Modern Portfolio Concepts
Learning Goals
1. Understand portfolio objectives and the
procedures used to calculate portfolio return
and standard deviation.
2. Discuss the concepts of correlation and
diversification and the key aspects of
international diversification.
3. Describe the components of risk and the use of
beta to measure risk.
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Modern Portfolio Concepts
Learning Goals (cont’d)
4. Explain the capital asset pricing model
(CAPM)conceptually, mathematically, and
graphically.
5. Review the traditional and modern approaches
to portfolio management.
6. Describe portfolio betas, the risk-return
tradeoff, and reconciliation of the two
approaches to portfolio management.
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What is a Portfolio?
• Portfolio is a collection of investments
assembled to meet one or more investment
goals.
• Growth-Oriented Portfolio: primary
objective is long-term price appreciation
• Income-Oriented Portfolio: primary
objective is to produce regular dividend and
interest income
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The Ultimate Goal:
An Efficient Portfolio
• Efficient portfolio
– A portfolio that provides the highest return for a
given level of risk
– Requires search for investment alternatives to
get the best combinations of risk and return
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Portfolio Return and Risk Measures
• The return on a portfolio is simply the
weighted average of the individual assets’
returns in the portfolio
• The standard deviation of a portfolio’s
returns is more complicated, and is a
function of the portfolio’s individual assets’
weights, standard deviations, and
correlations with all other assets
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Return on Portfolio
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Correlation:
Why Diversification Works!
• Correlation is a statistical measure of the
relationship between two series of numbers
representing data
• Positively Correlated items tend to move in the
same direction
• Negatively Correlated items tend to move in
opposite directions
• Correlation Coefficient is a measure of the
degree of correlation between two series of
numbers representing data
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Correlation Coefficients
• Perfectly Positively Correlated describes two
positively correlated series having a
correlation coefficient of +1
• Perfectly Negatively Correlated describes
two negatively correlated series having a
correlation coefficient of -1
• Uncorrelated describes two series that lack
any relationship and have a correlation
coefficient of nearly zero
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Figure 5.1 The Correlation Between
Series M, N, and P
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Correlation:
Why Diversification Works!
• Assets that are less than perfectly positively
correlated tend to offset each others
movements, thus reducing the overall risk
in a portfolio
• The lower the correlation the more the
overall risk in a portfolio is reduced
– Assets with +1 correlation eliminate no risk
– Assets with less than +1 correlation eliminate some risk
– Assets with less than 0 correlation eliminate more risk
– Assets with -1 correlation eliminate all risk
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Figure 5.2 Combining Negatively
Correlated Assets to Diversify Risk
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Figure 5.3 Portfolios of IBM and
Celgene
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Figure 5.4 Risk and Return for Combinations of
Two Assets with Various Correlation Coefficients
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Why Use International
Diversification?
• Offers more diverse investment alternatives than
U.S.-only based investing
• Foreign economic cycles may move independently
from U.S. economic cycle
• Foreign markets may not be as “efficient” as U.S.
markets, allowing true gains from superior
research
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International Diversification
• Advantages of International Diversification
– Broader investment choices
– Potentially greater returns than in U.S.
– Reduction of overall portfolio risk
• Disadvantages of International
Diversification
– Currency exchange risk
– Less convenient to invest than U.S. stocks
– More expensive to invest
– Riskier than investing in U.S.
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Components of Risk
• Diversifiable (Unsystematic) Risk
– Results from uncontrollable or random events
that are firm-specific
– Can be eliminated through diversification
– Examples: labor strikes, lawsuits
• Nondiversifiable (Systematic) Risk
– Attributable to forces that affect all similar
investments
– Cannot be eliminated through diversification
– Examples: war, inflation, political events
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Components of Risk
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Beta: A Popular Measure of Risk
• A measure of undiversifiable risk
• Indicates how the price of a security responds to market
forces
• Compares historical return of an investment to the market
return (the S&P 500 Index)
• The beta for the market is 1.0
• Stocks may have positive or negative betas. Nearly all are
positive.
• Stocks with betas greater than 1.0 are more risky than the
overall market.
• Stocks with betas less than 1.0 are less risky than the overall
market.
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Beta as a Measure of Risk
Table 5.4 Selected Betas and Associated
Interpretations
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Interpreting Beta
• Higher stock betas should result in higher expected
returns due to greater risk
• If the market is expected to increase 10%, a stock
with a beta of 1.50 is expected to increase 15%
• If the market went down 8%, then a stock with a
beta of 0.50 should only decrease by about 4%
• Beta values for specific stocks can be obtained
from Value Line reports or websites such as
yahoo.com
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Interpreting Beta
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Capital Asset Pricing Model (CAPM)
• Model that links the notions of risk and
return
• Helps investors define the required return
on an investment
• As beta increases, the required return for a
given investment increases
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Capital Asset
Pricing Model (CAPM) (cont’d)
• Uses beta, the risk-free rate and the
market return to define the required return
on an investment
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Capital Asset
Pricing Model (CAPM) (cont’d)
• CAPM can also be shown as a graph
• Security Market Line (SML) is the “picture”
of the CAPM
• Find the SML by calculating the required
return for a number of betas, then plotting
them on a graph
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Figure 5.6 The Security Market Line
(SML)
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Two Approaches to Constructing
Portfolios
Traditional Approach
versus
Modern Portfolio Theory
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Traditional Approach
• Emphasizes “ balancing” the portfolio using
a wide variety of stocks and/or bonds
• Uses a broad range of industries to diversify
the portfolio
• Tends to focus on well-known companies
– Perceived as less risky
– Stocks are more liquid and available
– Familiarity provides higher “comfort” levels for
investors
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Modern Portfolio Theory (MPT)
• Emphasizes statistical measures to develop
a portfolio plan
• Focus is on:
– Expected returns
– Standard deviation of returns
– Correlation between returns
• Combines securities that have negative (or
low-positive) correlations between each
other’s rates of return
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Key Aspects of MPT:
Efficient Frontier
• Efficient Frontier
– The leftmost boundary of the feasible set of
portfolios that include all efficient portfolios:
those providing the best attainable tradeoff
between risk and return
– Portfolios that fall to the right of the efficient
frontier are not desirable because their risk
return tradeoffs are inferior
– Portfolios that fall to the left of the efficient
frontier are not available for investments
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Figure 5.7 The Feasible or Attainable
Set and the Efficient Frontier
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Key Aspects of MPT:
Portfolio Betas
• Portfolio Beta
– The beta of a portfolio; calculated as the
weighted average of the betas of the individual
assets the portfolio includes
– To earn more return, one must bear more risk
– Only nondiversifiable risk (relevant risk)
provides a positive risk-return relationship
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Figure 5.8 Portfolio Risk and
Diversification
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Key Aspects of MPT: Portfolio Betas
Table 5.6 Austin Fund’s Portfolios V and W
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Interpreting Portfolio Betas
• Portfolio betas are interpreted exactly the same
way as individual stock betas.
– Portfolio beta of 1.00 will experience a 10% increase when
the market increase is 10%
– Portfolio beta of 0.75 will experience a 7.5% increase
when the market increase is 10%
– Portfolio beta of 1.25 will experience a 12.5% increase
when the market increase is 10%
• Low-beta portfolios are less responsive and less
risky than high-beta portfolios.
• A portfolio containing low-beta assets will have a
low beta, and vice versa.
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Interpreting Portfolio Betas
Table 5.7 Portfolio Betas and Associated Changes in Returns
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Reconciling the Traditional
Approach and MPT
• Recommended portfolio management policy uses
aspects of both approaches:
– Determine how much risk you are willing to bear
– Seek diversification between different types of securities
and industry lines
– Pay attention to correlation of return between securities
– Use beta to keep portfolio at acceptable level of risk
– Evaluate alternative portfolios to select highest return for
the given level of acceptable risk
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Figure 5.9 The Portfolio Risk-Return
Tradeoff
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Chapter 5 Review
Learning Goals
1. Understand portfolio objectives and the
procedures used to calculate portfolio return and
standard deviation.
2. Discuss the concepts of correlation and
diversification and the key aspects of international
diversification.
3. Describe the components of risk and the use of
beta to measure risk.
Copyright ©2014 Pearson Education, Inc. All rights reserved. 5-39
Chapter 5 Review (cont’d)
Learning Goals (cont’d)
4. Explain the capital asset pricing model (CAPM)
conceptually, mathematically, and graphically.
5. Review the traditional and modern approaches to
portfolio management.
6. Describe portfolio betas, the risk-return tradeoff, and
reconciliation of the two approaches to portfolio
management.
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Chapter 5
Additional
Chapter Art
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Table 5.1 Individual and Portfolio Returns and Standard
Deviation of Returns for IBM and Celgene
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Table 5.2 Portfolio Returns and Standard
Deviations for IBM and Celgene
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Table 5.3 Expected Returns, Average Returns, and
Standard Deviations for Assets X, Y, and Z and Portfolios
XY and XZ
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Table 5.5 The Growth Fund of America,
March 31, 2012
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