Chapter 8

Charles P. Jones, Investments: Analysis and Management,

Twelfth Edition, John Wiley & Sons

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 Diversification is key to optimal risk
management
 Asset allocation is most important single

decision
 Using Markowitz Principles

◦ Step 1: Identify optimal risk-return combinations

using the Markowitz efficient frontier analysis
 Estimate expected returns, variances and
covariances
◦ Step 2: Choose the final portfolio based on your
preferences for return relative to risk

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 Optimal diversification takes into account all
available information
 Assumptions in portfolio theory

◦ A single investment period (one year)

◦ Liquid position (no transaction costs)
◦ Preferences based only on a portfolio’s expected
return and risk

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 Smallest portfolio risk for a given level of
expected return
 Or largest expected return for a given level of

portfolio risk
 From the set of all possible portfolios

◦ Only locate and analyze the subset known as the

efficient set

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  Efficient frontier or
Efficient set (curved
line from A to B)
B  Global minimum
x
variance portfolio
E(R) (represented by
A point A)
y
 Portfolios on AB
C dominate those on
Risk =  AC

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 Portfolio weights are only variable that can
change in Markowitz analysis
 Assume investors are risk averse
 Indifference curves help select from efficient

set
◦ Description of preferences for risk and return
◦ Portfolio combinations which are equally desirable
◦ Match investor preferences with portfolio
possibilities

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 International diversification unlikely to offer
as much risk reduction as it has in the past
 Markowitz portfolio selection model

◦ Assumes investors use only risk and return to

decide
◦ Generates a set of equally “good” portfolios
◦ Does not address the issues of borrowed money or
risk-free assets
◦ Cumbersome to apply

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 Another way to use Markowitz model is with
asset classes
◦ Allocation of portfolio assets to asset types
 Asset class rather than individual security decisions
likely most important for investors
◦ Can be used when investing internationally
◦ Different asset classes offers various returns and
levels of risk
 Correlation coefficients may be quite low

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 Includes two dimensions
◦ Diversifying between asset classes
◦ Diversifying within asset classes
 Asset classes include
◦ International equities
◦ Bonds
◦ Treasury Inflation-Indexed Securities (TIPS)
◦ Real estate
◦ Gold
◦ Commodities

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 Correlation among asset classes must be
considered
 Correlations change over time
 For individual investors, allocation depends
on
◦ Time horizon
◦ Risk tolerance
 Diversified asset allocation doesn’t
necessarily provide benefits or guarantee
against loss

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10
 Index Mutual Funds and ETFs
◦ Investors can buy funds covering various asset
classes
 Domestic large-cap stocks, domestic small-cap stocks
 International stocks
 Bond funds
 Life Cycle Analysis
◦ Varies asset allocation based on age of investor
◦ Life-cycle funds (target-date funds) hold various
asset classes and the allocation changes as investor
ages
 No one “correct” approach to allocation

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11
Impact of Diversification on Risk
 Total risk = systematic (nondiversifiable) risk
+ nonsystematic (diversifiable) risk
◦ Systematic risk is market risk and common to
virtually all securities
◦ Nonsystematic risk is company-specific risk
 Total risk can go no lower than systematic
risk
 Both risk components can vary over time
 Affects number of securities needed to diversify

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12
p %
Total risk
35
Diversifiable (nonsystematic) risk

20
Nondiversifiable (systematic) risk

0
10 20 30 40 ...... 100+
Number of securities in portfolio
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