INVESTMENT PORTFOLIO
MANAGEMENT
CHAPTER 3
AN INTRODUCTION TO
PORTFOLIO MANAGEMENT
LEARNING OUTCOMES
After you finish this chapter, you should be able to answer the following questions:
¡ What do we mean by risk aversion, and what evidence indicates that investors are generally risk
averse?
¡ What are the basic assumptions behind the Markowitz portfolio theory?
¡ What do we mean by risk, and what are some measures of risk used in investments?
¡ How do we compute the expected rate of return for a portfolio of assets?
¡ How do we compute the standard deviation of rates of return for an individual risky asset?
¡ What is the formula for the standard deviation for a portfolio of risky assets, and how does it differ
from the standard deviation of an individual risky asset?
¡ What is the risk–return efficient frontier of risky assets?
¡ Why do different investors select different portfolios from the set of portfolios on the efficient frontier?
¡ What determines which portfolio an investor selects on the efficient frontier?
SOME BACKGROUND ASSUMPTIONS
¡ One basic assumption of portfolio theory is that investors want to maximize the returns from
the total set of investments for a given level of risk.
¡ To understand such an assumption requires certain ground rules:
- Your portfolio should include all of your assets and liabilities.
- The relationship among the returns for assets in the portfolio is important.
SOME BACKGROUND ASSUMPTIONS
¡ Investors are basically risk averse, meaning that, given a choice between two assets with
equal rates of return, they will select the asset with the lower level of risk.
¡ For most investors, risk means the uncertainty of future outcomes. An alternative definition
might be the probability of an adverse outcome.
SOME BACKGROUND ASSUMPTIONS
¡ For most investors, risk means the uncertainty of future outcomes.
¡ An alternative definition might be the probability of an adverse outcome.
MARKOWITZ PORTFOLIO THEORY
The Markowitz model is based on several assumptions regarding investor behavior:
1. Investors consider each investment alternative as being represented by a probability distribution of
expected returns over some holding period.
2. Investors maximize one-period expected utility, and their utility curves demonstrate diminishing
marginal utility of wealth.
3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.
4. Investors base decisions solely on expected return and risk, so their utility curves are a function of
expected return and the expected variance (or standard deviation) of returns only.
5. For a given risk level, investors prefer higher returns to lower returns. Similarly, for a given level of
expected return, investors prefer less risk to more risk.
ALTERNATIVE MEASURES OF RISK
¡ The variance, or standard deviation of expected returns is a statistical measure of the
dispersion of returns around the expected value whereby a larger variance or standard
deviation indicates greater dispersion.
¡ It is assumed that a larger range of expected returns, from the lowest to the highest, means
greater uncertainty regarding future expected returns.
¡ The semi-variance is a measure that only considers deviations below the mean. An extension
of the semi-variance measure only computes expected returns below zero (that is, negative
returns), or returns below the returns of some specific asset such as T-bills, the rate of
inflation, or a benchmark.
EXPECTED RATES OF RETURN
§ The expected rate of return for a portfolio of investments is simply the weighted average of
the expected rates of return for the individual investments in the portfolio.
§ The weights are the proportion of total value for the individual investment.
EXPECTED RATES OF RETURN
EXPECTED RATES OF RETURN
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR
AN INDIVIDUAL INVESTMENT
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR
AN INDIVIDUAL INVESTMENT
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
¡ Covariance is a measure of the degree to which two variables move together relative to their
individual mean values over time.
¡ Note that when we apply formula 7.4 to actual sample data, we use the sample mean as an
estimate of the expected return and divide the values by (n − 1) rather than by n to avoid
statistical bias.
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
¡ Standardizing the covariance by the product of the individual standard deviations yields the
correlation coefficient rij, which can vary only in the range −1 to +1.
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
VARIANCE (STANDARD DEVIATION) OF RETURNS FOR A
PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
¡ Equal Risk and Return—Changing Correlations
Example: E(R1) = 0.20, E(σ1) = 0.10
E(R2) = 0.20, E(σ2) = 0.10
w1 = 0.50; w2 = 0.50
a. r1,2 = 1.00
b. r1,2 = 0.50
c. r1,2 = 0.00
d. r1,2 = −0.50
e. r1,2 = −1.00
STANDARD DEVIATION OF A PORTFOLIO
¡ Equal Risk and Return—Changing Correlations
Example: E(R1) = 0.20, E(σ1) = 0.10
E(R2) = 0.20, E(σ2) = 0.10
w1 = 0.50; w2 = 0.50
a. For r1,2 = 1.00, Cov1,2 = 0.01, σport(a) = 0.10
b. For r1,2 = 0.50, Cov1,2 = 0.005, σport(b) = 0.0866
c. For r1,2 = 0.00, Cov1,2 = 0.000, σport(c) = 0.0707
d. For r1,2 = −0.50, Cov1,2 = −0.005, σport(d) = 0.05
e. For r1,2 = −1.00, Cov1,2 = −0.01, σport(e) = 0
STANDARD DEVIATION OF A PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
¡ Combining Stocks with Different Returns and Risk
Example:
STANDARD DEVIATION OF A PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
STANDARD DEVIATION OF A PORTFOLIO
¡ Constant Correlation with Changing Weights
Example:
STANDARD DEVIATION OF A PORTFOLIO
A THREE-ASSET PORTFOLIO
Example:
rS,B = 0.25; rS,C = −0.08; rB,C = 0.15
A THREE-ASSET PORTFOLIO
ESTIMATION ISSUES
¡ We can reduce the number of correlation coefficients that must be estimated by assuming that
stock returns can be described by the relationship of each stock to a market index—that is, a
single index market model, as follows:
ESTIMATION ISSUES
¡ If all the securities are similarly related to the market and a slope coefficient bi is derived for
each one, it can be shown that the correlation coefficient between two securities i and j is
THE EFFICIENT FRONTIER
THE EFFICIENT FRONTIER
THE EFFICIENT FRONTIER
¡ The efficient frontier represents that set of portfolios that has the maximum rate of
return for every given level of risk or the minimum risk for every level of return.
¡ The slope of the efficient frontier curve decreases steadily as we move upward. This
implies that adding equal increments of risk as we move up the efficient frontier gives
diminishing increments of expected return.
THE EFFICIENT FRONTIER AND INVESTOR UTILITY
¡ An individual investor’s utility curves specify the trade-offs he or she is willing to
make between expected return and risk.
¡ The optimal portfolio is the efficient portfolio that has the highest utility for a given
investor. It lies at the point of tangency between the efficient frontier and the utility
curve with the highest possible utility.
THE EFFICIENT FRONTIER AND INVESTOR UTILITY
