• Chapter 7

Chapter Title
Efficient
Diversification

INVESTMENTS | Bodie et al. 10th CE | © 2022 McGraw-Hill Education Limited

 Overview
• The investment decision:
– Capital allocation (risky vs. risk-free)
– Asset allocation (construction of the risky
portfolio)
– Security selection

• Optimal risky portfolio

• The Markowitz portfolio optimization model
• Risk pooling and risk sharing

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 The Investment Decision

• Top-down process of investment:

1. Capital allocation between the risky portfolio
and risk-free asset
2. Asset allocation across broad asset classes
 e.g., Canadian stocks, international stocks,
long-term bonds

3. Security selection of individual assets within

each asset class

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Diversification and Portfolio Risk

• Market risk
– Market-wide risk sources
– Remains even after diversification
– a.k.a. systematic or non-diversifiable risk

• Firm-specific risk
– Risk that can be eliminated by diversification
– a.k.a. diversifiable or non-systematic risk

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Portfolio Risk and the Number of
Stocks in the Portfolio

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Portfolio Diversification

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 Portfolios of Two Risky Assets:
Expected Return

Consider a Portfolio made up of Equity (stock)

and Debt (bond) fund.

E(rp) = wD E(rD) + wE E(rE)

wD = proportion of funds in bond fund (D)

wE = proportion of funds in stock fund (E)
E(rD) = expected return on D
E(rE) = expected return on E

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Portfolios of Two Risky Assets:
Risk

• Portfolio variance

Cov(rD, rE)= Covariance of returns for bond

and equity
D = Standard deviation of bond returns
E = Standard deviation of equity returns

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 Portfolios of Two Risky Assets:
Risk

• Covariance of returns on bond and equity:

DE = Correlation coefficient of returns

D = Standard deviation of bond returns
E = Standard deviation of equity returns

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Portfolios of Two Risky Assets:
Correlation Coefficients

Range of values for ρD,E

-1.0 ≤ ρ ≤ 1.0

• If ρ = 1.0, the securities would be perfectly

positively correlated
• If ρ = -1.0, the securities would be perfectly
negatively correlated
• If ρ = 0, the securities would be uncorrelated
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 Portfolio Expected Return as a
Function of Standard Deviation

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The Minimum Variance Portfolio
• The minimum variance portfolio: the
portfolio composed of risky assets with
smallest standard deviation
• Risk reduction depends on the correlation:
– The smaller the correlation, the greater
the risk reduction potential
– If ρ = +1.0, no risk reduction is possible
– If ρ = -1.0, a riskless hedge is possible
– If ρ < 1, σP can be less than the standard
deviation of either component asset
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 The Sharpe Ratio

• Maximize the slope of the CAL for any

possible portfolio, P

• The objective function is the slope:

E rp   rf
Sp 
σp
Sharp ratio measures the excess return per unit of risk.

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Optimal Risky Portfolio
E rP   11%
σ P  14.2%
ErP   rf
SP 
P
11%  5%

14.2%
 .42

Optimal Allocation to P
A4
E rP   rf
y
Aσ P2
11%  5%
  .7439
4  14.2%
2

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The Proportions of the Optimal
Complete Portfolio

Overall Portfolio
E rP   11% y  .7439
σ P  14.2% rf  5%
E rOverall   y  E rP   1  y  rf
 .7439  11%  .2561  5%
 9.46%
σ Overall  .7439  14.2%  10.56%
9.46%  5%
SOverall   .42
10.56%
In case of two risky assets, the weights of the optimal risky
portfolio (i.e., split between D and E) are given in Eq. 7.13.
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 Markowitz Portfolio
Optimization Model (1)

• Security selection
– Determine the risk-return opportunities
available
– All portfolios that lie on the minimum-
variance frontier from the global
minimum-variance portfolio and upward
provide the best risk-return combinations

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The Minimum-Variance Frontier of
Risky Assets

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 Markowitz Portfolio
Optimization Model (2)

• What is the optimal risky portfolio P?

• Search for the CAL with the highest
reward-to-variability ratio
• Everyone invests in P, regardless of their
degree of risk aversion
– More risk averse investors put less in P
– Less risk averse investors put more in P

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Efficient Frontier of Risky Assets
with the Optimal CAL

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 Markowitz Portfolio
Optimization Model (3)
• Capital Allocation and the Separation
Property
– Portfolio choice problem may be separated
into two independent tasks
 Determination of the optimal risky portfolio
is purely technical and objective
 Allocation of the complete portfolio to risk-free
versus the risky portfolio depends on personal
preference

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 Markowitz Portfolio
Optimization Model (4)

• The Power of Diversification

– We can express portfolio variance as

– Portfolio variance can be driven to zero if the

average covariance is zero
– The irreducible risk of a diversified portfolio
depends on the covariance of the returns

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 Markowitz Portfolio
Optimization Model (5)
• Optimal Portfolios and Non-normal Returns
– Fat-tailed distributions can result in extreme
values of Value-at-Risk (VaR) and expected
shortfall (ES)  smaller allocations
– If other portfolios provide sufficiently better VaR
and ES values than the mean-variance efficient
portfolio, we may prefer these when faced with
fat-tailed distributions

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 Risk Pooling and the Insurance
Principle
• Risk pooling
– Merging uncorrelated, risky projects as a means
to reduce risk
– It increases the scale of the risky investment by
adding additional uncorrelated assets
• The insurance principle
– Risk increases less than proportionally to the
number of policies when the policies are
uncorrelated
– Sharpe ratio increases
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 Risk Sharing
• As risky assets are added, a portion of the
pool is sold to maintain a risky portfolio of
fixed size but better return-risk trade-off
• True diversification means spreading a
portfolio of fixed size across many assets, not
merely adding more risky bets
– Naturally own a smaller fraction of each
invested company; sharing risk with others
– Think about holding a share in an insurance
company

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