Chapter 11

Diversification and Risky

Asset Allocation

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 Diversification and Risky
Asset Allocation

“It is the part of a wise man not to venture all his eggs in one
basket.”
–Miguel de Cervantes

11-2
 Learning Objectives

To get the most out of this chapter,

spread your study time across:

1. How to calculate expected returns and variances for a

security.

2. How to calculate expected returns and variances for a

portfolio.

3. The importance of portfolio diversification.

4. The efficient frontier and the importance of asset

allocation.
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 Diversification

• Intuitively, we all know that if you hold many

investments:
— Through time, some will increase in value
— Through time, some will decrease in value
— It is unlikely that their values will all change in the same way

• Diversification has a profound effect on portfolio

return and portfolio risk.

• But, exactly how does diversification work?

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 Diversification and Asset Allocation

• Our goal in this chapter is to examine the role of diversification

and asset allocation in investing.

• In the early 1950s, professor Harry Markowitz was the first to

examine the role and impact of diversification.

• Based on his work, we will see how diversification works, and we

can be sure that we have “efficiently diversified portfolios.”
―An efficiently diversified portfolio is one that has the highest expected
return, given its risk.
―You must be aware that diversification concerns expected returns.

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 Expected Returns, I.

• Expected return is the “weighted average” return on a risky asset, from

today to some future date. The formula is:
n
expected return i   p s  return i,s 
s 1

• To calculate an expected return, you must first:

― Decide on the number of possible economic scenarios that might occur.
― Estimate how well the security will perform in each scenario, and
― Assign a probability, ps, to each scenario.
― (BTW, finance professors call these economic scenarios, “states.”)

• The upcoming slides show how the expected return formula is used when
there are two states.
̶ Note that the “states” are equally likely to occur in this example.
̶ BUT! They do not have to be equally likely--they can have different
probabilities of occurring.

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 Expected Return, II.

• Suppose:
―There are two stocks:
o Starcents
o Jpod
―We are looking at a period of one year.

• Investors agree that the expected return:

―for Starcents is 25 percent
―for Jpod is 20 percent

• Why would anyone want to hold Jpod shares when

Starcents is expected to have a higher return?
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 Expected Return, III.

• The answer depends on risk.

• Starcents is expected to return 25 percent.

• But the realized return on Starcents could be

significantly higher or lower than 25 percent.

• Similarly, the realized return on Jpod could be

significantly higher or lower than 20 percent.
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Calculating Expected Returns

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 Expected Risk Premium

• Recall:
Expected Risk Premium  Expected Return  Riskfree Rate

• Suppose risk free investments have an 8% return. If so,

― The expected risk premium on Jpod is 12%.
― The expected risk premium on Starcents is 17%.

• This expected risk premium is simply the difference between

― The expected return on the risky asset in question and
― The certain return on a risk-free investment.

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 Calculating the Variance of
Expected Returns

• The variance of expected returns is calculated using this formula:

 
n
Variance  σ   p s   return s  expected return 
2 2

s 1

• This formula is not as difficult as it appears.

• This formula says:

̶ add up the squared deviations of each return from its expected return
̶ after it has been multiplied by the probability of observing a particular
economic state (denoted by “s”).

Standard Deviation  σ  Variance

• The standard deviation is simply the square root of the variance.

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Example: Calculating Expected Returns and Variances:
Equal State Probabilities

Calculating Expected Returns:

Starcents: Jpod:
(1) (2) (3) (4) (5) (6)
Return if Return if
State of Probability of State Product: State Product:
Economy State of Economy Occurs (2) x (3) Occurs (2) x (5)
Recession 0.50 -0.20 -0.10 0.30 0.15
Boom 0.50 0.70 0.35 0.10 0.05
Sum: 1.00 E(Ret): 0.25 E(Ret): 0.20

Calculating Variance of Expected Returns:

Note that the lower pard
of the spreadsheet is only
Starcents:
for Starcents. What
(1) (2) (3) (4) (5) (6) (7)
would you get for Jpod?
Return if
State of Probability of State Expected Difference: Squared: Product:
Economy State of Economy Occurs Return: (3) - (4) (5) x (5) (2) x (6)
Recession 0.50 -0.20 0.25 -0.45 0.2025 0.10125
Boom 0.50 0.70 0.25 0.45 0.2025 0.10125
Sum: 1.00 Sum = the Variance: 0.20250

Standard Deviation: 0.45

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Expected Returns and Variances,
Starcents and Jpod

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 Portfolios

• Portfolios are groups of assets, such as stocks and

bonds, that are held by an investor.

• One convenient way to describe a portfolio is by listing

the proportion of the total value of the portfolio that is
invested into each asset.

• These proportions are called portfolio weights.

―Portfolio weights are sometimes expressed in percentages.
―In calculations, make sure you use proportions (i.e., decimals).
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 Portfolios: Expected Returns

• The expected return on a portfolio is a linear

combination, or weighted average, of the expected
returns on the assets in that portfolio.

• The formula, for “n” assets, is:

n
E R P     w i  E R i  
i 1

In the formula: E(RP) = expected portfolio return

wi = portfolio weight for portfolio asset i
E(Ri) = expected return for portfolio asset i
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 Example: Calculating Portfolio Expected Returns

Note that the portfolio weight in Jpod = 1 – portfolio weight in Starcents.

Calculating Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Starcents Starcents Jpod Jpod Portfolio
Return if Portfolio Contribution Return if Portfolio Contribution Return
State of Prob. State Weight Product: State Weight Product: Sum: Product:
Economy of State Occurs in Starcents: (3) x (4) Occurs in Jpod: (6) x (7) (5) + (8) (2) x (9)
Recession 0.50 -0.20 0.50 -0.10 0.30 0.50 0.15 0.05 0.025
Boom 0.50 0.70 0.50 0.35 0.10 0.50 0.05 0.40 0.200

Sum: 1.00 This Sum is Expected Portfolio Return: 0.225

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 Variance of Portfolio Expected Returns

• Note: Unlike returns, portfolio variance is generally not a simple

weighted average of the variances of the assets in the portfolio.
• If there are “n” states, the formula is:


VAR  RP    p s  ERp,s   E RP   
n
2

s 1

• In the formula, VAR(RP) = variance of portfolio expected return

ps = probability of state of economy, s
E(Rp,s) = expected portfolio return in state s
E(Rp) = portfolio expected return

• Note that the formula is like the formula for the variance of the
expected return of a single asset.
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 Example: Calculating Variance of
Portfolio Expected Returns
• It is possible to construct a portfolio of risky assets with zero portfolio
variance! What? How? (Open this spreadsheet, scroll up, and set the
weight in Starcents to 2/11ths.)

• What happens when you use .40 as the weight in Starcents?

Calculating Variance of Expected Portfolio Returns:

(1) (2) (3) (4) (5) (6) (7)
Return if
State of Prob. State Expected Difference: Squared: Product:
Economy of State Occurs: Return: (3) - (4) (5) x (5) (2) x (6)
Recession 0.50 0.209 0.209 0.00 0.0000 0.00000
Boom 0.50 0.209 0.209 0.00 0 0.00000
Sum: 1.00 Sum is Variance: 0.00000

Standard Deviation: 0.000

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Diversification and Risk, I.

11-19
Diversification and Risk, II.

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 The Fallacy of Time Diversification, I.

• Young people are often told that they should hold a large percent
of their portfolio in stocks.

• The advice could be correct, but often the typical argument used
to support this advice is incorrect.
―The Typical Argument: Even though stocks are more volatile, over time, the
volatility “cancels out.”
―Sounds logical, but the typical argument is incorrect.

• This argument is called the fallacy of time diversification.

• How can such a plausible argument be incorrect?

11-21
 The Fallacy of Time Diversification, II.
• What IS true about this piece of advice?
• Recall that the average yearly return of large-cap stocks over about the last 87
individual years is 11.7 percent, and the standard deviation is 20.2 percent.
• For most investors, however, time horizons are much longer than one year.
• So, let’s look at the average returns of longer investment horizons.
• Using data elsewhere in the book, we compute returns for rolling investment
holding periods.

11-22
 The Fallacy of Time Diversification, III.

• As the time period grows, the average geometric return falls.

• Look at the pattern of the standard deviation of average returns.

• Notice that as the time period increases, the standard deviation of the
geometric averages also falls (it actually approaches zero).

• The problem is that even though the standard deviation of the

geometric return tends to zero as the time horizon grows, the
standard deviation of your wealth does not.

As investors, we care about wealth levels and the

standard deviation of wealth levels over time.
11-23
 The Fallacy of Time Diversification, IV.
• Suppose someone invested a lump sum of $1,000 in 1926.
― Using the return data from Table 1.1, it grows to $1,515.85 five years later.
― Make calculations for all possible five-year investment periods and others.

• What do you notice about the wealth averages and standard deviations?

• The average ending wealth amount is larger over longer time periods.
• Makes sense—after all, we are investing for longer time periods.
• Notice that the standard deviation of wealth increases with the time horizon.

• Wealth volatility INCREASES over time: it does not “cancel out” over time.

Investing in equity has a greater chance of having an extremely large

value AND increases the probability of ending with a really low value.

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The Very Definition of Risk—a Wider Range of
Possible Outcomes from Holding Equity

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 So, Should Younger Investors Put a
High Percent of Their Money into Equity?
• The answer is probably still yes, but for logically sound reasons that differ
from the reasoning underlying the fallacy of time diversification.

• If you are young and your portfolio suffers a steep decline in a particular
year, what could you do?

• You could make up for this loss by changing your work habits (e.g., your
type of job, hours, second job).

• People approaching retirement have little future earning power, so a major

loss in their portfolio will have a much greater impact on their wealth.

• Thus, the portfolios of young people should contain relatively more equity
(i.e., risk).
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 Why Diversification Works, I.

• Correlation: The tendency of the returns on two

assets to move together. Imperfect correlation is the
key reason why diversification reduces portfolio risk
as measured by the portfolio standard deviation.

• Positively correlated assets tend to move up and down together.

• Negatively correlated assets tend to move in opposite directions.

• Imperfect correlation, positive or negative, is why

diversification reduces portfolio risk.
11-27
 Why Diversification Works, II.

• The correlation coefficient is denoted by Corr(RA, RB)

or simply, A,B.

• The correlation coefficient measures correlation and

ranges from -1 to 1:
-1 (perfect negative correlation)
0 (uncorrelated)
+1 (perfect positive correlation)

11-28
Why Diversification Works, III.

11-29
Why Diversification Works, IV.

11-30
Why Diversification Works, V.

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 Calculating Portfolio Risk
• For a portfolio of two assets, A and B, the variance of
the return on the portfolio is:

σ p2  x 2A σ 2A  x B2 σ B2  2x A xBCOV(A,B)
σ p2  x 2A σ 2A  x B2 σ B2  2x A xBσ A σ BCORR(RARB )

Where: xA = portfolio weight of asset A

xB = portfolio weight of asset B
Note: xA + xB = 1.

(Important: Recall Correlation Definition!)

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 The Importance of Asset Allocation, Part 1.

• Suppose that as a very conservative, risk-averse

investor, you decide to invest all of your money in a
bond mutual fund. Very conservative, indeed?

Uh, is this decision a wise one?

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Correlation and Diversification, I.

11-34
Correlation and Diversification, II.

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 Correlation and Diversification, III.

• The various combinations of risk and return available all fall

on a smooth curve.

• This curve is called an investment opportunity set,

because it shows the possible combinations of risk and
return available from portfolios of these two assets.

• A portfolio that offers the highest return for its level of risk
is said to be an efficient portfolio.

• The undesirable portfolios are said to be dominated or

inefficient.
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More on Correlation and the Risk-Return Trade-Off
(The Next Slide is an Excel Example)

11-37
 Example: Correlation and the
Risk-Return Trade-Off, Two Risky Assets
Expected Standard
Inputs Return Deviation Efficient Set--Two Asset Portfolio
Risky Asset 1 14.0% 20.0%
Risky Asset 2 8.0% 15.0% 18%
Correlation 30.0% 16%
14%

Expected Return
12%
10%
8%
6%
4%
2%
0%
0% 5% 10% 15% 20% 25% 30%
Standard Deviation

11-38
 The Importance of Asset Allocation, Part 2.

• We can illustrate the importance of asset allocation with 3

assets.

• How? Suppose we invest in three mutual funds:

− One that contains Foreign Stocks, F
− One that contains U.S. Stocks, S
− One that contains U.S. Bonds, B

Expected Return Standard Deviation

Foreign Stocks, F 18% 35%
U.S. Stocks, S 12 22
U.S. Bonds, B 8 14

• The next slide shows the results of calculating various expected returns
and portfolio standard deviations with these three assets.
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Risk and Return with Multiple Assets, I.

11-40
 Risk and Return with Multiple Assets, II.
rp  x FRF  x SR S  x BRB
• We use these formulas for
portfolio return and variance
σ p2  x F2σ F2  x S2 σ S2  x B2 σ B2
in the previous slide:
 2x F x Sσ Fσ SCORR(RFR S )
• But, we made a simplifying  2x F x Bσ Fσ BCORR(RFRB )
assumption. We assumed  2x S x Bσ Sσ BCORR(RSRB )
that the assets are all
uncorrelated.

• If so, the portfolio variance σ p2  x F2σ F2  x S2 σ S2  x B2 σ B2

becomes:
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 The Markowitz Efficient Frontier

• The Markowitz Efficient frontier is the set of portfolios with the

maximum return for a given risk AND the minimum risk given a return.

• For the plot, the upper left-hand boundary is the Markowitz efficient
frontier.

• All the other possible combinations are inefficient. That is, investors
would not hold these portfolios because they could get either:

―more return for a given level of risk

or

―less risk for a given level of return.

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 Useful Internet Sites

• [Link] (source for expected returns)

• [Link] (for more on risk measures)
• [Link] (also contains more on risk measure)
• [Link] (measure diversification using “instant x-
ray”)
• [Link] (review modern portfolio theory)
• [Link] (check out the reading list)
• [Link] (reference for current financial
information)

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 Chapter Review, I.

• Expected Returns and Variances

―Expected returns
―Calculating the variance

• Portfolios
―Portfolio weights
―Portfolio expected returns
―Portfolio variance

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 Chapter Review, II.

• Diversification and Portfolio Risk

―The principle of diversification
―The fallacy of time diversification

• Correlation and Diversification

―Why diversification works
―Calculating portfolio risk
―More on correlation and the risk-return trade-off

• The Markowitz Efficient Frontier

―Risk and return with multiple assets
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