P. The reward-to-variability ratio is
s = 8/22 = .36. As one might expect, the leveraged portfolio has a higher standard deviation than does
an unleveraged position in the risky asset.
CONCllPT CHECK Question 2. Can the reward-to-variability ratio, S = [E(re - r ]la e• of any combina- Of course, nongovernment investors cannot borrow at the risk-free rate. The risk of
1
tion of the risky asset and the risk-free asset be different from the ratio far the risky a borrower's default causes lenders to demand higher interest rates on loans. Therefore,
asset taken alone, [E(rp) - r¡]lap. which in this case is .36? the nongovernment investor's borrowing cost will exceed the lending rate of r¡ = 7%.
Suppose that the borrowing rate is r/
= 9%. Then, in the borrowing range the reward-
to-variability ratio, the slope ofthe CAL, will be [E(rp) - r/Jlap = 6/22 = .27. The
What about points on the line to the right of portfolio P in the investment opportu- . ······--•·
nity set? If investors can borrow al the (risk-free) rate of r¡ = 7%, they can construct CAL will, therefore, be "kinked" al point P, as shown in Figure 6.4. To the left of P
portfolios that may be plotted on the CAL to the right of P. the investor is lending al 7%, and the slope of the CAL is .36. To the right of P, where
Suppose the investment budget is $300,000 and our investor borrows an additional y> 1, the investor is borrowing to finance extra investments in the risky asset, and the
$120,000, investing the total available funds in the risky asset. This is a leveraged posi- slope is .27.
tion in the risky asset; it is financed in part by borrowing. In that case In practice, borrowing to invest in the risky portfolio is easy and straightforward
if you have a margin account ~ith a broker. All you have to do is tell your broker that
420,000 you want to buy "on margin." Margin purchases may not exceed 50% of the purchase
y= 300,000 value. Therefore, if your net wortb in the account is $300,000, the broker is allowed
= 1.4 to lend you up to $300,000 to purchase additional stock.2 You would then have
and 1 - y = 1 - 1.4 = - .4, reflecting a short position in the risk-free asset, which is $600,000 on the asset side of your account and $300,000 on the liability side, resulting
a borrowing position. Rather than lending at a 7o/o interest rate, the investor borrows at iny = 2.0.
7%. The distribution of the portfolio rate of return still exhibits the sarne reward-to-vari-
ability ratio:
E(rc) = 7% + (1.4 X 8%) = 18.2% 2 Margin purchases require the investor to maintain the securities in a margin account with the broker. If the va!ue of the
rrc = 1.45 X 22% = 30.8% securities declines below a "maintenance margin," a "margin cal!" is sent out, requiring a deposit to bring lhe nel worth of
S = E(rc) - rr 18.2 - 7 = . the account up to the appropriate leve!. If the margin call is not met, regulations mandate that sorne or ali of the securities
36 be sold by the broker and the proceeds used to reestablish the required margin. See Chapter 3, Section 3.6, for further dis-
rrc 30.8 cussion.
180 PART II Portfolio Theory
CHAPTER 6 Capital Allocation between fhe Risky Asset and the Risk-Free Asset 181

CONCEPT CHECK , _ E(rp) - ''r (6.3)

Question 3. Suppose that there is a shift upward in the expected rate of retum on the
y. - .01Aa,l
risky asset, from 15% to 17%. If ali other parameters remain unchanged, what will be
the slope of the CAL for y 5 1 and y> 1? This solution shows that .the optima! position in the risky asset' is, as one would
expect, inversely proportional to the level of risk ayersion and the level of risk, as mea-
sured by the variance, and directly proportiona1.to the risk premium offer~d by the risky
6.4 R.ISK TOLERANCE ANll ASSET ALLOCATION asset.
'°'
Going back to our numerical example [r¡ 7%, E(rp) = 15_%, and ap ".' 22%], the
We have shown how to develop the CAL, the graph of ali feasible risk-retum combi- optimal solut1on for an 1nvestor w1th a coeffic1ent of nsk avers1on, A = 4, is
nations available from different asset allocation choices. The investor confronting the
15 - 7
CAL now must choose one optima! combination from the set of feasible choices. This
y* = .01 X 4 X 222 = .4l
choice entails a trade-off between risk and return. Individual investor differences in risk
aversion imply that, given an identical opportunity set (as described by a risk-free rate In other words, this particular investor will invest 41 % of the invesllnent budget in the
anda reward-to-variability ratio), different investors will choose different positions in risky asset and 59% in the risk-free asset.
the risky asset. In particular, the more risk-averse investors will choose to hold less of With 41 % invested in the risky portfolio, the rate of return of the complete portfolio
the risky asset and more of the risk-free asset. will have an expected return and standard deviation as follows:
In Chapter 5 we showed that the utility an investor derives from a portfolio with a 1
E(re) = 7 + .41 X (15 - 7)
given probability distribution of rates of retum can be described by the expected retum
and vanance of the portfoho rate of return. Specifically, we developed the following
representatton:
= 10.28%
ae= .41 X22
t
= 9.02%
U = E(r) - .005Aa2
The risk premium of the complete portfolio is E(r el - r = 3.28%, which is obtained
1
where A is the coefficient of risk aversion. We interpret this expression to say that by takmg on a portfoho w1th a standard devrnl1on of 9.02%. Notice that 3.28/9.02 = 1
the utility from a portfolio increases as the expected rate of retum increases, and it ·de- .36, which is the reward-to-variability ratio assumed for this problem.
creases when the variance increases. The relative magnitude of these changes is gov- A graphical way of presenting this decision problem is to use indifference curve
erned by the coefficient of risk aversion A. Por risk-neutral investors, A = O. Higher analysis. Recall from Chapter 5 that the indifference curve is a graph in the expected
levels of risk aversion are reflected in larger values for A. retum-standard deviation plane of all points that result in a given leve! of utility. The
An investor who faces.ª risk-fr~e rate, r1 , anda risky portfolio with expected retum curve then displays the investor's required trade-off between expected return and stan-
E(rp) and standard deviation a p w11l fmd that, for any choice of y, the expected retum dard deviation.
of the complete portfoho 1s given by equation 6.1, part of which we repeat here: Por exarnple, suppose that the initial portfolio under consideration is the risky asset
itself, y = l. The dark-blue curve in Figure 6.5 represents the indifference curve for an
E(re) = r1 + y[E(rp) - r¡l
investor with a degree of risk aversion, A = 4, that passes through the risky asset with
From equation 6.2, the variance of the overall portfolio is E(rp) = 15% and ap = 22%. The light-blue curve, by contras!, shows an indifference
curve going through P with a smaller degree of risk aversion, A = 2. The light indif-
a¿= y 2aj,
ference curve is flatter, that is;the more risk-tolerant (less risk-averse) investor requires
The investor attempts to maximize his or her utility leve!, u, by choosing the best allo- a smaller increase in expected return to compensate for a given increase in standard
cat10n to the nsky asset, y. Typ1cally, we write this problemas follows: deviation. The intercept of the indifference curve with the vertical axis is the certainty
M;" U= E(rc) - .005Aaf = r1 + y[E(rp) - r¡] - .005Ay2aj, equivalent of the risky portfolio's expected rate of return because it gives a risk-free
return with the sarne utility as the risky portfolio. Notice in Figure 6.5 that the less risk-
where A is the coefficient of risk aversion. averse investor (with A = 2) has a higher certainty equivalen! for a risky portfolio such
. Students. of calculus _will remember that the maximization problem is solved by set- as P than the more risk-averse investor (A = 4).
tmg the _denvative of th1s express10n to zero. Doing so and solving for y yields the opti- Indifference curves can be drawn for many benchmark portfólios, representing var-
ma! pos1tlon for r1sk-averse investors 1n the risky asset, y*, as follows3: ious levels of utility. Figure 6.6 shows this set of indifference curves.
To show how to use indifference curve analysis to determine the choice of the opti-
3
The derivative with respect to Y equals E(rp) - r¡ - .OlyAu~. Setting this expression equal to zero and solving for y ma! portfolio for a specific CAL, Figure 6.7 superimposes the graphs of the indiffer-
yields equation 6.3.
ence curves on the graph of the investment opportunity set, the CAL.

/
182 PART II Portfolio Theory CHAPTER 6 Capital Allocatiori between the Risky Ass~t and the Risk-Free Asset 183

Figure 6.5 E(r)

figure 6.6
Two indifference A=4 A set of indifference
curves through a curves
risky asset

=2
Certainty equivalent of Greater utility
portfolio P' s expected retum
far two different investors

E(,p)= 15% ~-- ----------(

1
1
______________________ )1
r¡=7%
'
''

<Jp = 22%

Figure 6.7
The graphical
solution to the
portfolio decision
The investor seeks the position with the highest feasible leve! of utility, represented
by the highest possible indifference curve that touches the investment opportunity set.
This is the indifference curve tangen! to the CAL.
This optima! overall portfolio is represented by point C on the investment opportu-
nity set. Such a graphical approach yields the same solution as the algebraic approach:;;

E(rc) = 10.28%

and
'f
rrc = 9.02%

which yields y* = .41.

In summary, the asset allocation process can be broken down into two
(!)determine the CAL, and (2) find the point of highest utility along that line.

6.5 PASSIVE S'l'R.i\:l'EGrns: Tm: CAPITAL IVIAmrnr L!Nll

CONCEl'T CHECK Question 4.
The CAL is derived with the risk-free and "the" risky portfolio P. Determination of the
a. lf an investor's coefficient of risk aversion is A = 3, how <loes the optima! asset mix
assets to include in risky portfolio P may result from a passive oran active strategy. A
change? What are the new E(r el and rre?
b. Suppose that_ the borrowing rate, r/ r
= 9%, is greater than the lending rate, = 7%.
passive strategy describes a portfolio decision that avoids any direct or indirect secu-
rity analysis. 4 At first blush, a passive strategy would appear to be naive. As will
Show, graph1cally, how the optima! portfolio choice of sorne investors wi{¡ be aL
fected by the higher borrowing rate. Which investors will not be affected by the
4 By "indirect security analysis" we mean the delegation of that responsibility to an intennediary such as a professional
borrowing rate?
money manager.
184 PART Il Portfolio Theol}· CHAPTER 6 Capital Allocation betw~en the Risky Asset and the Risk-Free Asset 185

Table 6.1 Average Rates of Return and Standard Deviations far Common Stocks and We cal! the capital allocation line provided by one-month T-bills and a broad index
One-Month Bilis, and the Risk Prcmium over Bilis of Common Stock of common stocks the capital market line (CML). A passive strategy generales an
investrnent opportunity·set that is represented byº the CML.
How reasonable is it for an investor to pursue a passive strategy? Of course, we can-
not answer suclÍ a question withoiit comparing the strategy to the costs and benefits
accruing to an active portfolio strategy. Sorne thoughts are relevan! arthis point, how-
ever.
First, the altemative active. strategy is not free. Whether you choose to invest the
1926-1942 8.0 29.7 1.2 1.6 6.8 29.8 time and cost to acquire the information needed to generate an optimal active portfolio
1943-1959 18.4 17.1 1.3 .9 17.1 17.4 of risky assets, or whether you delegate the task to a professional who will charge afee,
1960-1976 8.4 17.4 4.7 1.7 3.7 18.3 construction of an active portfolio is more expensive than a passive one. The passive
1977-1993 14.4 13.2 7.8 3.0 6.6 13.3
8.6 20.9 portfolio requires only small commissions on purchases ofT-bills (or zero commtssions
1926-1993 12.3 20.5 . 3.7 3.3
if you purchase bills directly from the government) and management fees to a mutual
fund company that offers a market index fund to the public. Vanguard, far example,
<\
operates the Index Trust 500 Portfolio that mimics the S&P 500 index. It purchases
shares of the firms constituting the S&P 500 in proportion to the market values of the
become apparent, however, forces of supply and demand in large capital markets may outstanding equity of each firm, and therefore essentially replicates the S&P 500 index.
make such a strategy a reasonable choice for many investors. The fund !bus duplicates the performance of this market index. It has one of the lowest
A comprehensive compilation of the history of rates of retum on different asset operating expenses (as a percentage of assets) of ali mutual stock funds precisely
classes in the 20th century is available on an ongoing basis.5 The data also are available because it requires minirnal rnanagerial effort.
on computer tape from the University of Chicago 's Center for Research in Security A second reason to pursue a passive strategy is the free-rider benefit. If there are
Prices (CRSP). This database includes rates of retum on 30-day T-bills, long-term man y active, knowledgeable investors who quickly bid up prices of undervalued assets
T-bonds, long-term corporate bonds, and common stocks. The CRSP tapes provide a and force down prices of overvalued assets (by selling), we have to conclude that at any
monthly rate of return series far the period 1926 to the present and, for common stocks, time most assets will be fairly priced. Therefore, a well-diversified portfolio of common
a daily rate of return series from 1963 to the present. We can use these data to develop stock will be a reasonably fair buy, and the passive strategy may not be inferior to that
various passive strategies. of the average active investor. (We will explain this assumption and provide a more
A natural candidate far a passively held risky asset would be a well-diversified port- comprehensive analysis of the relative success of passive strategies in later chapters.)
folio of common stocks. We have already said that a passive strategy requires that we Indeed, the nearby box shows that passive index funds have become quite popular
devote no resources to acquiring information on any individual stock or group of stocks, investments in the last few years.
so ~e 1nust follow a "neutral" diversification strategy. One way is to selecta diversi- To sumrnarize, however, a passive strategy involves investment in two passive port-
fied portfolio of stocks that mirrors the value of the corporate sector of the U.S. econ- folios: virtually risk-free short-term T-bills (or, altematively, a money market fund), and
omy. This results in a value-weighted portfolio in which, far example, the proport10n a fund of common stocks that mimics a broad market index. The capital allocation line
invested in GM stock will be the ratio of GM's total market value to the market value representing such a strategy is called the capital market line. Historically, based on
of all listed stocks. 1926 to 1993 data, the passive risky portfolio offered an average risk premium of 8.6%
The most popular value-weighted index of U.S. stocks is the Standard & Poor's and a standard deviation of 20.9%, resulting in a reward-to-variability ratio of .41.
composite index of the 500 largest capitalization corporations (S&P 500). (Befare Passive investors allocate their investment budgets among instruments according to
March 1957 it consisted of 90 of the largest stocks.) Table 6.1 shows the historical their degree of risk aversion.
record of this portfolio. We can use our analysis to deduce a typical investor's risk-aversion parameter. In
The last pair of columns shows the average risk premium over T-bills and the stan- 1993, the total market value ofthe S&P 500 stocks was about four times as large as the
dard deviation of the common stock portfolio. The risk premium of 8.6% and standard market value of ali outstanding T-bills of less than six months' maturity. If we ignore
deviation of 20.9% over the entire period are similar to the figures we assumed for the all other assets (e.g., long-term bonds and real estate), and pretehd that all investors fol-
risky portfolio we used as an example in Section 6.4. lowed a passive strategy, then the average investor's position in the risky asset (the S&P
500) was
4
5 R. G. Ibbotson and R. A. Sinquefield, Stocks, Bonds, Bilis, and lnflation (SBBI), Updated in SBBI 1994 Yearbook
y= 1 +4 = ·8
(Chicago: Ibbotson Associates, 1995).
186 PART 11 Portfolio Theory CHAPTER 6 Capital Allocation 'betwee'n the Risky Asset and the Risk-Free Asset 187

E(rM) - r1
y*= .01 X Acr;\
= .8
8.6
.01 X A X 20.92
which implies a coefficient of risk aversion of
8.6
A ~ .01 X .8 X 20.9 2 = 2 .4 6
This is, of course, mere speculation. We have assumed without basis that the aver-
age 1993 investor held the naive view that historical average rates of retum and stan-
dard deviations are the best estimates of expected rates of return and risk, looking to the
future. To the extent that in 1993 the average investor took advantage of contemporary
information in addition to simple historical data, our estimate of A = 2.46 would be an
unjustified inference. Nevertheless, a bread range of studies, taking into account the full
range of available assets, places the degree of risk aversion for the representative
investor in the range of 2.0 to 4.0. 6

CONCllP'l' CHECK Question 5. Suppose that expectations about the S&P 500 index and the T-bill rate are
the same as they were in 1993, but you find that today a greater proportion is invested
in T-bills than in 1993. What can you conclude about the change in risk tolerance over
the years since 1993?

SuMMARY l. Shifting funds from the risky p011folio to the risk-free asset is the simples! way
to reduce risk. Other methods involve diversification of the risky portfolio and hedg-
ing. We take up these methods in later chapters.
2. T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless,
the standard deviation of real rates on short:term T-bills is small compared to that of
other assets such as long-term bonds and common stocks, so for the purpose of our
analysis we consider T-bills as the risk-free asset. Money market funds hold, in addi-
tion to T-bills, short-term relatively safe obligations such as CP and CDs. These entail
sorne default risk, but again the additional risk is small relative to most other risky
assets. Por convenience, we often refer to money 1narket funds as risk-free assets.
3. An investor's risky portfolio (the risky asset) can be characterized by its reward-
to-variability ratio, S = [E(rp) - r¡]lcr p· This ratio is also the slope of the CAL, the line
that, when graphed, goes from the risk-free asset through the risky asset. Ali combina-
tions of the risky asset and the risk-free asset lie on this line. Other things equal, an
investor would prefer a steeper-sloping CAL, because that means higher expected
What degree of risk aversion must investors have for this portfolio to be optima!? return far any leve! of risk. If the borrowing rate is greater !han the lending rate, the
Assuming that the average investor uses the historical average risk premium (8.6%) CAL will be "kinked" al the point of the risky asset.
and standard deviation (20.9%) to forecast future retum and standard deviation, and
6 See, for cxample, J. Friend and M. Blume, "The Demand for Risky Assets," American Economic Review 64 {1974) or
noting that the weight in the risky portfolio was .80, we can work out the average
S. J. Grossman and R. J. Shiller, "The Determinants of the Variability of Stock Market Prices," American Economic Review
investor's risk tolerance as follows: 71 (1981).
188 PART II Porifolio Theory CHAPTER 6
'
Capital AllocatiOn betw'een the Risky Asset and the Risk-Free Asset 189
' . .
4. The investor's degree of risk aversion is characterized by the slope of his or her ;¡/. Suppose t\¡at your risky portfalio includes the fallowing investrnents in the
indifference curve. Indifference curves show, at any level of expected retum and risk, given proportions:
the required risk premium far taking on one additional percentage of standard devia-
Stock A: 27%
tion. More risk-averse investors have steeper indifference curves; that is, they require a
Stock E: 33%
greater _risk prernium for taking on more risk.
Siock C: 40%
5. The optima! position, y*, in the risky asset, is proportional to the risk premium
and inversely proportional to the variance and degree of risk aversion: What are the investment proportions of your client's overall portfolio, including
the position in T-bills?
* _ E(rp)- r¡
':}(What is the reward-to-variability ratio (S) ofyour risky portfolio? Your client's?
y - .OIAcrt
~ Draw the CAL of your portfolio on an expected retnm-standard deviation dia-
Graphically, this portfalio represents the point at which the indifference curve is tan- . gram. What 1s the slope of the CAL? Show the position of your client on your
gen! to the CAL. _,Jund's CAL.
6. A passive investment strategy disregards security analysis, targeting instead the 0 Suppose that your client decides to invest in your portfolio a proportion y of the
risk-free asset anda broad portfalio of risky assets such as the S&P 500 stock portfalio. '--- total investment budget so that the overall portfolio will have an expected rate
If in 1993 investors took the mean historical retum and standard deviation of the S&P of retum of 15%.
500 as proxies far its expected retum and standard deviation, then the market values of a. What is the proportion y?
outstanding T-bills and the S&P 500 stocks would imply a degree of risk aversion of b. What are your client's investment proportions in your three stocks and the
about A ~ 2.46 far the average investor. This is in line with other studies, which estí- T-bill fund?
mate typical risk aversion in the range of 2.0 through 4.0. c. ·what is the standard deviation of the rate of return on your client's port-
folio?
l\cy Terms r/suppose that your client prefers to invest in your funda proportion y that max-
'"---- imizes the expected return on the overall portfolio subject to the constraint that
Capital allocation decision Risk-free asset the overall portfolio's standard deviation will not exceed 20%.
Asset allocation decision Capital allocation line a. What is the investment proportion, y?
Security selection decision Reward-to-variabi1ity ratio . / h. What is the expected rate of return on the overall portfolio?
Risky asset Passive strategy y1. Your client's degree of risk aversion is A ~ 3.5.
\__
Complete portfalio Capital market line
a. What proportion, y, of the total investment should be invested in your fund?
b. What is the expected value and standard deviation of the rate of return on
Selected Readings your client's optimized portfolio?
The classic article describing the asset-allocation choice, whereby investors choose the optima[ You estimate that a passive portfolio, that is, one invested in a risky portfolio that mim-
fraction of their wealth to place in riskjree as sets, is: ics the S&P 500 stock index. yields an expected rate of return of 13% with a standard
Tobin, James. "Liquidity Preference as Behavior Towards Risk." Review of Economic deviation of 25%.
Studies 25 (February 1958).
Practitioner-oriented approaches to asset allocation may be JOund in: J(Draw the CML and your funds' CAL on an expected retum-standard deviation
Maginn, John L., and Donald L. Tuttle. Managing Invest1nent Portfolios: A Dynamic diagram.
Process. 2nd ed. New York: Warren, Gorham, & Lamont, 1990. a. What is the slope of the CML?
b. Characterize in one short paragraph the advantage of your fund over the
passive fund.
l'roblems
You manage a risky portfolio with an expected rate of retum of 17% and a standard
I
'~ Your client ponders whether to switch the 70% that is invested in your fund to
the passive portfolio.
deviation of 27%. The T-bill rate is 7%. a. Explain to your client the disadvantage of the switch.
,/I. Your client chooses to invest 70% of a portfolio in your fund and 30% in a b. Show your client the maximum fee you could charge (as a percentage of
T-bill money market fund. What is the expected value and standard deviation of the investment in your fund deducted at the end of the year) that would still
the rate of retum on your client's portfolio? leave the client at least as well off investing in your fund as in the passive
 CHAPTER 6
' '
Capital Allocation' between the Risky Asset and the Risk-Free Asset 191
190 PART 1l Portfolio Theory

one. (Hint: The fee will lower the slope of your client"s CAL by reducing Problems 15-18 ar¡; more advanced. Suppose that the borrowing rate that your client
the expected retum net of the fee.) faces is 9%. Continue to assume that the S&P 500 Index has an expected retum of
Consider the client in question 7 with A = 3.5 13% and standard deviation of 25%, and that yóur fund has the,parameters given in
a. If the client chose to invest in the passive portfolio. what proportion, y, Problem 13.
would be selected? 15. Draw a diagram of the CML your client faces with the borrowing constraints.
b. What fee (percentage of the investment in your fund, deducted at the end Superimpose on it two sets of indifference curves, one for a client who will
of the year) can you charge to make the client indifferent between your fund choose to borrow, and one who will invest in both the index fund and a rnoney
and the passive strategy? market fund.
Look at the data in Table 6.1 on the average risk premium of the S&P 500 over
lA·
1 T-bills, and the standard deviation of that risk premium. Suppose that the S&P
16. What is the range of risk aversion for which the client will neither borrow nor
lend, that is, for which y = 1?
500 is your risky portfolio. 17. Solve problems 15 and 16 for a client who uses your fund rather than an index
a. [f your risk-aversion coefficient is 4 and you believe that the entire fund.
1926-1993 period is representative of future expected performance, what

•
18. Amend your solution to problem IO(b) for clients in the risk-aversion range that
fraction of your portfolio should be allocated to T-bills and what fraction to you found in problem 16.
equity? 19. You manage an equity fund with an expected risk premiurn of 10% and an
b. What if you believe that the 1977-1993 period is representative? ? expected standard deviation of 14%. The rate on Treasury bilis is 6%. Your
c. What do you conclude upon comparing your answers to (a) and (b),
client chooses to invest $60,000 of her portfolio in your equity fund and $40,000
'
1\2. What do you think would happen to the expected retum on stocks 1f mvestors in a T-bill money market fund. What is the expected retum and standard devia-
perceived higher volatility in the equity market? Relate your answer to equat1on tion of return on your client's portfolio?*
6.3.
Consider the following information about the risky portfolio that you manage, Expected Standard Deviation
anda risk-free asset: E(rp) = 11 %, rrp = 15%, rf = 5%. . Return of Return
a. Your client wants to invest a proportion oí.her total investment budget in
your risky fund to provide an expected rate ofreturn on her ov~rall ar.com- a. 8.4°/o 8.4o/a
b. 8.4°/o 14.0%
plete portfolio equal to 8 percent. What proportion should she mvest m the C. 12.0% 8.4%

•
risky portfolio, P, and what proportion in the risk-free asset? . d. 12.0% 14.0%
b. What will be the standard deviation of the rate of retum on her portfoho?
c. Your other client wants the highest retum possible subject to the constraint 20. What is the reward-to-variability ratio for the equity fund in question 19?*
that you limit his standard deviation to be no more than 12%. Which client a. 0.71.
b. 1.00.

•
is more risk averse?
14. The change from a straight to a kinked capital allocation line is a result of the:* c. 1.19 .
a. Reward-to-variability ratio increasing. d. 1.91.
b. Borrowing rate exceeding the lending rate.
c. Investors risk tolerance decreasing.
d. Increase in the portfolio proportion of the risk-free asset.

*Reprinted, with pennission, from the Leve! I 1991 CFA Study Guide. Copyright 1991, Association for Investment *Reprinted, with permission, from the Level 11993 CFA Study Guide. Copyright 1993, Association for lnvestment Manage-
Management and Research, Charlottesville, VA. Ali rights reserved. ment and Research, Charlottesville, VA. Ali rights reserved.
 1
CHAPTER 7 Optima! Risky Portfolios· 193

Chapter 7 Finally, in the la,st two appendices, we examine common fallacies regarcling the

Optimal Risky Portfolios power of diverslfication in the contexts of the insufance principle and the notion of
time diversification.

7.1 DIVF.RSIFICATION AND PORTFOLIO RISK

Suppose that your risky portfolio is composed of only one stock, Digital Equipment
Corporation. What would be the sources of risk to this "portfolio?" You might think of
two broad sources of uncertainty. First, there is the risk that comes from conditionS in
the general economy, such as the business cycle, the inflation rate, interest rates, and
exchange rates. None of these macroeconomic factors can be predicted with certainty,
and ali affect the rate of return that Digital stock eventually will provide. In adclition to
IN CHAPTER 6 \Vil DISCUSSllD THll CAPITAL ALLOCATION
these macroeconomic factors there are firm-specific influences, such as Digital's suc-
DllCISION. That decision governs how an investor chooses between cess in research and development, and personnel changes. These factors affect Digital
risk-free assets and "the" optimal portfolio of risky assets. This chapter without noticeably affecting other firms in the economy.
explains how to construct that optima! risky portfolio. Now considera naive_!IJy~rsification strategy, in which you include additional secu-
rities in your risky portfoTio:-For example, suppose that you place half of your risky
We begin at the simplest level. with a discussion of how diversifica-
portfolio in Exxon, leaving the other half in Digital. What should happen to portfolio
tion can reduce the variability of portfolio returns. After establishing risk? To the extent that the firm-specific influences on the two stocks differ, we should
this basic point, we examine efficient diversification strategies at the reduce portfolio risk. Far example, when oil prices fall, hurting Exxon, computer prices
asset allocation and security selection levels. We start with a simple, might rise, helping Digital. The two effects are offsetting, and stabilize portfolio return.
But why end diversification at only two stocks? If we diversify into man y more secu-
restricted example of asset allocation that excludes the risk-free asset.
rities, we continue to spread out our exposure to firm-specific factors, and portfolio
To that effect we use two risky mutual funds: a long-term bond fund and a stock fund. volatility should continue to fall. Ultimately, however, even if we include a large num-
With this example we investigate the relationship between investment proportions and ber of risky securities in our portfolio, we cannot avoid risk altogether. To the extent
the resulting portfolio expected return and standard deviation. We then add a risk-free that virtually all securities are affected by the common macroeconomic factors, we can-
not eliminate our exposure to these risk sources. For example, if all stocks are affected
asset, for example, T-bills, to the menu of assets and detennine the optima! asset allo-
by the business cycle, we cannot avoid expósure to business cycle risk no matter how
cation. We do so by combining the principies of optimal allocation between risky many stocks we hold.
assets and risk-free assets (from Chapter 6) with the risky portfolio construction When ali risk is firm-specific, as in Figure 7.IA, cliversification can reduce risk to
methodology. arbitrarily low levels. The reason is that with ali risk sources independent, and with the
portfolio spread across many secllrities, the exposure to any particular source of risk is
Moving from asset allocation to security selection we first generalize our discus-
reduced to a negligible leve!. This is justan application of the well-known la.w of aver-
sion of restricted asset allocation (with only two risky assets) to a universe of many ages. The reduction of risk to very low levels in the case of inclependent risk sources
risky securities. This generalization relies on the celebrated Markowitz portfolio is sometimes called the insurance principie, because of the common belief that an
selection model, 1 which identifies the set of efficient stock portfolios from the avail- insurance company depends oiithe·n·sk"fedUCtlon achieved through diversification when
it writes many policies insuring against many independent sources of risk, each policy
able uni verse of securities. Proceeding to capital a11ocation, we show how the best
being a small part of the company's overall portfolio. (See Appendix B to this chapter
attainable capital allocation line emerges from the Markowitz algorithm. We pause to for a discussion of the insurance principie.)
explain why portfolio optimization is often conducted in two stages, asset allocation When common sources of risk affect all firrns, however, evén extensive diversifica-
and security selection, and discuss the potential inefficiency that may result from sep- tion cannot eliminate risk. In Figure 7. IB, portfolio standard deviation falls as the num-
ber of securities increases, but it cannot be reduced to zero.2 The risk that remains even
arating the asset allocation decision from security selection.
2 The interested reader can find a more rigorous demonstration of these points in Appendix A. That discussion, however,
1 Harry Markowitz, Portfolio Selection: Efficient Diversification of Jnvestments (New York: John Wiley and Sons, 1959).
relies on tools developed later in this chapter.
194 PART 11 Portfolio Theory CHAPTER 7 Optima! Risk:) Portj~lios · 195

Figure 7. t A B
Table 7. t DescripLíve Statistics for Two Mutual Funds
Portfolio risk as a
function of the number
of stocks in the
portfolio Expected return, E(r) 8% 13o/o
Standard deviation, rr 12°/o 20°/o
Covariance, Cov(r0,rE) 72
Unique risk Correlation coefficient, PoE .30

as a function of the number of stocks in the portfolio. On average, portfolio risk <loes
Market risk fall with diversification, but the power of diversification to reduce risk is limited by sys-
tematic or common sources of risk.

7.2 POR'l'FOLIOS OF Two RISKY AsSF:TS

*';' 5045
.g
In the last section we analyzed naive diversification, examining the risk of equally
weighted portfolios of several securities. It is time now to study efficient diversifica-
-~ 40
tion. whereby we construct risky portfolios to provide the lowest possible risk for any
""""" 35 given level of expected retum.
~ 30
"" 25 Constructing the optima! risky portfolio is a complicated statistical task. The princi-
~o 20 pies we follow, however, are the same as those used to construct a portfolio from two
;§ 15 10
risky assets only. We will analyze this easier process first and then backtrack a bit to see
"§ how we can generalize the technique to more realistic cases.
o. 5

~
o ~~~~~~~~~~~~~~~.,.,o Assume far this purpose that an investor is limited to two assets. To benefit from
>
o 2 4 6 8 10 12 14 16 18 20 100 200 300 400 500 600 700 800 900 1.000 diversification, our investor chooses for the first asset shares in a mutual fund that main-
Number of stocks in portfolio
"" tains a broad portfolio oflong-term debt securities (D). and chooses for the second asset
shares in a mutual fund that specializes in equities (E). The parameters of the joint prob-
ffigure 7.2
ability distribution ofretums is shown in Table 7.1.
Portfolio diversification. The average standard deviation of returns of portfolios composed of only one stock was 49.2%.
The average portfolio risk fell rapidly as the number of stocks included in the portfolio increased. In the limit, portfolio
A proportion denoted by wD is invested in the bond fund, and the remainder. 1 - w D'
risk could be reduced to only 19.2o/o. denoted Wp is invested in the stock fund. The rate of return on this portfolio will be
Source: Elton and Gruber, Modern Portfolio Theory and lnvestment Analysis, 2nd ed. (New York: John Wiley and Sons, 1989), p. 35; adapted by Meir
Statman, "How Many Stocks Malee a Diversified Portfolio," Joumal of Financia[ and Quantitative Analysis 22 (September 1987).
·rp = wDrD + wErE
where rp stands for the rate of return on the portfolio, r D the rate of retum on the debt
fund, and rE the rate of return on the equity fund.
after extensive diversification is called market risk, risk that is attributable to mar- As we noted in Chapter 5, the expected rate of return on the portfolio is a weighted
ketwide risk sources. Such risk is also called systematic risk, or nondiversiliable risk. average of expected returns on the component securities with portfolio proportions as
In conÍrast, the risk that can be eliminated by diversification is called unique risk, finu- weights:
specilic risk, nonsystematic risk, or diversiliable risk.
This analysis is borne out by empirical studies. Figure 7.2 shows the effect of port- E(rp) ~ wDE(rD) + wEE(rE) (7.1)
folio diversification, using data on NYSE stocks. 3 The figure shows the average stan- The variance of the two-asset portfolio (Rule 5 of Chapter 5) is
dard deviation of equally weighted portfolios constructed by selecting stocks at random
";, ~ wypf, + wko"~ + 2wDwg:.ov(rD,rE) (7.2)
3Meir Statman, "How Many Stocks Make a Diversified Portfolio," Journal of Financia! and Quantitative Analysis 22 The first observation is that the variance of the portfolio. unlike the expected retum.
(September 1987).
is not a weighted average of the individual asset variances. To understand the formula
 Optima! Risky Po~tfolios
0

CHAPTER 7 197
196 PART 11 Portfolio Theory
As we discuSsedin Chapter 5, the portfolio vari~nce is reduced if the covariance term
Table 7 .2 Bordered Covariance Matrix
is negative. This is the case in the use of hedge assets. It is important to recognize that
even if the covariance term is poSitive, the portfoÍio standard deviation still is ie-ss than
the weighted average of the individual security standard deviations, unless the two secu-
rities are perfectly positively correlated.
To see this, recall from Chapter 5, equatioh 5.5; that the Covariance can be written as

Cov(rv,re) = Pveªvªe
Substituting into equation 7 .2, we can rewrite the variance and standard deviation of the
portfolio as
for the portfolio variance more clearly, recall that the covariance of a variable with hsel~
(in this case the variable is the uncertain rate of return) 1s the variance of that vanable, (7.3)
1,
that is (7.4)
¡
scenarios You can see from this information that the covariance term adds the most to the port-
folio variance when the correlation coefficient, PnE• is highest, that is, when it equa]s
¡ Pr(scenario)[rD - E(rvll
2
1-as it would in the case ofperfect positive correlation. In this case the right-hand side
scenarios
of equation 7.3 is a perfect square, so it may be rewritten as follows:
= rrb
a~= (wvªv + wEaE)2
Therefore, another way to write the variance of the portfolio is as follows:
or
cr2P = wvwvCov(rv,rv) + wEw¡;Cov(rE,rE) + 2wvw¡;Cov(rD,rE)
U'p = WDU'D + WEU'E
In words, the variance of the portfolio is a weighted sum of covaria~ces, where .each
weight is the product of the portfolio proportions of the pair of assets m the covanance In other words, the_o;_tan_cLar..<l.Ee_vi."ti_()ll ofJ]¡_e__p()r:tfolio in the case of perfect positive cor-
relation isjust the "'.~~g~ttx!_"'ver."g!'()ft~_"C()~r2_n~iil_stiu,dar:d cle_yi~\ions, I~ ali ~Íher
term. . h
Why do we do uble the covariance between the tw~ different ~ssets 1n t e 1ast. ter~ cases the cüríelatiün cÜefficient is less than 1, making the portfolio standard deviation
of equation 7.2? This should become clear in the covariance matnx, Table 7.2, wh1ch 1s less than the weighted average of the componen! standard deviations.
bordered by the portfolio weights. . . . .. We know already from Chapter 5 that a hedge asset reduces the portfolio variance.
The diagonal (from top Jeft to bottom right) of the covanance matnx 1s made up of This algebraic exercise adds the additional insight that the. st"11darc!Ae_v:i.'1!igg_()f a_po!_t~
the asset variances. The off-diagonal elements are the covar1ances. Note that folio _cif"'S§."!~\_sJ¡;§,!.llli!n.!11.\'. w~_\g.ht".d_!!Y,!'f~g"_of.!h.e componentsecurity standard_devi-
~t·~-~~~,~Y.~!J--~~~E--~~-l'.-~,~-~~!-~~-a.X.~._-PQ§_HiY.~~);'. P-º!-:1::_~J.3:~ed. Because the portfolio expected
Cov(rv,rE) = Cov(re,rv) return is always the weighted average of its component expected returns, whereas its
so that the matrix is symmetric. To compute the portfolio variance: we sum ?ver each standard deviation is less than the weighted average of the componen! standard devia-
term in the matrix, first multiplying it by the product of the portfoho proport1ons from \-1 :-tions, porifolios of less than peifectly correlated assets always offer better risk-return

the corresponding row and column. Thus, we have one term _far each asset va:iance but i \: iopportunities tha-fl the individual componen! securities on their own. The less correla-

twice the term far each covariance pair, because each covanance appears tw1ce. tion between the assets, the greater the gain in efficiency.
How low can portfolio standard deviation be? The lowest possible value of the cor-
relation coefficient is -1, representing perfect negative correlation, in which case the
CONCllPT CHECK Question l. . . . portfolio variance is as follows 4:
a. Confirm that this simple rule for computing portfoho vanance from the covanance
matrix is consistent with equation 7 .2 "f, = (wvªv - wEaE)2
b. Consider a portfolio of three funds, X, Y, Z, with weights Wx, Wp and Wz. Show that
and the portfolio standard deviation is
the portfolio variance is
w}¡2 + w}r} + w~~ + 2wxwyCov(rx,ry) +
X \ J 2wxwzCov(rx,rz) + 2wyWzCov(rprz) 4This expression also can be derived from equation 7.3. When PoE = -1, equation 7.3 is aperfect square that can be fac-
tored as shown.
198 PART II Portfolio Theory
CHAPTER 7 Optima/ Risky Portfolios
199
"P = Absolute value (wD"D - WE<YE) Figure 7.3 E [r(portfoliÓ)J
When p = -1, the investor has the opportunity of creating a perfectly hedged position. Portfolio expected
return as a function of
If the portfolio proportions are chosen as
investment proportions
<YE
w -~~­

D - O"D +<JE

<YD 13% - - - - - - - -
WE = = 1- WD
O'D + (J'E
the standard deviation of the portfolio will equal zero. 5
Let us apply this analysis to the data of the bond and stock funds as presented in Table
7.1. Using these data, the formulas for the expected return, variance, and standard devi-
ation of the portfolio are

E(rp) = 8wD + 13wE (7.5)

<Y
2 = 122w2D + 202 wE2 + 2 X 72wD w E (7.6)
p

<Yp = {;;'{,
Now we are ready to experiment with different portfolio proportions to observe the -0.5 o w (stocks)
1.0 2.0
effect on portfolio expected retum and variance. Suppose we change !he proportion
invested in bonds. The effect on the portfolio's expected retum is plotted in Figure 7.3.
1.5 1.0 w (bonds) == 1-w (stocks)
When the proportion invested in bonds varies from zero to 1 (so that the proportion in o -1.0
stock varies from l to zero), the portfolio expected return goes from 13% (the stock
fund's expected retum) to 8% (the expected retum on bonds).
What happens to the right of this region, when wD > 1 and wE <O? In this case port-
Table 7.3
folio strategy would be to sell the equity fund short and invest the proceeds of the short
sale in the debt fund. This will decrease the expected return of the portfolio. For exam-
ple, when wD = 2 and wE = -1, expected portfolio return falls to 3% [2 X 8 + (-1)
X 13]. At this point the value of the bond fund in the portfolio is twice the net worth of
the account. This extreme position is financed in part by short selling stocks equal in
value to the portfolio's net worth. o 1.00 20.00°/o 20.00% 20.00°/o
0.25 0.75 20.00%
The reverse happens when wD <O and wE> l. This strategy calls for selling the bond 12.00 15:30 16.16
0.50 0.50 18.00
fund short and using the proceeds to finance additional purchases of the equity fund. . 4.00 11.66 13.11
0.75 0.25 16.00
Of course, varying investment proportions also has an effect on portfolio standard 4.00 10.30 11.53
1.00 o 14.00
12.00 12.00 12.00
deviation. Table 7 .3 presents portfolio standard deviations for different portfolio weights 12.00
calculated from equations 7.3 and 7.4 far the assumed value of the correlation coeffi- minimum a 0.00 10.29
cient, .30, as well as far other values of p. Figure 7.4 shows the relationship between W0 atmin~ 0.63 0.74
11.45
0.82
standard deviation and portfolio weights. Look first at the curve far PDE = .30. The
graph shows that as the portfolio weight in the equity fund increases from zero to 1,
portfolio standard deviation first falls with the initial diversification from bonds into
stocks, but then rises again as the portfolio becornes heavily concentrated in stocks, and
ª.gain is undiversified. This pattern will generally hold as long as the correlation coef-
flcient between the funds is not too high. For a pair of assets wi'th 1 ··
¡ · f . a arge posit1 ve cor-
5 It is possible to drive portfolio variance to zero with perfectly positively correlated assets as well, but this would require re atJ.~n o retums, the ~ortf?ho standard deviation will increase rnonotonically from the
short sales. low-nsk asset to .the ~?h-~1sk asset. Even in this case, however, there is a positive (if
small) value of d1vers1flcat10n.
 PART U Portfolio Theory CHAPTER 7 Optimal Risky Portfolios
200 201
What is the minimum leve! to which portfolio standard deviation can be held? For Figure 7.4 Portfolio standard dei/iation
-the pararneter values stipulated in Table 7.1, the portfolio weights that salve this mini- Portfolio standard
\
mization problem tum out to be6 : deviation as a function \
\
~f investment propor-
(7.7) \
\
cr~ - Cov(rv,rE) tions \
WMin(D) = ~2-~2~--c-=-=-) \
crv + crE - 2 ov(rv,rE \
\
\
202 - 72 20o/o

122 + 202 - 2 X 72
.82
·. . . . . '>\ ' .........~/
• f
.. f
f

1 - .82
·.... ·.,\ \ í/ _. I

.18 1 ---
.· ,
-........ -_...,--- 1l
I

This minimum variance portfolio has a standard deviation of ! ,~· .......................·· / r

10%
,,
;í \
\ ., I 1

crMin(P) = [.822 X 122 + .182 X 202 + 2 X .82 X .18 X 72]1/2 /i \ /

= 11.45% \
\
\ I
,I
•
as indicated in the next-to-last line of Table 7 .3 for the column p = .30. 11 \_ /,·
/\ I
The solid blue line in Figure 7.4 represents the portfolio standard deviation when \ J
\ I
p = .30 as a function of the investment proportions. It passes through the two undiver-
-~0-~5-----!ó--~_c~:-,-_c__~--~-----L w (stocks)
Ü ,\ I .

sified portfolios of wD = 1 and wE = l. Note that the minimum-variance portfolio 0.5 In 1.5
has a standard deviation smaller than that of either of the individual componen! assets. w (bonds) = 1-w (stocks)
This highlights the effect of diversification. 1.5 1.0 0.5 o -0.5
The other three lines in Figure 7.4 show how portfolio risk varies for other values of
the correlation coefficient, holding the variances of each asset constan!. These lines plot
the values in the other three columns ofTable 7.3.
The straight line connecting the undiversified portfolios of ali bonds or ali stocks, WMin(D;p = -1) = aE 20 625
wD = 1 or wE = 1, demonstrates portfolio standard deviation with perfect positive crD + crE 12 + 20 = ·
correlation, p = 1. In this case there is no advantage from diversification, and the port- WMin(E;p = -1) = 1 - .625 = .375
folio standard deviation is the simple weighted average of the componen! asset standard
and the portfolio variance (and standard deviation) is zero
deviations. We can combine Figures 7 3 and 7 4 1 d · .
The dotted curve below the p = .30 curve depicts portfolio risk for the case of uncor- folio's leve! of risk (standard. deviati~n)ºan~m~~s~~~:c~~rel~tm~ship between the port-
li<>--gfiven the pararneters of the available assets. This is ~o~eo i:~~:r~n/~a~portfo­
related assets, p = O. With lower correlation between the two assets, diversification is
more effective and portfolio risk is lower (al leas! when both assets are held in positive pa1r o investment proport1ons w d h . . or any
amounts). The minimum portfolio standard deviation when p = O is 10.29% (see Table the standard deviation from Flgu~~ ;~~~rea \e expe~ted retum from Figure 7.3 and
7 .3), again lower than the standard deviation of either asset. and standard deviation are tabulated ln. Ta:i:~.~ :~ ~~~:: ~f.po;tfolio ;'i'ected retum
The sohd blue line in Figure 7 .5 shows the _p_'!!!_f'olio o~p~~~!~e s~t ~
Finally, the upside-down triangular broken line illustrates the perfect hedge potential
=
when the two assets are perfectly negatively correlated (p = - l ). In this case the solu- We cal! it the portfoho opportunity set becaus ·¡ h~--·-h·--·---~--,-- or p .30. !
tion for the minimum-variance portfolio is return and standard deviation of ali th ' .e 1 s ows_t__e E<Jmb1nat10n of expected ,1
-~J!
---r¡;r-····------~---~-----·- ···-·· ~ port.ohosthat can be constructed fromiti r·
......t!!§§_eJ§c The broken and dotted Hne; sho\\' th~ orttoÜo_o_ ......., ----·· ----~--'.:'.'..°­ 11
values of the correlation coefficient. The line farthe p . pportumty set far other
line connecting the undiversified portfolios shows :~~~~e nght, wbh1ch~s the straight ¡

sification when the correlation between the ~wo assets is ere is no ~~e it from diver-
1

---- ---- ------- - - - - -- ---------- - - -- ---- '

6 This solution uses the minimization techniques of elementary calculus. Write out the expres~ion for portfolio variance from opportunity set is not "pushed" to the north t Th d perfe~tly pos1tlve (p = 1). The ¡,
cquation 7.2, substitute 1 - wD for Wp differentiate the result with respect to wD, set the derivative equal to zero, and solve bl h wes . e otted !me to the left of the s l'd
for wD. Altematively, with a computer spreadsheet, you can obtain an accurate ~olutioh by generating a fine grid for Table
17.3 and observing the minimum.
co~~~=~ ~s ~:~ ~~nt~~:~si~~:~~:i~::efit from diversification when the correla~~n ¡,
11

¡·:¡

,:¡
 1
202 PART II Portfolio Theory
CHAPTER 7 Optima! Risky Portfolios
203
Tuble 7 .4 Portfolío F:xpected Returns and Standard DeviaLions wiLh Various Figure 7.5 E (r)
Correlation Coefficicnts Portfolio expected
return as a function of
standard deviation

o 1.00 13.00 20.00°/o 20.00o/o 20.00o/o 20.00°/o

0.25 0.75 11.75 12.00 15.30 16.16 18.00 13o/o -
0.50 0.50 10.50 4.00 11.66 13.11 16.00
0.75 0.25 9.25 4.00 10.30 11.53 14.00 ~-
....... ----" 1
1

~:;'~§.~>~·~·~·~·<'° ~----
1.00 o 8.00 12.00 12.00 12.00 12.00

Minimum Variance Portfolio

--- !
............... •••• ,,, 1
"', W0(min) 0.630 0.74 0.82
f(r,) 9.875 9.32 8.90 <........................ ,:.· . . . . ······ -t• ¡
ªP 0.000 10.29 11.45 .............. P::::: r

...... '/ ...... ~

:
1
.... •••• 1

8% -----------~~~" 1
1
Finally, the broken p = - 1 lines show the effect of perfect negative correlation. The 1
1
portfolio opportunity set is linear, but now it offers a perfect hedging opportunity and 1
1
the rnaximum advantage from diversification. 1

1
To summarize, although the expected rate of return of any portfolio is simply the 1
1
weighted average of the asset expected retums, this is not true of the portfolio standard 1

1
deviation. Potential benefits from diversification arise when correlation is less than per- 1
fectly positive. The lower the correlation coefficient, the greater the potential benefit of '--r~~1~2~%~~,---~~,--~--,~~--+~~~~~~~~~__....a
20%
diversification. In the extreme case of perfect negative correlation, we have a perfect
hedging opportunity and can construct a zero-variance portfolio.
Suppose now that an investor wishes to select the optima! portfolio from the oppor-
tunity set. The best portfolio will depend on risk aversion. Portfolios to the northeast in
Figure 7 .5 provide higher rates of retum, but impose greater risk. The best trade-off
7 .3 ASSllT ALLOCATION WITll STOCKS, BONDS, AND 811,LS
among these choices is a matter of personal preference. Investors with greater risk aver-
sion will prefer portfolios to the southwest, with lower expected return, but lower risk.7 ~ the previ.ous chapter we examined the simplest asset allocation decision, that involv-
mg the chmce of how much of the portfolio to leave in risk-free money market securi-
CONCEPT CHllCK Question 2. Compute and draw the portfolio opportunity set far the debt and equity l!es v~rsus m a nsky portfolio. We simply assumed that the risky portfolio was
funds when the correlation coefficient between them is p = .25. con_ipnsed of a stock .and bond fund in given proportions. Of course, investors need to
decide on the proport10n of their portfolios to allocate to the stock versus the bond mar-
ket. This, too: IS an asset all_ocation decision. As the nearby box emphasizes, most invest-
7 Given a leve! of risk aversion. one can detennine the portfolio that pro vides the highest levcl of utility. Rccall from Chapter ment profess10nals recogmze that "the really critica! decision is how to divvy up your
6 that we were able to describe the utility provided by a portfolio as a function ofits expectcd return, E(rp), and its variance, money among stocks, bonds and supersafe investrnents such as Treasury bills."
O"~, according to the relatíonship U= E(rP) - ,005AO"~ The portfolio mean and variance are determined by the portfolio
weights in the two funds, wE and w0 • according to equations 7.1 and 7.2. Using those equations, one can show using ele- In the last secl!on, we den ved the properties of portfolios forrn. ed by mixin t · ky
ta· th"b g~ns
mentary calculus that the optima\ investment proportions in the two funds are: ass_e s. ~ven. IS ackground, we now reintroduce the choice of the third, risk-free port-
foho. Th1s w1ll allow us to complete the basic problem of asset allocation across the
E(rv) - E(rE) + .OIA (O"b- ªvªEPDE)
three key asset classes: stocks, bonds, and risk-free money market securities. Once you
.OIA(ub +O"~ - 2CT"DCT"EPDE)
understand th1s case, it w11l be easy to see how portfolios of many risky securities might I'
best be constructed.
[;
 CHAPTER 7 Optima! Risky Po~tfolio; 205
PARTii Portfolio Theory
204

E(')
I•'igure 7 .6
The opportunity set of
the debt and equity 14%
funds and two feasible
13
CALs.
12
11
10
9
8 D
7.667.38 .....
7

6
5

4
3
2

2 4 6 8 10 12 14 16 18 20%

The Optimal Risky Portfolio with Two Risky Assets and a

Risk-Free Asset
What if our risky assets are still confined to the bond and stock funds, but now we can
also invest in risk-free T-bills yielding 5%? We start with a graphical solution. Figure
7 .6 shows the opportunity set generated from the joint probability distribution of the
bond and stock funds, using the data from Table 7. l.
Two possible capital allocation lines (CALs) are drawn from the risk-free rate (r¡ =
5%) to two feasible portfolios. The first possible CAL is drawn through the minimum-
variance portfolio A, which is invested 82% in bonds and 18% in stocks (equation 7.7).
Portfolio A's expected retum is E(rA) = 8.90%, and its standard deviation is "A =
11.45%. With a T-bill rate of r¡ = 5%, the _reward-to-variability ratio, which is the
slope of the CAL combining T-bills and the minimum-variance portfolios, is
--· ---- -·---·------ ---- - - -
s = E(rA) - r¡- 1
s = 9.5 - 5 = 38
A CT \
Jl.7 .
·······-g:9-c.:"~34
B
'1

= 11.45 = · which· is· higher than

th · the reward-to-variability
. ratio of the CAL that we obta1ne· d us1ng
·
e m1n1mum-var1ance portfoho and T-bills.
Now consider the CAL that uses portfolio B instead of A. Portfolio B invests 70% in
th lf the CAL that uses Portfolio B has a better reward- to-variability ratio than the CAL
bonds and 30% in stocks. Its expected retum is 9 .5% (giving ita risk premium of 4.5% ), at mes Portfoho A, then for any leve! of risk (standard deviation) that an investor is
and its standard deviation is 11.70%. Thus, the reward-to- variability ratio on the CAL w1llmg to bear, the expected retum is higher with Portfolio B. Figure 7.6 reflects this in
that is generated using Portfolio B is
 1

PART Il PortfOlio Theol)' CHAPTER 7 Optimal Risky Porifolios ' 207

206

showing that the CAL for Portfolio B is above the CAL for Portfolio A. In this sense, Figure 7.7
Portfolio B dominates Portfolio A. The opportunity set of
In fact, the difference between the reward-to-variability ratios is the debt and equity 14%
funds with the optimal 13
SE - SA = .04 CAL and the optima}
risky portfolio 12
This means we get four extra basis points expected retum with CAL8 for each percent-
11 - - - - - - - - - - - - - - - - - - - -
age point increase in standard deviation. ?
/1 Look at Figure 7 .6 again. If we are willing to bear a standard deviation of crP = 7%, !O
1

.l we can achieve a 7 .38% expected retum with the CAL of Portfolio A: 9

8
E(rp)(CALA; "P = 7%) = r¡ + 7SA
7
=5+7X .34 = 7 .38% .,
1

6 1
With the CAL of Portfolio B, we get expected return of 7.66%:
r¡=5

E(rp)(CAL8 ; "P = 7%) = r¡ + 7S8 4

=5+7 X .38 = 7.66% 3

This is a difference of .04 X 7 = .28%, or 28 basis points. 2

But why stop at Portfolio B? We can continue to ratchet the CAL upward until it ulti-
rnately reaches the point of tangency with the investment opportunity set. This must
yield the CAL with the highest feasible reward-to-variability ratio. Therefore the tan- o~-2:;-~4~,6,.---8~-1'0~'12~'14~\:--1'6~1's~2'0-%~~~a
gency portfolio, P, drawn in Figure 7.7, is the optima! risky portfolio to mix with T- 14.2
bills. We can read the expected retum and standard deviation of Portfolio P from the
graph in Figure 7. 7.
E(rp) = 11% Max S = E(rP) - r¡
w p (J
Cfp = 14.2% ' p

In practice, we obtain the solution to this problem with a computer prograrn. W~ can Subject to ¡w 1 = 1. This is a standard problem in calculus.
describe the process briefly, however. !n the case of two risky assets, the solution far the weights of the optima! risky port-
The objective is to find the weights wD, wE that result in the highest slope of the CAL foho, P, can be shown to be as follows8:
(i.e., the weights that result in the risky portfolio with the highest reward-to-variability
[E(rD) - r¡Jcr1;- [E(rE) - r¡]Cov(rD,rE)
wD = Íl[E;;;(-=:-rn-;l~-:r¡-:];::cr31;-+;-;[E~~(r-E);--Lr:_¡~]crc.,b,-'._-[2-:E'!':(r'._D..,-)~-Lr¡=+-'E"-'(':r"..!cE)"..._-_r_¡_
ratio). Therefore, the objective is to maximize the slope of the CAL for any possible
]C-o-v-(r-D-,r-E-)
portfolio, p. Thus, our objective function is the slope that we have called SP:
WE = J - WD (7.8)
S = E(rP) - r¡
p (f
p
Substituting our data, the solution is
(8 - 5) 400 - (13 - 5) 72
For the portfolio with two risky assets, the expected return and standard deviation of WD =
Portfolio p are
(8 5) 400 + (13 - 5) 144 - (8 - 5 + 13 - 5) 72
E(rp) = wvECrvl + wEE(rE) = .40
= 8wD + 13wE WE = ) - .4
2 cr2 + wk 2 + 2w w Cov(r r )] 112 = .6
crp = [w D D "-E D E D' E
112 The expected retum of this optima! risky portfolio is ll %:
= [144wb + 400w1- + 2 X 72wnwE]
When we maximize the objective function, SP' we have to satisfy the constraint that
the portfolio weights sum to one (100%), that is, wD + wE = 1. Therefore, we salve a 8The solu.tion pr~cedure is as follows. Substitute for E(rp) from equation 7.1 and for CT' from equatio~
;.2 Substit:te 1 _ ~
mathematical problem formally written as for wE. D1fferentrate the resulting expression for SP with respect to wD. set the derivttive equal to zero, ~d solve for wD.D
 (

208 PART 11 Portfolio Theory CHAPTER 7 Optima! Risky Portfolios 209

E(rp) = .4 X 8 + .6 X 13 •1gurc 7.3 E(r)

Determination of
The standard deviation is 14.2%: the optima! overall 14o/o
portfolio 13
<Ip = (.42 X 144 + .62 X 400 +2 X .4 X .6 X 72)112 Ir'-
= 14.2% 12 /

ll
The CAL using this optima! portfolio has a slope of

. · ?:::D- ..
10
11 - 5 9
Sp= - - = .42 i
14.2
8
BpndS- ..
which is the reward-to-variability ratio of Portfolio P. Notice that this slope exceeds the 7 Optimal 1
slope of any of the other feasible portfalios that we have considered, as it must if it is complete 1
6 portfolio :
to be the slope of the best feasible CAL. 1
In Chapter 6 we faund the optima! complete portfalio given an optima! risky Port- r¡=5 1

falio and the CAL generated by a combination of this portfolio and T-bills. Now that 4
we have constructed the optimal risky portfolio, P, we can use the individual investor's 3
degree of risk aversion, A, to calculate the optimal proportion of the complete portfalio 2
to invest in the risky component.
An investor with a coefficient of risk aversion, A = 4, would take a position in
Portfalio P of o 2 4 6 8 10 12 14.2 16 18 20%
10.56
E(rp) - r
1 (7.9)
y=
.01 X Auj\
11 - 5 Figure 7.9
7439
.01 X 4 X 14.22 = · The proportions of
the optimal overall
Thus, the investor will invest 74.39% of his or her wealth in Portfalio P and 25.61 % portfolio
in T-bills. Portfalio P consists of 40% in bonds, so the percentage of wealth in bonds
will be ywD = .4 X .7439 = .2976, or 29.76%. Similarly, the investment in stocks will
Stocks
be ywE = .6 X .7439 = .4463, or 44.63%. The graphical solution of this asset alloca- 44.63%
tion problem is presented in Figures 7.8 and 7.9.
Once we have reached this point, generalizing to the case of many risky assets is
straightfarward. Befare we move on, let us briefly summarize the steps we fallowed to
arrive at the complete portfolio.
l. Specify the return characteristics of ali securities (expected returns, variances,
covariances).
2. Establish the risky portfalio:
a. Calculate the optima] risky portfolio, P (equation 7.8).
b. Calculate the properties of Portfalio P using the weights deterrnined in step Befare moving on, recall that the two assets in the asset allocation problem are
(a) and equations 7 .1 and 7 .2. already diversified portfalios. The diversification within each of these portfolios rnust
3. Allocate funds between the risky portfalio and the risk-free asset: be credited far a good deal of the risk reduction compared to undiversified single secu-
a. Calculate the fraction of the complete portfolio allocated to portfolio P (the rities. For example, the standard deviation of the rate of return on an average stock is
risky portfolio) and to T-bills (the risk-free asset) (equation 7.9). about 50% (see Figure 7.2). In contras!, the standard deviation ofourhypothetical stock-
b. Calculate the share of the complete portfolio invested in each asset and in index fund is only 20%, about equal to the historical standard deviation of the S&P 500
T-bills. portfolio. This is evidence of the importance of diversification within the asset class.
210 PART II Portfolio Theory
CHAPTER 7 Optima! Risky Porifolios
211
Asset allocation between bonds and stocks contributed incrementally to the improve- Figure 7.IO
ment in the reward-to-variability ratio of the complete portfolio. The CAL with stocks, The minimu1n-
bonds, and bills (Figure 7.7) shows that the standard deviation of the complete portfo- variance frontier
lio can be further reduced to 18% while maintaining the same expected return of 13% of risky assets
Efficient frontier
as the stock portfolio.

CONCEPT CHECK Question 3. The universe of available securities includes two risky stock funds, A and . ·~~
B, and T-bills. The data far the universe are as fallows:
Globa/ : • • ºe ~ Indmdual
as sets
Expected Return Standard Deviation •
---.----.-- •
vananee
portfolio Minimum-variance frontier
A 1Oo/o 20o/o
B 30 60
T-bills 5 o
The correlation coefficient between funds A and B is - .2.
a. Draw the opportunity set of Funds A and B.
b. Find the optima! risky portfolio, P, and its expected return and standard deviation.
c. Find the slope of the CAL supported by T-bills and Portfalio P.
d. How much will an investor with A 5 5 invest in Funds A and B, and in T-bills?

folios co~stitut~d º'. only a single asset are inefficient. Diversifying investments leads
to portfohos w1th _h1gher expected returns and lower standard deviations.
7.4 THE MARKOWITZ PORTFOl.IO SELECTION MODEL
Ali the portfohos that lie on the minimum-variance frontier from the ¡ b ¡ · ·
. . g o a m1n1-
Security Selectio11 mum-va?ance portfoho ~nd upward, provide the best risk-return combinations and thus
are cand1dates_ far the optima! portfolio. The part of the frontier that lies abo ve the global
Now we can generalize the portfalio construction problem to the case of many risky mm1mum-vanance portfaho'. therefore, 1s called the efficient frontier. Por any portfolio
securities and arisk-free asset. As in the two risky assets exarnp1e, the problem has three on the lower ?º~tlon of the m1n1mum-variance frontier, there is a portfolio with the same
parts. First, we identify the risk-return combinations available from the set of risky standard devrnt10n and .ª greater expected return positioned directly above it. Hence, the
assets. Next, we identify the optima! portfalio of risky assets by finding the portfalio bottom part of the rmn1mum-var1ance frontier is inefficient.
weights that result in the steepest CAL. Finally, we choose an appropriate complete port- The second part of the optimization plan involves the risk-free asset. As befare we
falio by mixing the risk-free asset with the optima! risky portfolio. Befare describing search for the capital allocation line with the highest reward-to-variability ratio (th~t ·
the process in detail, let us first present an overview. the steepest slope) as shown in Figure 7.11. is,
The first step is to determine the risk-return opportunities available to the investor. The CAL that is_ supported by the optima! portfalio, P, is, as before, the one that is
These are summarized by the minimum-variance frontier of risky assets. This fron- tangen! to the effic1ent frontier. This CAL dominates ali alternative feasible lines (the
tier is a graph of the lowest possible portfalio variance that can be attained far a given broken lmes_that are drawn through the frontier). Portfolio P, therefare is the optima!
portfalio expected return. Given the set of data far expected returns, variances, and nsky portfoho. '
covariances, we can calculate the minirnum-variance portfolio (or equivalently, mini- Finally, in the last part of the problem the individual investor chooses the appropri-
mum standard deviation portfalio) far any targeted expected return. Performing such a ate m1x between the optunal nsky portfolio p and T-gills, exactly as in Figure 7 .8.
calculat:ion far many such expected return targets results in a pairing between expected Now_ let us cons1der each part of the portfalio construction problem in more detail.
returns and minimum-risk portfolios that offer !hose expected returns. The plot of these In the flrst part of the problem, nsk-return analysis, the portfolio manager needs as
expected return-standard deviation pairs is presented in Figure 7 .10. 1nputs, a set ~f estimate~ for the expected returns of each security ánd a set of estim~tes
Notice that al! the individual assets lie to the right inside the frontier, at leas! when for the covanance matnx. (In Part V on security analysis we will examine the security
we allow short sales in the construction of risky portfalios.9 This tells us that risky port-

9 When short sales are prohibited, single securities may lie on the frontier, For example, the security with the highest expected
retum must Jie on the frontier, as the security represents the only way that one can obtain a retum that high, and so it must
212 PART II Portfolio Tlwory
CHAPTER 7 Optimal Risky Portfolios
213
Figure 7.11 CAL(P) Figure 7.12 E(r)
The efficient frontier The efficient
of risky assets with portfolio set
the optimal CAL
_,, ,,. J;ffiét(nt frontier

J..----
'
Efficient frontier
of risky assets

'
-1---------__L_
i } ---

!'
r¡

variance portfolio
E (r,) ¡--~--=__, Q-~-t--------i----
'

~----------------------------u
' i

valuation techniques and methods of financia! analysis that analysts use. Far now, we
will assume that analysts already have spent the time and resources to prepare the On~e th~se esti~ates. are compiled, the expected retum and variance of an risk
inputs.) r:r:~:~~l~tth We1ghts lil each Security, W;, can be calcuJated from the faiiowin~
Suppose that the horizon of the portfolio plan is one year. Therefare, ali estimates
pertain to a one-year holding period return. Our security analysts cover n securities. As
of now, time zero, we observed these security prices: pe¡, ...
P?,. The analysts derive E(r1) =
i= l
¡" wE(r)
/ ¡
(7.10)
estimates far each security's expected rate of return by farecasting end-of-year (time !)
n
prices: E(P\), ... , E(P~), and the expected dividends far the period: E(D 1), ... , E(Dn).
¡¡ 11

The set of expected rates of return is then computed from crfa = {~J wfa} + {~I J~I W¡ w1Cov(r¡,r1) 7
( .lt)
i """- j '
E(P 1.) + E(D.) - pO
E(r.) = ' ' ' ~~ mentioned_earlier that the idea of diversification is age-old. The phrase "don't
i P¡0 pul a your eggs m one basket" existed long befare modern finance theory It
The covariances among the rates of return on the analyzed securities (the covariance until 1952, however, that Harry Markowitz published a formal model of portfoli::~l~~:
matrix) usually are estimated from historical data. Another method is to use a scenario llon e;nbodymg d1vers1flca1Jon principles, thereby paving the way far his 1990 Nobel
pnze ior econom1cs. H1s model is precisely step one o·fport' ¡·
analysis of possible returns from al! securities instead of, or as a supplement to, histor- T · 'º to management· the .d
ical analysis. ~/c.atkyion of the efficient set of portfolios, or, as it is often called the e"ície~tfro~te1·enr-
0J ris assets. ' JJL
The portfalio manager is now armed with the n estimates of E(r;) and the n X n esti-
mates in the covariance matrix in which the n diagonal elements are estimates of the The principal idea behind the frontier set of risky portfolios is that, for any risk 1 1
variances, uf, and the n 2 - n = n(n - !) off-diagonal elements are the estimates ofthe :e :e mterest~d only m that portfolio with the highest expected return. Alternati~~~y,
covariances between each pair of asset returns. (You can verify this from Table 7 .2 far re;urn~ntler is t e set of portfohos that minimize the variance for any target expected
the casen = 2.) We know that each covariance appears twice in this table, so actually
we have n(n - 1)/2 different covariances estimates. If our portfolio management unit Indeed, the two methods of computing the efficient set of risky portfolios are e uiv-
covers 50 securities, our security analysts need to deliver 50 estimates of expected ahlent. To see _th_1s, constder the graphical representation of these procedures. Figure~ 12
s ows the m1n1mum-var1ance frontier. ·
returns, 50 estimates of variances, and 50 X 49/2 = 1,225 different estimates of covari-
ances. This is a daunting task! (We show later how the number of required estimates JOE .
quatton 7.11 follows frorn our discussion in Section 7 2 on usin the bo : -
can be reduced substantially.) the formula for the variance of a portfolio. · g rdered covanance matrix to obtain each term in
214 PART Il Portfolio Theory
CHAPTER 7 Optima! Risky Por(folios
215
The points marked by rectangles are the result of a variance-minimization prograrn. Figure 7 .13 E(;)
We first draw the constraint, that is, a horizontal line al the leve! of required expected Capital aliocation lines
return. We then look for the portfolio with the lowest standard deviation that plots on with various portfolios
this horizontal line-we Jook for the portfolio that will plot farthest to the left (srnallest from the efficient set
standard deviation) on that line. When we repeat this for various levels of required
expected returns, the shape of the minimum-variance frontier emerges. We then discard
the bottom (dotted) half of the frontier, because it is inefficient.
In the altemative approach, we draw a vertical line that represents the standard devi-
ation constraint. We then consider all portfolios that plot on this line (have the same
standard deviation) and choose the one with the highest expected return, that is, that
portfolio falling highest on this vertical line. Repeating this procedure for various ver-
tical lines (levels of standard deviation) gives us the points rnarked by circles that trace
the upper portian of the minimum-variance frontier, the efficient frontier.
When this step is completed, we have a Jist of efficient portfolios, because the solu-
tion to the optimization program includes the portfolio proportions, w¡, and the expected
F
retum, E(rp), and standard deviation, "p·
Let us restate what our portfolio manager has done so far. The estimates generated
by the analysts were transformed into a set of expected rates of return anda covariance
matrix. This group of estimates we shall call the input list. This input list is then fed
into the optimization prograrn.
Befare we proceed to the second step of choosing the optima! risky portfolio from
Capital Allocation ami the Separation Property
the frontier set, let us considera practica! point. Sorne clients rnay be subject to addi- We are now ready to proceed to step two. This step introduces the risk-free asset. Figure
tional constraints. Por example, many institutions are prohibited from taking short posi- 7.13 shows the efficient frontier plus three CALs representing various portfolios from
tions in any asset. Far these clients the portfolio manager will add to the prograrn the effic1ent set. As befare, we ratchet up the CAL by selecting different portfolios until
constraints that rule out negative (short) positions in the search for efficient portfolios. ~e reach P~rtfoho P: W:h1ch 1s the tangency point of a line from F to the efficient fron-
In this special case it is possible that single assets may be, in and of themselves, effi- tler. Portf~ho P max1nuzes the reward-to-variability ratio, the slope of the line from F
cient risky portfolios. For example, the asset with the highest expected return will be a to port_foho~ on the. effici~nt frontier. At this point our portfolio manager is done.
frontier portfolio because, without the opportunity of short sales, the only way to obtain Portfoho Pis the optima! nsky_ portfo!io for the manager's c!ients. This is a good time
that rate of retum is to hold the asset as one's entire risky portfolio. ( to ponder our results and the1r 1mplementation.
Short-sale restrictions are by no means the only such constraints. Far examplé, sorne ll The_ most striking_ conclusion is that a pmtfolio manager will offer the same risky
clients may want to assure a minimal leve! of expected dividend yield frorn the optimal portfoho, _P, to all chents regardless of their degree of 1isk aversion.11 The degree of
portfolio. In this case the input list will be expanded to include a set of expected divi- r1sk avers1on of the chent comes 1nto play only in the selection of the desired point
dend yields d 1, ... , dn and the optirnization prograrn will include an additional con- th~ e~. ~hus the only_differe~ce between clients' choices is that the more risk-aver~:
straint that ensures that the expected dividend yield of the portfolio will equal or exceed chent ~1ll 1nvest. more in the .r1sk-free asset and less in the optimal risky portfolio, P,
the desired leve!, d. than w11! a less nsk-averse chent. However, both will use Portfolio p as their optima!
Portfolio managers can tailor the efficient set to conform to any desire of the client. nsky 1nvestment vehicle.
Of course, any constraint carries a price tag in the sense that an efficient frontier con- This result is call"d," sepa~on prope_rty; it tells us that.the..J).m:tfolio_choic.e_prob-
structed subject to extra constraints will offer a reward-to-variability ratio inferior to that len:i_lll.'IY ,lie§"ll¡rrateQ_J!110_t'O'_Q. !!1Q"ll".11'1_em_ta~k;&Ihe_first task. __determination .of .the
of a less constrained one. The client should be rnade aware of this cost and should care- °cP_t1_m_al_nsk:y portfolio, P, ispurely tec_h¡¡ic_aL_QJVJe!1-.1he manager's input Iist, the best
fully consider constraints that are not mandated by law. nsky portfoho rn the sarne for all clients, regardless of risk aversion. The second task
Another type of constraint is aimed at ruling out investments in industries or coun- however, allocat1QIJ.-ºLthe__complete _portfolio_ to__ J:bil!L"'rs~_he -~i~l<:i~portfolio:
tries considered ethically or politically undesirable. This is referred to as sociolly respon- .~.~p~nds on personal preference. Here the client is the decision makei:
sible investing, which entails a cost in the form of a lower risk premium on the resultant
11
constrained, optima! portfolio. This cost can be justifiably seen as contribution to the Clients who impose special restrictions (constraints) on the manager such as div,·d·nd y•'eld ·¡¡ bt · h ·
rtf0 r A · · ' ... • w1 o am anot eroplimal
underlying cause, albeit nota tax-deductible one. po 10. ny constramt t~at IS added to an optimization problem leads, in general; to a different and less desirable optim
compared to an unconstramed program. um
 CHAPTER 7 Optima! Risky Portfolios 217
PART JI Portfolio Theory
216
the growing spectrum of financia! markets and financia! instruments has put sophisti-
f r p that the manager offers is the same
The crucial point is that the optima] port o 10 ff . t and hence less cated investment beyond the capacity of most amateur investors. Finally, there are strong
for al1 clients. This result makes professional manag~men; ~~;~t: ~~~~nrelative1y small economic returns to scale in inv~stment management. The end result is that the size of
costly. One management firm can serve any num er o e a competitive investment company has grown with the industry, and efficiency in orga-
incremental administrativ~ costs. ·n estimate different input lists, thus deriv- nization has become an important.issue. ·
In practice, however, different managers _w1 " . " ortfolios to their clients. A large investment company is likely tó invest both in domestic and international
ing different efficient frontiers, .and offer d1fferen~ ~ptJ.:;'al p rth mentioning here that markets and in a broad set of asset élasses, each of which requires specialized exper-
The source of the disparity hes in the secunty ana ys~s. is wo . . the ual- tise. Hence, the management of each asset-class portfolio needs to be decentralized, and
the rule of GIGO (garbage in-garbage out) also apphes to secunty a~:~yi~~~~ fundq will it becomes impossible to simultaneously optimize the entire organization's risky port-
ity of the security analysis is poor,/ pass~;of¡~r:~~~1~:~~~0~-~:.~ty security analysis folio in one stage, although this would be prescribed as optima! on theoretical grounds.
result in a better CAL than an ac ivde po . 1 favorable (i.e., seemingly mispriced) The practice is therefore to optimize the security selection of each asset-class port-
to tilt the portfoho we1ghts towar seemmg y folio independently. At the sarne time, top management continually updates tlle asset
allocation ofthe organization, adjusting the investment budget of each asset-class port-
secAurit::·have seen optima] risky portfolios for different clients also. may vary becathuse
8 ' . ld · ts tax cons1derations, oro er folio. When changed frequently in response to intensive forecasting activity, these real-
ofportfolio constraints such as divi~end-y1e. requ1remen ' 1 a ver limited number locations are called market timing. The shortcoming of this two-step approach to
client preferences. Nevertheless, t111s an~ys~' su;;;:~/~ª:~;, ~ange ¿f investors. This portfolio construction, versus the theory-based one-step optimization, is the failnre to
of portfolios may be suff1c1ent to serve t e. em exploit the covariance of the individual securities in one asset-class portfolio with the
is the theoretical basis of the mutual fund mdustry. h . . t rt of the portfolio con- individual securities in the other asset classes. Only the covariance matrix of the secu-
The (computerized) optimization technique IS t e eas1es p~ . . his- rities within each asset-class portfolio can be used. However, this loss might be small
struction problem. The real arena of competition among portfoho managers IS in sop because of the depth of diversification of each portfolio and the extra layer of diversi-
ticated security analysis. fication al the asset allocation leve!.

CoNCEl'T CHECK
~1. :l~~~=!a~E:~;;~~;.~;:~~~º:~r~~~;i~~}~~u~~E~E~:~El~!!~~
or e . h t f manager B By dom1natlon we
7.5 01'TIMAL PORTFOLIOS Wl'l'H RESTRIC'flONS ON Tllll RISK·FREE ASSET
The availability of a risk-free asset greatly simplifies the portfolio decision. When all
tier obtained by portfolio manager A. dolnnnates~ a ~ of B's He~ce given a choice, investors can borrow and lend at that risk-free rate, we are led to a unique optima} risky
mean that A's optima! risky portfoho ies nor wes . , portfolio that is appropriate for all investors given a common input list. This portfolio
investors will always prefer the risky portfoho that hes on the CAL of A. maximizes the reward-to-variability ratio. AH investors use the same risky portfollo and
What should be made of this outcome? . , ? differ only in the proportion they invest in it and in the risk-free asset.
~: Should it be attributed to better secunty analys1s bf A s analysts. What if a risk-free asset is not available? Although T-bills are risk-free assets in nom-

c. Could it be th;t.A_'s co~!~~e[a~~o~:~~~sa~~:~~~limpse at the efficient frontiers of

inal terms, their real returns are uncertain. Without a risk-free asset, there is no tangency
portfolio that is best for all investors. In this case investors have to choose a portfolio
d. lf you were ag:~:)ng:o~ld you tell tllem to periodically switch their money around from the efficient frontier ofrisky"assets redrawn in Fignre 7.14.
var1 ous mana ' . ?
to the manager with the most northwesterly portfo110. Each investor will now choose the optima! risky portfolio by superimposing a par-
ticular set of indifference curves on the efficient frontier, as Figure 7 .14 shows. The opti-
ma] portfolio, P, for the investor whose risk aversion is represented by the set of
indifference curves in Figure 7.14 is tangent to the highest attainable indifference curve.
Investors who are more risk averse than the one represented in Figure 7 .14 would
have steeper indifference cnrves, meaning that the tangency portfolio will be of smaller
standard deviation and expected return than Portfolio P, such as Pqrtfolio Q. Conversely,
investors who are more risk toleran! than the one represented in Figure 7.14 would be
characterized by flatter indifference curves, resulting in a tangency portfolio of higher
expected return and standard deviation than Portfolio P, such as Portfolio S. The com-
mon featnre of all these rational investors is that they choose portfolios on the efficient
frontier; that is, they choose mean-variance efficient portfolios.
 1
218 PART 11 Portfolio Theory CHAPTER 7 Optima! Risky fortfoli~s
219
I•'igure 7 .14 Figure 7.15
Portfolio selection Portfolio selection • CAL
without a risk-free with risk-free lending /
as set only

More risk-averse investor

Even ifvirtually risk-free lending opportunities are available, many investors do face
borrowing restrictions. They may be unable to borrow altogether, or, more realistically,
they may face a borrowing rate that is significantly greater than the lending rate. Let us
first consider investors who can lend without risk, but are prohibited from borrowing.
When a risk-free investrnent is available, but an investor can take only positive posi-
tions in it (he or she can lend at rf but cannot borrow), a CAL exists but is limited to Figure 7.16 EV)
·CAL 1
the line FP as in Figure 7.15. The investment oppor-
Any investors whose preferences are represented by indifference curves with tan- tunity set with differ-
gency portfolios on the portian FP of the CAL, such as Portfolio A, are unaffected by ential rates for , , , · - - - - - - CAL,

the borrowing restriction. Por such investors the borrowing restriction is a nonbinding
borrowing and lending ,, _ ----~--- Efffificc;1eenntt F
Frontier
,,_-
/
constraint, because they are net lenders, lending sorne of their money at rate r1 .
Aggressive or more risk-tolerant investors, who would choose Portfolio B in the - ----
"' /. /.

absence of the borrowing restriction, are affected, however. For them, the borrowipg rf -
restriction is a binding constraint. Such investors will be driven to portfolios on the effi-
cient frontier, such as Portfolio Q. which have higher expected retum and standard devi-
ation than does Portfolio P (but less than the unavailable Portfolio B). Portfolios such
as Q, which are on the efficient frontier of risky assets, represent a zero investment in
the risk-free asset.
Finally, we consider a more realistic case, that of feasible borrowing, but at a higher t¡ F

rate than rf An individual who borrows to invest in a risky portfolio will have to pay
an interest rate higher than the T-bill rate. The lender will require a premium commen-
surate with the probability of default. For example, the call money rate charged by bro-
kers on margin accounts is higher than the T-bill rate.
Investors who face a borrowing rate greater than the lending rate confront a three-
part CAL such as in Figure 7.16. CAL 1, which is relevan! in the range FP 1• represents . CAL2, which is relevan! in a range to the right of Portfolio p 2 , represents the effi-
the efficient portfolio set far defensive (risk-averse) investors. These investors invest c1ent p~rtfoho set for more aggressive, or risk-tolerant, investors. This Iine starts at the
part of their funds in T-bills at rate rf" They find that the tangency Portfolio is P 1, and borrowmgrnte, r1j.but it is unavailable in the range r'P2 , because lending (investing
they choose a complete portfolio such as PortfolioA in Figure 7.17. m T-b1lls) 1s available only at the nsk-free rate r , which is Jess than r1j.
1
 CHAPTER 7
'
Optima[ Risky Po'rtjOlios' 221
220 PART II Portfolio Theory

figure 7.19
Figure 7.17 E(d
,,,CAL 1 The optimal portfolio E(r)
The optimal portfolio / CAL, of moderatel y risk-
/
of defensive investors / tolerant investors with
/
with differential bor- / differential borroviing
/
rowing and lending / and lending rates
rates --7"__ _ /

r¡lJ - - --
--- --, /
/

r¡

Figure 7.18
Investors in the middle range, neither defensive enough to invest in T-bills nor
The optimal portfolio
EV) aggressive enough to borrow, choose a risky portfolio from the efficient frontier in the
of aggressive investors
with differential range P 1P 2. This case is described in Figure 7.19. The indifference curve representing
borrowing and the investor in Figure 7.19 leads to a tangency portfolio on the efficient frontier,
lending rates Portfolio C.

CONCEPT CHECK Question 5. With differential lending and borrowing rates, only investors with about
average degrees ofrisk aversion will choose a portfolio in the rangeP 1P 2 in Figure 7.17.
Other investors will choose a portfolio on CAL 1 ifthey are more risk averse, or on CALi
if they are more risk tolerant.
/
/
/
a. Does this mean that investors with average risk aversion are more dependent on the
' /
/
quality of the forecasts that generate the efficient frontier?
r¡
b. Describe the trade-off between expected retum and standard deviation far portfolios
between P 1 and P 2 in Figure 7.17 compared with portfolios on CAL2 beyond P 2.
r¡

SUMMARY l. The expected retum of a portfolio is the weighted average of the componen! asset
expected returns with the investment proportions ás weights.
Investors who are willing to borrow at the higher rate, r1j. to invest in an optima! 2. The variance of a portfolio is the weighted sum of the elements of the covariance
risky portfolio will choose Portfolio P2 as their risky investment vehicle. Such a case IS matrix with the product ofthe investment proportions as weights. Thus, the variance of
described in Figure 7.18, which superimposes a relatively risk-tolerant investor's indif- each asset is weighted by the square of its investment proportion. Each covariance of
ference curve on CAL of Figure 7 .16. The investor with the indifference curve in Figure any pair of assets appears twice in the covariance matrix and, thus, the portfolio vari-
2 ance includes twice each covariance weighted by the product of the investment pro-
7 .18 chooses Portfolio P as the optima! risky portfolio and borrows to invest in it, arriv-
2 portions in each of the two assets.
ing al the overa!! Portfolio B.
 (
222 PART Il Portfolio Theory CHAPTER 7 Optimal Risky PorifoliOs
223
3. Even if the covariances are positive, the portfolio standard deviation is leSs than The seminal wo'rks q,n porif~lio selection are:
the weighted average of the component standard deviations, as long as the assets are not Markow~tz, Harry M. "Portfolio Selection." Journa1 of Finance, March 1952. .
perfectly positively correlated. Thus portfolio diversification is of value as long as assets Markow1tz, H~y M.,Portfolid Selection: Efficient Diversification of Investments. New
are less than perfectly correlated. York: John WJ!ey & Sons, 1959.
4. The greater an asset's covariance with the other assets in the portfolio, the more Also see:
it contributes to portfolio variance. An asset that is perfectly negatively correlated with Samuelson, Paul A. "Risk & Uncertainty: A ~all~cy of Large Numbers.'' Scientia 98 (1963).
a portfolio can serve as a perfect hedge. The perfect hedge asset can reduce the port-
folio variance to zero. Problems
5. The efficient frontier is the graphical representation of a set of portfolios that
maximize expected return for each level of portfolio risk. Rational investors will choose The following data apply to Questions 1 through 8:
a portfolio on the efficient frontier. A pension fund manager is considering three mutual funds. The first is a stock fund
6. A portfolio manager identifies the efficient frontier by first establishing estimates the second is a long-terrn govemment and corporate bond fund, and the third is a T-bill
for the asset expected returns and the covariance matrix. This input list is then fed into money market fund that yields arate of 9%. The probability distribution of the risky
an optimization prograrn that reports as outputs the investment proportions, expected funds is as follows:
retums, and standard deviations of the portfolios on the efficient frontier.
Expected Return Standard Deviation
7. In general, portfolio managers will arrive at different efficient portfolios because
of difference in methods and quality of security analysis. Managers compete on the qual- Stock fund (S) 22°!o 32o/o
ity of their security analysis relative to their management fees. Bond fund (B) 13 23
8. !f a risk-free asset is available and input lisis are identical, all investors will
choose the same portfolio on the efficient frontier of risky assets: the portfolio tangen! The correlation between the fund retums is .15.
to the CAL. Ali investors with identical input lists will hold an identical risky portfolio,
l. What are the investment proportions of the minimum-variance portfolio of the
differing only in how much each allocates to this optima! portfolio and to the risk-free
two risky funds, and what is the expected value and standard deviation of its rate
asset This result is characterized as the separation principle of portfolio construction. of return?
9. When a risk-free asset is not available, each investor chooses a risky portfolio on
2. Tabulate and draw the investment opportunity set of the two risky funds. Use
the efficient frontier. If a risk-free asset is available but borrowing is restricted, only
1nvestment proportions for the stock funds of zero to 100% in incrernents of
aggressive investors will be affected. They will choose portfolios on the efficient fron- 20%.
tier according to their degree of risk tolerance.
3. Draw a tangen! from the risk-free rate to the opportunity set. What does your
graph show for the expected retum and standard deviation of the optima!
Key Terms portfolio?
Diversification Minimum-variance portfolio 4. Sol ve numerically for the proportions of each asset. and for the expected retum
Insurance principle Portfolio opportunity set and standard deviat10n of the opllmal risky portfolio.
Market risk Reward-to-variability ratio S. What is the reward-to-variability ratio of the best feasible CAL?
Systematic risk Optima! risky portfolio 6. You _require that your portfolio yield an expected retum of 15%, and that it be
Nondiversifiable risk Minimurn-variance frontier efflc1ent on the best feasible CAL.
Unique risk Efficient frontier a. What is the standard deviation of your portfolio?
Firm-specific risk Input list b. What is the proportion invested in the T-bill fund and each of the two risky
Nonsystematic risk funds?
Separation property
Diversifiable risk 7. lfyou were to use only the_two risky funds. and still require an expected retum
of 15%, what must be the mvestment proportions of your portfolio? Compare
its standard dev1at10n to that of the optimized portfolio in Question 6. What do
Selected Readings you conclude? -
Two frequently cited papers on the impact ofdiversification on portfolio risk are: 8, Suppose that you face the same opportunity set, but you cannot borrow. You wish
Evans, John L.; and Stephen H. Archer. "Diversification and the Reduction of Dispersion: to construct a portfolio with an expected retum of 29%. What are the appropri-
An Empirical Analysis." Journal of Finance, December 1968. ate portfoho proport10ns and the resulting standard deviations? What reduction
Wagner, W. H.; and S. C. Lau. '"The Effect of Diversification on Risk." Financia! Analysts
in standard deviation could you attain if you were a1lowed to borrow at the risk-
Journal, November-December 1971. free rate?
224 PART 11 Portfolio Theory CHAPTER 7 Optimal Risky PortfoÚos 225

9. Stocks offer an expected rate ofreturn of 18%, with a standard deviation of22%. Hennessy is a/'bottom-up" manager. The firm largely avoids any atternpt to "time
Gold offers an expected retum of 10% with a standard deviation of 30%. the rnarket." It also facuses on selection of indi.vidual stocks, rather than the weighting
a. In light of the apparent inferiority of gold with respect to both mean retum of favored industries.
and volatility, would anyone hold gold? If so, demonstrate graphically why There is no apparent conforrnity of style among the six equity managers. The five
one would do so. managers. other than Hennessy, inanage portfolios aggregating $250 million made up
b. Given the data above, reanswer Question (a) with the additional assumption of more than 150 individual issues.
that the correlation coefficient between gold and stocks equals 1. Draw a Janes is convinced that Hennessy is able to apply superior skill to stock selection.
graph illustrating why one would or would not hold gold in one's portfolio. but the favorable retums are. limited by the high degree of diversification in the port-
Could this set of assumptions for expected retums, standard deviations, and folio. üver the years, the portfolio generally held 40--50 stocks, with about 2% to 3%
correlation represent an equilibrium for the security market? of total funds cornmitted to each issue. The reason Hennessy seerned to do well rnost
10. Suppose that there are many stock in the market and that the characteristics of years was because the firrn was able to identify each year 10 or 12 issues which regis-
Stocks A and B are given as follows: tered particularly large gains.
Based on this overview, Janes outlined the following plan to the Wilstead pension
Stock Expected Return Standard Deviation
committee:
-~\

A 10% 5°/o Let's tell Hennessy to Iimit the portfolio to no more than 20 stocks. Hennessy will double the
8 15 10 commitments to the stocks that it really favors, and eliminate the remainder. Ex.cept for this one
Correlation = -1 new restriction, Hennessy should be free to manage the portfolio exactly as before.
Suppose that it is possible to borrow at the risk-free rate, rf" What must be the
Ali the rnembers of the pension committee generally supported Jones's propasa!
value of the risk-free rate? (Hint: Think about constructing·a risk-free portfolio
because all agreed that Hennessy had seemed to demonstrate superior skill in selecting
frorn Stocks A and B.)
stocks. Yet, the propasa! was a considerable departure from previous practice, and sev-
11. Assume that expected returns and standard deviations for all securities (includ-
era! committee members raised questions. Respond to each of the fallowing questions.
ing the risk-free rate far borrowing and lending) are known. In this case all

12.

13.
investors will have the same optima] risky portfa!io. (True or false?)
The standard deviation of the portfolio is always egua! to the weighted average
of the standard deviations of the assets in the portfalio. (True or false?)
Suppose you have a project that has a .7 chance of doubling your investment in • 15. a. Will the limitations of 20 stocks likely increase or decrease the risk of the
portfolio? Explain. *
b. Is there any way Hennessy could reduce the number of issues from 40 to 20

•
without significantly affecting risk? Explain.
a year and a .3 chance of halving your investment in a year. What is the stan- 16. One committee member was particularly enthusiastic concerning Jones's pro-
dard deviation of the rate of return on this investment? posal. He suggested that Hennessyºs performance might benefit further from
14. Suppose that you have $1 million and the fallowing two opportunities from reduction in the number of issues to 10. If the reduction to 20 could be expected
which to construct a portfolio: to be advantageous, explain why reduction to 10 might be less likely to be advan-
a. Risk-free asset earning 12ºk per year. tageous. (Assume that Wilstead will evaluate the Hennessy portfolio indepen-
h. Risky asset earning 30% per year with a standard deviation of 40%.

•
dently of the other portfalios in the fund.)*
If you construct a portfolio with a standard deviation of 30 percent, what will be 17. Another committee member suggested that. rather than evaluare each managed
the rate of return? portfolio independently of other portfolios, it might be better to consider the

• The fallowing data apply to questions 15 through 17.*

Hennessy & Associates manages a $30 million equity portfalio far the multimanager
Wilstead Pension Fund. Jasan Janes, financia] vice president of Wilstead, noted that
Hennessy had rather consistently achieved the best record among the Wilstead's six
equity managers. Performance of the Hennessy portfolio had been clearly superior to
that of the S&P 500 in four of the past five years. In the one less favorable year, the
effects of a change in the Hennessy portfolio on the total fund. Explain how this
broader point of view could affect the committee decision to lirnit the holdings
in the Hennessy portfolio to either 10 or 20 issues. *

The following data are for problems 18 through 20.

The correlation coefficients between pairs of stocks is as follows: Corr(A.B) = .85;
Corr(A,C) = .60; Corr(A,D) = .45. Each stock has an expectecl retum of 8% anda stan-
shortfall was trivial. dard deviation of 20%.

*Reprinted, with pcrmission, from the Leve! Ill 1982 CFA Study Cuide. Copyright 1982, The Institute of Chartcrcd Financia! *Reprinted, with permission, from the Leve! Ill 1982 CFA Study Guide. Copyright 1982, The Institute of Chartered Financial
Analyst, Charlottesville, VA. AH rights reserved. Analyst, Charlottesvi\le, VA. Ali rights reserved.
226 PART II Portfolio Theory CHA.PTER 7 Optima! Risky PortJoÚos
227
18. If your entire portfolio is now composed of Stock A and you can add sorne of
1 n 1 n (7A.2)
only one stock to your portfolio. would you choose (explain your choice): cr2 = -
P
2, -
n¡=¡n
cr'1 + 2,
j=l
a. B. j 7 i
b. C.
Note that thei;e aren variance terms and n(n - 1) covariance terms in equation 7A.2.
c. D.
If we define the average variánce and average covariance of the securities as
d. Need more data.
19. Would the answer to Question 18 change for more risk-averse or risk-tolerant l n
0:2 =-Icr?1
investors? Explain. ni= I
20. Suppose that in addition to investing in one more stock you can invest in T-bills __ l n n
as well. Would you change your answers to Questions 18 and 19 if the T-b1JJ rate Cov = n-(-n-'_'--1-) 1 ~1 j~l Cov(r1,r)

•
is 8%? j7i

21. Which one of the following portfolios cannot lie on the efficient frontier as we can express portfolio variance as
described by Markowitz?* l_ n-1- (7A.3)
cr2 = - cr2 + - - Cov
Standard Deviation(º/o) P n n
Porlfolio Expected Return (%)
Now examine the effect of diversification. When the average covariance arnong secu-
a. w 15 36 rity retums is zero, as it is when all risk is firm-specific, portfolio variance can be dri-
b. X 12 15 ven to zero. We see this frorn equation 7A.3: The second term on the right-hand side
c. z 5 7
will be zero in this scenario, while the first term approaches zero as n becomes Iarger.
d. y 9 21

•
Hence, when security returns are uncorrelated, the power of diversification to limit port-
22. Which statement about portfolio diversification is correct?* folio risk is unlimited.
a. Proper diversification can reduce or eliminate systematic risk. . - However,. the more important case is the one in which economywide risk factors
b. Diversification reduces the portfolio's expected retum because It reduces a impart positive correlation among stock returns. In this case, as the portfolio becornes
portfolio's total risk. more highly diversified (n increases) portfolio variance remains positive. Although firm-
c. As more securities are added to a portfolio, total risk typically would be specific risk, represented by the first term in equation 7 A.3, is still diversified away, the
expected to fall at a decreasing rate. . . second term simply approaches Cov as n becomes greater. [Note that (n - l)/n =
d. The risk-reducing benefits of diversification do not occur meamngfully untII 1 - !In, which approaches 1 for large n.] Thus, the irreducible risk of a diversified port-
at Jeast 30 individual securities are included in the portfolio. folio depends on the covariance of the returns of the component securities, which in turn
is a function of the importance of systematic factors in the economy.
To see further the fundamental relationShip between systematic risk and security cor-
APPt•:Nmx A: Tmi Pmn:R oF D1vllRSIFICATION relations, suppose for simplicity that all securities have a common standard deviation,
Section 7.1 introduced the concept of diversification and the limits to the benefits of cr, and ali security pairs have a common correlation coefficient p. Then the covari3.nce
diversification resulting from systematic risk. Given the tools we have developed, we between all pairs of securities is pcr2 , and equation 7A.3 becomes
can reconsider this intuition more rigorously and at the same time sharpen our insight
1 n- 1 (7A.4)
regarding the power of diversification. . . cr2 = - cr2 + - - pcr2
P n n
Recall from equation 7 .11 that the general formula far the variance of a portfoho 1s
The effect of correlation is now explicit. When p = O, we again obtain the insurance
n
" (7A.1)
cr2
p
= k
i= 1
w?cr?1
/
+2,
j=I
principie, where portfolio variance approaches zero as n becomes greater. For p > O,
however, portfolio variance remains positive. In fact, for p = 1, portfolio variance equals
j7i 2
cr regardless of n, demonstrating that diversification is of no benefit: in the case of per-
Consider now the naive diversification strategy in which an equally weighted portfolio
fect correlation, all risk is systematic. More generally, as n becomes greater, equation
is constructed, meaning that w; = l!n far each security. In this case equation 7 A.1 may 7 A.4 shows that systematic risk becomes pcr2. ·
be rewritten as follows: Table 7A.1 presents portfolio standard deviation as we include ever greater numbers
of securities in the portfolio far two cases: p = O and p = .40. The table takes u to be
50%. As one would expect, portfolio risk is greater when p = .40. More surprising, per-
*Reprinted, with pennission, from the Leve! I 1993 CFA Study Guide. Copyright 1993, Association for Investment haps, is that portfolio risk diminishes far less rapidly as n increases in the positive cor-
Management and Research, Charlottesville, VA. Ali rights reserved.
relation case. The correlation among security retums limits the power of diversification.
228 PART TI Portfolio Theory CHAPTER 7 Optima[ Risky Portfolios 229
Table 7A.1 Risk Reduction of Equally Weighted Portfolios in Correlated and
Uncorrelated Universes APPENDIX 8: 'fml ll\SIJRANCE i'RINCIPLÉ: RtSK·SHARING VllRS!iS RISK·POOLING

Mean-variance analysis has taken a Strong hold am~ng investment professionals, and
insight into the rne~hanics of efficient diversification has become quite widespread.
Common rnisconceptions or fallacies about diversifiCation still persist, however, and we
will try to pul sorne to rest.
It is commonly believed that a large portfolio of independent insurance policies is a
1 100 50.00 14.64 50.00 8.17 necessary and suftlcient condition for an insurance cornpany to shed its risk. The fact is
2 50 35.36 41.83
that a rnultitude of independent insurance policies is neither necessary nor sufficient far
5 20 22.36 1.95 36.06 .70 a sound insurance portfolio. Actually, an individual insurer who would not insure a sin-
6 16.67 20.41 35.36 gle policy also would be unwilling to insure a large portfolio of independent policies.
Consider Paul Samuelson's (1963) story. He once offered a colleague 2-to-l odds on
10 10 15.81 .73 33.91 .20 a $1,000 bet on the toss of a coin. His colleague refused, saying, "! won't bet because
:;;, 11 9.09 15.08 33.71
1 would feel the $1,000 loss more than the $2,000 gain. But 1'11 take you on if you
20 55 11.18 .27 32.79 .06 promise to Jet me make a hundred such bets."
21 4.76 10.91 32.73 Sarnuelson's colleague, as many others, might have explained bis position, not quite
correctly, that "One toss is not enough to make it reasonably sure that the law of aver-
100 1 5.00 .02 31.86 .00 ages will turn out in rny favor. But with a hundred tosses of a coin, the Iaw of averages
101 .99 4.98 31.86
will make it a darn good bet."
Another way to rationalize this argurnent is to think in terms of rates of return. In
each bet you pul up $1,000 and then get back $3,000 with a probability of one half, or
zero with a probability of one half. The probability distribution of the rate of return is
200% with p = Yo and -100% with p = Y,.
Note that, for a 100-security portfolio, the standard deviation is 5% in the uncorre- The bets are all independent and identical and therefore the expected retum is
lated case-still significant when we consider the potential of zero standard deviation. _ ~;~!::; E(r) = './,(200) + Yo( -100) = 50%, regardless of the number of bets. The standard devi-
For p = .40, the standard deviation is high, 31.86%, yet it is very close to undiversifi- ation of the rate of return on the portfolio of independent bets is12
able systematic risk in the infinite-sized universe, ;Jprr2 = ;J.4 X 502 = 31.62 percent.
rr
At this point, further diversification is of little value. rr(n) = Yn
We also gain an importan! insight from this exercise. When we hold diversified port-
folios, the contribution to portfolio risk of a particular security will depend on the where rr is the standard deviation of a single bet:
covariance of that security's return with those of other securities, and not on the secu- rr = [ './,(200 - 50) 2 + Y,(-100 - 50)2]1/2
rity's variance. As we shall see in Chapter 8, this implies that fair risk premiums also = 150%
should depend on covariances rather than total variability of retums.
The rate of return on a sequence of bets, in other words, has a sn1aller standard devi-
ation than that of a single bet. By increasing the number of bets we can reduce the stan-
CONCEPT CHECK Question 7 A. l Suppose that the universe of available risky securities consists of a large dard deviation of the rate of retum to any desired leve!. It seems at first glance that
number of stocks, identically distributed with E(r) = 15%, rr = 60%, and a common Sarnuelson's colleague was correct. But he was not.
correlation coefficient of p = .5. The fallacy of the argument lies in the use of arate of return cr:iterion to choose from
a. What is the expected retum and standard deviation of an equally weighted risky port- portfolios that are not equal in size. Although the portfolio is equally weighted across
folio of 25 stocks? bets, each extra bet increases the scale of the investrnent by $1,000. Recall from your
b. What is the smallest number of stocks necessary to generate an efficient portfolio corporate finance class that when choosing among mutually exclusiVe projects you can-
with a standard deviation equal to or smaller than 43%? not use the interna} rate of return (IRR) as your decision criterion when the projects are
c. What is the systematic risk in this universe? of different sizes. You have to use the net present value (NPV) mle.
d. If T-bills are available and yield 10%, what is the slope of the CAL?
12
This follows from equation 7 .11, setting wi = 1/11 and all covariances equal to zero beca use ofthe indcpendence of thc bets.
230 PART II Portfolio Theory CHAPTER 7 Optimal Risky Pori¡olios , 231

Consider the dallar profit (as opposed to rate of return) distribution of a single bet: position is exactly the same as if you were to make 1,000 small bets of $2 against $ 1.
E(R)= Y, X 2,000 + Y, X (-1,000) A 1/1,000 share of a $1,000 bet is equivalen! to a $1 bet. Holding a small share of many
= $500 large bets essentially allows you to replace a stake in one large bet with a diversified
u R = [/;(2,000 - 500J2 + /;( -1,000 - 500)2] l/2 portfalio of manageable bets.
= $1,500 How <loes this 'apply to insurance ·companies? Investors can purchase insurance cam-
pan y shares in the stock market, so they can ·choose to hold as small a position in the
These are independent bets where the total profit from n bets is the sum of the profits overall risk as they please. No matter ·how great the risk of the policies, a large group
from the single bets. Therefare, with n bets of individual small investors wjll agree to bear the risk if the expected rate of return
E[R(n)] = $500n exceeds the risk-free rate. Thus, it is the sharing of risk among many shareholders that
n makes the insurance industry tick.
V ariance ( ¡
i= 1
R;) = nu'f¡

u R(n) = -Jnu'f¡
APPENDIX C: THE FALIACY OF TIME DIVERSIFICAl'ION
=uRTu
The insurance story just discussed illustrates a misuse of rate of return analysis, specif-
so that the standard deviation of the dollar return increases by a factor equal to the square ically the mistake of comparing portfolios of different sizes. A more insidious version
root of the number of bets, n, in contrast to the standard deviation of the rate of retum, of this en·or often appears under the guise of "time diversification."
which decreases by a factor of the square root of n. Considerthe case ofMr. Frier, who has $100,000. He is trying to figure out the appro-
As further evidence, consider the standard coin-tossing game. Whether one flips a priate allocation of this fund between risk-free T-bills that yield 10% and a risky port-
fair coin JO times or 1,000 times, the expected percentage ofheads flipped is 50%. One folio that yields an annual rate of return with E(rp) = 15% and O"P = 30%.
expects the actual proportion of heads in a typical running of the 1,000-toss experiment Mr. Frier took a course in finance in his youth. He likes quantitative models, and after
to be closer to 50% than in the 10-toss experiment. This is the law of averages. careful introspection determines that his degree of risk aversion, A, is 4. Consequently,
But the actual number of heads will typically depart from its expected value by a he calculates that his optima] allocation to the risky portfalio is
greater amount in the 1,000-toss experiment. Far example, 504 heads is clase to 50%
and is 4 more than the expected number. To exceed the expected number of heads by 4 E(rP) - r 1 15 - 10
in the JO-toss garne would require 9 out of JO heads, which is a much more extreme y= .01 X Au~ = .01 X 4 X 30 2
departure from the mean. In the many-toss case, there is more volatility of the number = .14
of heads and less volatility of the percentage of heads. This is the same when an insur-
ance company takes on more policies: The dallar variance of its portfolio increases that is, a 14% investment ($14,000) in the risky portfolio.
while the rate of return variance falls. With this strategy, Mr. Frier calculates his complete portfalio expected retum and
The lesson is this: Rate of return analysis is appropriate when considering mutually standard deviation by
exclusive portfalios of equal size, which is what we did in ali the exarnples so far. We E(r el = r1 + y[E(rp) - r¡l
applied a fixed investment budget, and we investigated only the consequences of vary- = 10.70%
ing investrnent proportions in various assets. But if an insurance company tak:es on more
and more insurance policies, it is increasing portfo1io dallar investments. The analysis ªc=yrrP
called far in that case must be cast in terms of dallar profits, in much the same way that = 4.20%
NPV is called far instead of IRR when we compare different-sized projects. This is why At this point, Mr. Frier gets cold feet because this fund is intended to provide the
risk-pooling (i.e., accumulating independent risky prospects) does not act to eliminate mainstay of his retirement wealth. He plans to retire in five years, and any mistake will
risk. be burdensome.
Samuelson's colleague should have counteroffered: "Let's make 1,000 bets, each Mr. Fríer calls Ms. Mavin, a highly recofilmended financial advisor. Ms. Mavin
with your $2 against my $1." Then he would be holding a portfalio of fixed size, equal explains.that indeed the time factor is all importan!. She cites academic research show-
to $1,000, which is diversified into 1,000 identical independent prospects. This would ing that asset rates of return over successive holding periods are i'ndependent. Therefore,
make the insurance principle work. she argues, returns in good years and bad years will tend to cancel out over the five-
Another way far Sarnuelson's colleague to get around the riskiness of this tempting year period. Consequently, the average portfolio rate of return over the investment
bet is to share the large bets with friends. Consider a firm engaging in 1,000 of Paul period will be less risky than would appear frorn !he standard deviation of a single-
Samuelson's bets. In each bet the firm puts up $1,000 and receives $3,000 or nothing year portfolio return. Because returns in each year are independent, Ms. Mavin tells
as befare. Each bet is too large far you. Yet if you hold a 1/1,000 share of the firm, your Mr. Frier that a five-year investment is equivalen! to a portfolio of five equally weighted
 CHAPTER 7 Optimal Risky 'PortjoÚos 233
232 PART ll Portfolio Theory

Figure 7C.1 Compound annual retum (o/o) Wealth ($)

Figure 7C.2 20
27.9
Simulated return ·;(bollar returns on com-
distributions for the 24.0 .::c.· ·mon stocks. Simulated
period 1994-2013. - · distributions of nomi-
Geometric average 21.0 10
Ilal wealth index for
annual rates. 18.0 :<:\he period 1994-2013
Source: Stocks, Bonds, Bi/ls, "(Year-end 1993 equals
1.md lnjlation: 1994 Yearbook
15.0 95th percentile 4.99
I.00)
(Chicago: lbbotson 12.0 ._ -. Source: Stocks, Bonds, Bi/ls,
Associates, lnc., 1994). Süth percentile ·;,,.\iÍlid lnjlation: 1994 Yearbook
9.0i--------------------~~-
"· (Chicago: Ibbotson
2.38
6.0 5th percentile -AsSociates, Inc., 1994).

3.0

o.o
-3.0

-6.0
-8.2 +~...,~-.---.--,----,r-r--,-----,----,---,-r-,-----,---,----,-,---,
19941995 2000 2005 2010
Forecast year

0.l

independent assets. With such a portfolio, the (five-year) holding period retum has
1973 1975 1980 1985 1990 1995 2000 2005 2010 2013
a mean of Forecast year- end
E[r (5)}
p
= 15% per year
and standard deviation of13
30 Ms. Mavin is wrong: Time diversification <loes not reduce risk. Although it is true
a/5) = {5 that the per year average rate of retum has a smaller standard deviation for a longer time
= 13.42% per year horizon, it also is true that the uncertainty compounds over a greater number of years.
Unfortunately, this !alter effect dominates in the sense that the total return becomes more
Mr. Frier is relieved. He believes that the effective standard deviation has fallen from.: uncertain the longer the investment horizon.
30% to 13.42%, and that the reward-to-variability ratio is much better than his first Figures 7C. l and 7C.2 show the fallacy of time diversification. They represen! sim-
assessment. . . . , ulated retums to a stock investment and show the range of possible outcomes. Although
Is Mr. Frier's newfound sense of security warranted? Spec1fically, is Ms. M.avm. the confidence band around the expected rate of return on the investment narrows with
time diversification really a risk-reducer? It is true that the standard deviation of th<\ investment life, the dallar confidence band widens.
annualized rate of return over five years really is only 13.42% as Mavin claims, com- _ Again, the coin-toss analogy is helpful. Think of each year's investment return as one
pared with the 30% one-year standard deviation. But what about the volatility of Mr.• flip of the coin. After many years, the average number of heads approaches 50%,
Frier's total retirement fund? With a standard deviation of the five-year average return. but the possible deviation of total heads from one-half the number of flips still will
of 13.42%, .ª one-standard-deviation disappointment in Mr. Frier's aveffa~e return ovef;; be growing.
the five-year period will affect final wealth by a factor of (1 - .1342) - . .487, mean The lesson is, once again, that one should not use rate of feturn analysis to compare
ing that final wealth will be less than one half of its expected value. Th1s is a larg~ portfolios of different size. Investing far more than one holding period means that the
impact !han the 30% one-year swing. amount of risk is growing. This is analogous toan insurer taking on more insurance poli-
---- ------- cies. The fact that these policies are independent does not offset the effect of placing
__ ,_. ,. . -~ . h h fi t ·sthesumofeach
13 The calculation for standard deviation is only approx1mate, because 1t assumes t at t e 1ve-year re urn 1 ·fü ~ more funds at risk. Focus on the standard deviation of the rate of retum should never
of the five one-year retums, and this formulation ignores compounding. The error is small, however, and <loes not affect .-.-~:
obscure the more proper emphasis on the possible dallar values of a portfolio strategy.
point we wan:t to make.