Risk & Return: Concept of Risk, Component

& Measurement of Risk

So far our analysis of risk-return was confined to single assets held in isolation. In real world, we
rarely find investors putting their entire wealth into single asset or investment. Instead they build
portfolio of investments and hence risk-return analysis is extended in context of portfolio.

A portfolio is composed of two or more securities. Each portfolio has risk-return characteristics
of its own. A portfolio comprising securities that yield a maximum return for given level of risk
or minimum risk for given level of return is termed as ‘efficient portfolio’. In their Endeavour to
strike a golden mean between risk and return the traditional portfolio managers diversified funds
over securities of large number of companies of different industry groups.

However, this was done on intuitive basis with no knowledge of the magnitude of risk reduction
gained. Since the 1950s, however, a systematic body of knowledge has been built up which
quantifies the expected return and riskiness of the portfolio. These studies have collectively come
to be known as ‘portfolio theory’.

A portfolio theory provides a normative approach to investors to make decisions to invest their
wealth in assets or securities under risk. The theory is based on the assumption that investors are
risk averse. Portfolio theory originally developed by Harry Markowitz states that portfolio risk,
unlike portfolio return, is more than a simple aggregation of the risk, unlike portfolio return, is
more than a simple aggregation of the risks of individual assets.

This is dependent upon the interplay between the returns on assets comprising the portfolio.
Another assumption of the portfolio theory is that the returns of assets are normally distributed
which means that the mean (expected value) and variance analysis is the foundation of the
portfolio.

I. Portfolio Return:

The expected return of a portfolio represents weighted average of the expected returns on the
securities comprising that portfolio with weights being the proportion of total funds invested in
each security (the total of weights must be 100).

The following formula can be used to determine expected return of a portfolio:

Applying formula (5.5) to possible returns for two securities with funds equally invested in
a portfolio, we can find the expected return of the portfolio as below:

II. Portfolio Risk:

Unlike the expected return on a portfolio which is simply the weighted average of the expected
returns on the individual assets in the portfolio, the portfolio risk, σp is not the simple, weighted
average of the standard deviations of the individual assets in the portfolios.

It is for this fact that consideration of a weighted average of individual security deviations
amounts to ignoring the relationship, or covariance that exists between the returns on securities.
In fact, the overall risk of the portfolio includes the interactive risk of asset in relation to the
others, measured by the covariance of returns. Covariance is a statistical measure of the degree to
which two variables (securities’ returns) move together. Thus, covariance depends on the
correlation between returns on the securities in the portfolio.

Covariance between two securities is calculated as below:

1. Find the expected returns on securities.

2. Find the deviation of possible returns from the expected return for each security
3. Find the sum of the product of each deviation of returns of two securities and respective
probability.

The formula for determining the covariance of returns of two securities is:
Let us explain the computation of covariance of returns on two securities with the help of
the following illustration:

So far as the nature of relationship between the returns of securities A and B is concerned, there
may be three possibilities, viz., positive covariance, negative covariance and zero covariance.
Positive covariance shows that on an average the two variables move together.

A’s and B’s returns could be above their average returns at the same time or they could be below
their average returns at the same time. This signifies that as the proportion of high return and
high risk assets is increased, higher returns on portfolio come with higher risk.

Negative covariance suggests that, on an average, the two variables move in opposite direction.
It means A’s returns could be above its average returns while B’s return could be below its
average returns and vice-versa. This implies that it is possible to combine the two securities A
and B in a manner that will eliminate all risk.

Zero covariance means that the two variables do not move together either in positive or negative
direction. In other words, returns on the two securities are not related at all. Such situation does
not exist in real world. Covariance may be non-zero due to randomness and negative and positive
terms may not cancel each other.

In the above example, covariance between returns on A and B is negative i.e., -38.6. This
suggests that the two returns are negatively related.

The above discussion leads us to conclude that the riskiness of a portfolio depends much more on
the paired security covariance than on the riskiness (standard deviations) of the separate security
holdings. This means that a combination of individually risky securities could still comprise a
moderate-to-low-risk portfolio as long as securities do not move in lock step with each other. In
brief, low covariance’s lead to low portfolio risk.

III. Diversification:
Diversification is venerable rule of investment which suggests “Don’t put all your eggs in one
basket”, spreading risk across a number of securities.

Diversification may take the form of unit, industry, maturity, geography, type of security and
management. Through diversification of investments, an investor can reduce investment risks.

Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different securities is more
diversified than if the same amount is deployed evenly across 7 securities. This sort of security
diversification is naive in the sense that it does not factor in the covariance between security
returns.

The portfolio comprising 20 securities could represent stocks of one industry only and have
returns which are positively correlated and high portfolio returns variability. On the other hand,
the 7-stock portfolio might represent a number of different industries where returns might show
low correlation and, hence, low portfolio returns variability.

Meaningful diversification is one which involves holding of stocks of more than one industry so
that risks of losses occurring in one industry are counterbalanced by gains from the other
industry. Investing in global financial markets can achieve greater diversification than investing
in securities from a single country. This is for the fact that the economic cycles of different
countries hardly synchronize and as such a weak economy in one country may be offset by a
strong economy in another.

Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that the returns
overtime for Security X are cyclical in that they move in tandem with the economic fluctuations.
In case of Security Y returns are moderately counter cyclical. Thus, the returns for these two
securities are negatively correlated.

If equal amounts are invested in both securities, the dispersion of returns, up, on the portfolio of
investments will be less because some of each individual security’s variability is offsetting.
Thus, the gains of diversification of investment portfolio, in the form of risk minimization, can
be derived if the securities are not perfectly and positively correlated.

IV. Systematic and Unsystematic Risk:

Thus, the variance of returns on a portfolio moving in inverse direction can minimize portfolio
risk. However, it is not possible to reduce portfolio risk to zero by increasing the number of
securities in the portfolio. According to the research studies, when we begin with a single stock,
the risk of the portfolio is the standard deviation of that one stock.

As the number of securities selected randomly held in the portfolio increase, the total risk of the
portfolio is reduced, though at a decreasing rate. Thus, degree of portfolio risk can be reduced to
a large extent with a relatively moderate amount of diversification, say 15-20 randomly selected
securities in equal-rupee amounts.

Portfolio risk comprises systematic risk and unsystematic risk. Systematic risk is also known as
non- diversifiable risk which arises because of the forces that affect the overall market, such, as
changes in the nation’s economy, fiscal policy of the Government, monetary policy of the
Central bank, change in the world energy situation etc.

Such types of risks affect securities overall and hence, cannot be diversified away. Even if an
investor holds well diversified portfolio, he is exposed to this type of risk which is affecting the
overall market. This is why, non-diversifiable or unsystematic risk is also termed as market risk
which remains after diversification.

Another risk component is unsystematic risk. It is also known as diversifiable risk caused by
such random events as law suits, strikes, successful and unsuccessful marketing programmes,
winning or losing a major contract and other events that are unique to a particular firm.

Unsystematic risk can be eliminated through diversification because these events are random,
their effects on individual securities in a portfolio cancel out each other. Thus, not all of the risks
involved in holding a security are relevant because part of the risk can be diversified away. What
is relevant for investors is systematic risk which is unavoidable and they would like to be
compensated for bearing it. However, they should not expect the market to provide any extra
compensation for bearing the avoidable risk, as is contended in the Capital Asset Pricing Model.

Figure 5.3 displays two components of portfolio risk and their relationship to portfolio size.

Covariance
Covariance is a measure of the directional relationship between the returns on two risky assets.
A positive covariance means that asset returns move together while a negative covariance means
returns move inversely. Covariance is calculated by analyzing at-return surprises (standard
deviations from expected return) or by multiplying the correlation between the two variables by
the standard deviation of each variable.

Covariance evaluates how the mean values of two variables move together. If stock A’s return
moves higher whenever stock B’s return moves higher and the same relationship is found when
each stock’s return decreases, then these stocks are said to have a positive covariance. In finance,
covariances are calculated to help diversify security holdings.

When an analyst has a set of data, a pair of x and y values, covariance can be calculated using
five variables from that data. They are:

xi = a given x value in the data set

xm = the mean, or average, of the x values

yi = the y value in the data set that corresponds with xi

ym = the mean, or average, of the y values

n = the number of data points

Given this information, the formula for covariance is: Cov(x,y) = SUM [(xi – xm) * (yi – ym)] /
(n – 1)

It’s important to note that while the covariance does measure the directional relationship between
two assets, it does not show the strength of the relationship between the two assets. The
coefficient of correlation is a more appropriate indicator of this strength.

Covariance Applications

Covariances have significant applications in finance and modern portfolio theory. For example,
in the capital asset pricing model (CAPM), which is used to calculate the expected return of an
asset, the covariance between a security and the market is used in the formula for one of the
model’s key variables, beta. In the CAPM, beta measures the volatility, or systematic risk, of a
security in comparison to the market as a whole; it’s a practical measure that draws from the
covariance to gauge an investor’s risk exposure specific to one security.

Meanwhile, portfolio theory uses covariances to statistically reduce the overall risk of a portfolio
by protecting against volatility through covariance-informed diversification. Possessing financial
assets with returns that have similar covariances does not provide very much diversification;
therefore, a diversified portfolio would likely contain a mix of financial assets that have varying
covariance

Correlation Coefficient, Assumptions of

Correlation Coefficient

Correlation coefficient is a statistical measure that calculates the strength of the relationship
between the relative movements of the two variables. The range of values for the correlation
coefficient bounded by 1.0 on an absolute value basis or between -1.0 to 1.0. If the correlation
coefficient is greater than 1.0 or less than -1.0, the correlation measurement is incorrect. A
correlation of -1.0 shows a perfect negative correlation, while a correlation of 1.0 shows a perfect
positive correlation. A correlation of 0.0 shows zero or no relationship between the movements
of the two variables.

While the correlation coefficient measures a degree of relation between two variables, it only
measures the linear relationship between the variables. The correlation coefficient cannot capture
nonlinear relationships between two variables.

A value of exactly 1.0 means there is a perfect positive relationship between the two variables.
For a positive increase in one variable, there is also a positive increase in the second variable. A
value of -1.0 means there is a perfect negative relationship between the two variables. This
shows the variables move in opposite directions — for a positive increase in one variable, there
is a decrease in the second variable. If the correlation is 0, there is no relationship between the
two variables.

The strength of the relationship varies in degree based on the value of the correlation coefficient.
For example, a value of 0.2 shows there is a positive relationship between the two variables, but
it is weak and likely insignificant. Experts do not consider correlations significant until the value
surpasses at least 0.8. However, a correlation coefficient with an absolute value of 0.9 or greater
would represent a very strong relationship.

This statistic is useful in finance. For example, it can be helpful in determining how well a
mutual fund performs relative to its benchmark index, or another fund or asset class. By adding a
low or negatively correlated mutual fund to an existing portfolio, the investor gains
diversification benefits.

Correlation Coefficient Formulas

One of the most commonly used formulas in stats is Pearson’s correlation coefficient formula. If
you’re taking a basic stats class, this is the one you’ll probably use:
 Where,

r = Pearson correlation coefficient

x = Values in first set of data
y = Values in second set of data
n = Total number of values.

Assumptions of Correlation Coefficient:

 Linearity:

The primary assumption of Pearson’s correlation is that the relationship between the two
variables is linear. This means that the best-fit line through the data points (the regression line)
adequately describes the relationship. Non-linear relationships (where changes in one variable do
not correspond to proportional changes in the other) may not be accurately captured by Pearson’s
correlation.

 Bivariate Normality:

Both variables should be normally distributed, and the joint distribution of the variables should
be bivariate normal. This assumption ensures that the correlation is measuring a true linear
relationship and not being influenced by outliers or a skewed distribution of variables.

 Homoscedasticity:

The scatterplot of the two variables should show a consistent spread of data points around the
regression line throughout the range of values. In other words, the variance of one variable is the
same at all values of the other variable. Heteroscedasticity, where the spread of data points varies
along the range of data, can distort the correlation coefficient.

 Independence of Observations:
The observations (data points) should be independent of each other. There should be no hidden
relationship among observations that could influence the variables being studied. For instance,
measurements from the same subject or related subjects may violate this assumption.

 Interval or Ratio-Level Data:

Pearson’s correlation assumes that the variables are measured on an interval or ratio scale, where
the intervals between measurements are equally meaningful. Correlation calculations on ordinal
data or data that do not meet these measurement criteria may not be valid.

 No Outliers:

Outliers can have a disproportionate effect on the correlation coefficient, potentially

exaggerating or diminishing the perceived strength of a relationship. The analysis should either
exclude outliers or use a robust method of correlation that can handle outliers.

Measurement of systematic Risk

Systematic risk can be measured using beta. Stock Beta is the measure of the risk of an
individual stock in comparison to the market as a whole. Beta is the sensitivity of a stock’s
returns to some market index returns (e.g., S&P 500). Basically, it measures the volatility of a
stock against a broader or more general market.

It is a commonly used indicator by financial and investment analysts. The Capital Asset Pricing
Model (CAPM) also uses the Beta by defining the relationship of the expected rate of return as a
function of the risk free interest rate, the investment’s Beta, and the expected market risk
premium.

Beta is calculated using correlation or regression analysis.

Using the correlation method, beta can be calculated from the historical data of returns by
the following formula:

Where,

rim = Correlation coefficient between the returns of stock i and the returns of the market index

σi= Standard deviation of returns of stock i

σm = Standard deviation of returns of the market index

σ2m = variance of the market returns

Using the regression analysis, beta can be calculated from the historical data of returns by
the following formula:

Y = α + βX

Where,

Y = Dependent variable

X = Independent variable

α and β are constants.

The above regression equation can also be written as follows:

Ri = α +βi Rm

Where,

Ri = Return of the individual security

Rm = Return of the market index

Βi = Beta (Systematic Risk) of individual security

α= Estimated return of security when market is stationary

The formula for calculation of CC and β are as follows:

Where,

n = number of items

X = Independent variable scores (returns of the market index)

Y = Dependent Variable scores (returns of individual security)

Interpretation of Beta:

1. A beta of 1 indicates that the security’s price will move with the market.
2. A beta of less than 1 means that the security will be less volatile than the market.
3. A beta of greater than 1 indicates that the security’s price will be more volatile than the market.

For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market. The
Beta of the general and broader market portfolio is always assumed to be 1.

Fundamental Analysis: Economic, Industry,

Company Analysis

In security selection process, a traditional approach of Economic Industry Company analysis is

employed. EIC analysis is the abbreviation of economic, industry and company. The person
conducting EIC analysis examines the conditions in the entire economy and then ascertains the
most attractive industries in the light of the economic conditions. At last the most attractive
companies within the attractive industries are pointed out by the analyst.

EIC Analysis of a Company

Below are the further details of the components of EIC analysis, which analyst always consider
before choosing or reaching any decision about any business.

 Economic Analysis
 Industry Analysis
 Company Analysis

Economic Analysis:

Every common stock is susceptible to the market risk. This feature of almost all types of
common stock indicates their combined movement with the fluctuations in the economic
conditions towards the improvement or deterioration.

Stock prices react favorably to the low inflation, earnings growth, a better balance of trade,
increasing gross national product and other positive macroeconomic news. Indications that
unemployment is rising, inflation is picking up or earnings estimates are being revised downward
will negatively affect the stock prices. This relationship is reasonably reliable that the US
economy is better represented by the Standard & Poor 500 stock index, which is famous market
indicator. The stock market will forecast an economic boom or recession properly from the signs
in front of average citizen. The Federal bank of New York has conducted a research that
describes that the slope of the yield curve is the perfect indicator of the economic growth more
than three months out. Recession is indicated by negative slope while positive slope is
considered as good one.

The implications of market risk should be clear to the investor. When there is recession in the
economy, the prices of stocks moves downward. All the companies suffer the effects of recession
despite of the fact that these are high performing companies or low performing ones. Similarly
the stock prices are positively affected by the boom period of the economy.

Industry Analysis:

It is clear there is certain level of market risk faced by every stock and the stock price decline
during recession in the economy. Another point to be remembered is that the defensive kind of
stock is affected less by the recession as compared to the cyclical category of stock. In the
industry analysis, such industries are highlighted that can stand well in front of adverse economic
conditions.

In 1980, Michael Porter proposed a standard approach to industry analysis which is referred to as
competitive analysis frame work. Threats of new entrants evaluate the expected reaction of
current competitors to new competitors and obstacles to entry into the industry. In certain
industries it is quite difficult for new company to compete successfully.

For example new producers in the automobile industry face difficulty in competing the
established companies, like General Motors and Ford etc. There are certain other industries
where the entry of new company is easier like financial planning industry. No extraordinary
efforts are required in such kind of industries to establish any new company. The growth in the
industry is slowed down through the rivalry among the current competitors. Profits of the
company are reduced when it tries to cover more market share because under existing rivalry the
company has to invest a large portion of its earnings in this enhancing market share. The industry
where the rivalry is friendly or modest among competitors provides greater opportunity for
product differentiation & increased profits. The intense competition is favorable for the customer
but not good for the producer of the product. In case of airline industry there are common fare
price wars among the competitors. When one airline company reduces its price then the other
must also adjust its price accordingly in order to retain the existing customers.

Another threat faced by company in industry is the treat of substitutes which prevents the
companies to enhance the price of their products. When there is much increase in the price of
particular product, then the consumer simply switches to other alternative product which has
lower price. For example there are two different video games named Sega and Nintendo. These
games competes each other directly in the market. If the price of Nintendo is enhanced then the
new video game customers are switch toward the Sage which has relatively lower price. The
investor conducting industry analysis should focus the level of risk of product substitution which
seriously affects the future growth of company.

Another aspect of the industry analysis is the bargaining power of buyers which can greatly
influence the large percentage of sales of seller. In this condition the profit margins are lower.
Concessions are necessary to be offered by the seller because it is not affordable for him to lose
customer. For example there is ship building company and the US Navy is its main customer.
Only two to three ships are produced by the company every year and so it is very harmful for the
firm to lose the Navy contract. On the other hand in case of departmental store, there is large
number of customers and so the bargaining power of customers is low. In this business, losing
one or two customers will not much affect the sales or profitability of the retail store.

The only capital intensive industry should not be focused. There are other industries that are not
capital intensive like consultants required in retail computer store. There is need that is present
which force the computer technician to solve the problems of the computer systems of people. In
recent year, consumers are usually more sophisticated in area of personal computers. So they are
better guided and they try to make their own decisions in the needs of software and hardware
aspects. In fact they possess high power when they contact the sales staff.

The bargaining power of suppliers has also substantial influence over the profitability of the
company. The supplies for manufacturing products are required by the company and it does not
have sufficient control over the costs. It is not possible for the company to increase the price of
its finished products in order to cover the increased costs due to the presence of powerful buyer
groups in market of substitute products. So while conducing industry analysis, the presence of
powerful suppliers should be considered as negative for the company.

The above considerations of industry structure should be analyzed by the investor in order to
make an estimate about the future trends of the industry in the light of the economic conditions.
When potential industry is identified then comes the final step of EIC analysis which is narrower
relating to companies only.

Company Analysis:

In company analysis different companies are considered and evaluated from the selected industry
so that most attractive company can be identified. Company analysis is also referred to as
security analysis in which stock picking activity is done. Different analysts have different
approaches of conducting company analysis like

 Value Approach to Investing

 Growth Approach to Investing

Additionally in company analysis, the financial ratios of the companies are analyzed in order to
ascertain the category of stock as value stock or growth stock. These ratios include price to book
ratio and price-earnings ratio. Other ratios like return on equity etc. can also be analyzed to
ascertain the potential company for making investment.

Portfolio Risk and Return

Portfolio Risk and Return are fundamental concepts in investment management, driving the
decision-making process for constructing and managing a portfolio. Understanding these
concepts helps investors assess the potential rewards and dangers associated with their
investment strategies. The goal is to achieve the best possible returns while managing and
minimizing the risks.

Portfolio Return:

Portfolio return refers to the overall gain or loss generated by the portfolio over a specific period.
It is typically expressed as a percentage and can be calculated on a daily, monthly, or annual
basis. The return on a portfolio is derived from two primary sources: capital appreciation (or
depreciation) and income (dividends, interest).

Calculation of Portfolio Return:

The return of a portfolio is calculated as the weighted average of the returns of the individual
assets within the portfolio. The formula is:

Rp = ∑ (wi × Ri)

Where:

 Rp = Portfolio return
 wi = Weight of the individual asset in the portfolio (i.e., the proportion of total
investment in that asset)
 Ri = Return of the individual asset

This formula shows that the portfolio return depends on both the returns of the individual assets
and the proportion of the portfolio invested in each asset.

Expected Return:

The expected return is the anticipated return on a portfolio based on the historical performance of
the assets or their expected future performance. Investors use it to gauge potential profitability.

E(Rp) = ∑(wi × E(Ri))

Where E(Ri)) is the expected return of asset i.

Portfolio Risk

Portfolio risk refers to the uncertainty or variability of returns associated with the portfolio. It
reflects the potential for the actual return to deviate from the expected return. Unlike individual
asset risk, which can be mitigated through diversification, portfolio risk considers how the
various assets interact with each other.

Types of Portfolio Risk:

 1. Systematic Risk:

This is the risk inherent to the entire market or market segment. It is also known as market risk
and cannot be eliminated through diversification. Examples include risks due to economic
downturns, interest rate changes, inflation, and political instability.

Systematic risk is often measured by beta (β\betaβ), which indicates how sensitive a portfolio is
to market movements. A portfolio with a beta greater than 1 is more volatile than the market,
while a beta less than 1 is less volatile.

2. Unsystematic Risk:

Also known as specific risk, this type of risk is associated with individual assets or a specific
company. It includes risks such as poor management, product recalls, or competitive pressures.

Unsystematic risk can be reduced or even eliminated through diversification—by holding a

variety of assets that are not correlated with each other.

Measurement of Portfolio Risk:

1. Variance and Standard Deviation:

The most common measures of portfolio risk are variance and standard deviation. Variance
measures the dispersion of returns around the mean, and standard deviation is the square root of
variance. A higher standard deviation indicates greater risk or volatility.

For a Portfolio, the Variance is calculated as:

 2. Covariance and Correlation:

Covariance measures how two assets move together. A positive covariance means that the assets
tend to move in the same direction, while a negative covariance means they move in opposite
directions.

Correlation is a standardized measure of covariance, ranging between -1 and +1. A correlation of

+1 indicates perfect positive correlation, 0 indicates no correlation, and -1 indicates perfect
negative correlation.

Diversifying a portfolio by selecting assets with low or negative correlations can reduce overall
portfolio risk.

3. Beta (β):

Beta measures a portfolio’s sensitivity to market movements. A portfolio with a beta of 1 moves
in line with the market, while a beta greater than 1 indicates higher sensitivity to market
movements.

Risk-Return Tradeoff

The risk-return tradeoff is a fundamental principle in investing that suggests the potential return
rises with an increase in risk. Investors must balance the desire for higher returns with their
tolerance for risk. Generally, higher returns are associated with higher levels of risk, and lower-
risk investments typically offer lower potential returns.

Efficient Frontier

In Modern Portfolio Theory (MPT), the efficient frontier represents the set of optimal portfolios
that offer the highest expected return for a given level of risk. Portfolios on the efficient frontier
are considered efficient because no additional return can be obtained without increasing risk.

Concept of Beta, Classification of Beta-

Geared and Ungeared Beta

The beta (β) of an investment security (i.e. a stock) is a measurement of its volatility of returns
relative to the entire market. It is used as a measure of risk and is an integral part of the Capital
Asset Pricing Model (CAPM). A company with a higher beta has greater risk and also greater
expected returns.

The beta coefficient can be interpreted as follows:

  β =1 exactly as volatile as the market
 β >1 more volatile than the market
 β <1>0 less volatile than the market
 β =0 uncorrelated to the market
 β <0 negatively correlated to the market

Examples of beta

High β: A company with a β that’s greater than 1 is more volatile than the market. For example,
a high-risk technology company with a β of 1.75 would have returned 175% of what the market
return in a given period (typically measured weekly).

Low β: A company with a β that’s lower than 1 is less volatile than the whole market. As an
example, consider an electric utility company with a β of 0.45, which would have returned only
45% of what the market returned in a given period.

Negative β: A company with a negative β is negatively correlated to the returns of the market.
For an example, a gold company with a β of -0.2, which would have returned -2% when the
market was up 10%.

Equity Beta and Asset Beta

Levered beta, also known as equity beta or stock beta, is the volatility of returns for a stock
taking into account the impact of the company’s leverage from its capital structure. It compares
the volatility (risk) of a levered company to the risk of the market.

Levered beta includes both business risk and the risk that comes from taking on debt. It is also
commonly referred to as “equity beta” because it is the volatility of an equity based on its capital
structure.

Asset beta, or unlevered beta, on the other hand, only shows the risk of an unlevered company
relative to the market. It includes business risk but does not include leverage risk.

Portfolio Theories: Markowitz Model

Harry M. Markowitz is credited with introducing new concepts of risk measurement and their
application to the selection of portfolios. He started with the idea of risk aversion of average
investors and their desire to maximise the expected return with the least risk.

Markowitz model is thus a theoretical framework for analysis of risk and return and their inter-
relationships. He used the statistical analysis for measurement of risk and mathematical
programming for selection of assets in a portfolio in an efficient manner. His framework led to
the concept of efficient portfolios. An efficient portfolio is expected to yield the highest return
for a given level of risk or lowest risk for a given level of return.

Markowitz generated a number of portfolios within a given amount of money or wealth and
given preferences of investors for risk and return. Individuals vary widely in their risk tolerance
and asset preferences. Their means, expenditures and investment requirements vary from
individual to individual. Given the preferences, the portfolio selection is not a simple choice of
any one security or securities, but a right combination of securities.

Markowitz emphasized that quality of a portfolio will be different from the quality of individual
assets within it. Thus, the combined risk of two assets taken separately is not the same risk of
two assets together. Thus, two securities of TISCO do not have the same risk as one security of
TISCO and one of Reliance.

Risk and Reward are two aspects of investment considered by investors. The expected return
may vary depending on the assumptions. Risk index is measured by the variance of the
distribution around the mean, its range etc., which are in statistical terms called variance and
covariance. The qualification of risk and the need for optimisation of return with lowest risk are
the contributions of Markowitz. This led to what is called the Modern Portfolio Theory, which
emphasizes the tradeoff between risk and return. If the investor wants a higher return, he has to
take higher risk. But he prefers a high return but a low risk and hence the problem of a tradeoff.

A portfolio of assets involves the selection of securities. A combination of assets or securities is

called a portfolio. Each individual investor puts his wealth in a combination of assets depending
on his wealth, income and his preferences. The traditional theory of portfolio postulates that
selection of assets should be based on lowest risk, as measured by its standard deviation from the
mean of expected returns. The greater the variability of returns, the greater is the risk.

Thus, the investor chooses assets with the lowest variability of returns. Taking the return as the
appreciation in the share price, if TELCO shares price varies from Rs. 338 to Rs. 580 (with
variability of 72%) and Colgate from Rs. 218 to Rs. 315 (with a variability of 44%) during 1998,
the investor chooses the Colgate as a less risky share.

As against this Traditional Theory that standard deviation measures the variability of return and
risk is indicated by the variability, and that the choice depends on the securities with lower
variability, the modern Portfolio Theory emphasizes the need for maximization of returns
through a combination of securities, whose total variability is lower.

The risk of each security is different from that of others and by a proper combination of
securities, called diversification one can arrive at a combination wherein the risk of one is offset
partly or fully by that of the other. In other words, the variability of each security and covariance
for their returns reflected through their inter-relationships should be taken into account.

Thus, as per the Modern Portfolio Theory, expected returns, the variance of these returns and
covariance of the returns of the securities within the portfolio are to be considered for the choice
of a portfolio. A portfolio is said to be efficient, if it is expected to yield the highest return
possible for the lowest risk or a given level of risk.

A set of efficient portfolios can be generated by using the above process of combining various
securities whose combined risk is lowest for a given level of return for the same amount of
investment, that the investor is capable of. The theory of Markowitz, as stated above is based on
a number of assumptions.

Assumptions of Markowitz Theory:

The Portfolio Theory of Markowitz is based on the following assumptions:

(1) Investors are rational and behave in a manner as to maximise their utility with a given level
of income or money.

(2) Investors have free access to fair and correct information on the returns and risk.

(3) The markets are efficient and absorb the information quickly and perfectly.

(4) Investors are risk averse and try to minimise the risk and maximise return.

(5) Investors base decisions on expected returns and variance or standard deviation of these
returns from the mean.

(6) Investors choose higher returns to lower returns for a given level of risk.

A portfolio of assets under the above assumptions is considered efficient if no other asset or
portfolio of assets offers a higher expected return with the same or lower risk or lower risk with
the same or higher expected return. Diversification of securities is one method by which the
above objectives can be secured. The unsystematic and company related risk can be reduced by
diversification into various securities and assets whose variability is different and offsetting or
put in different words which are negatively correlated or not correlated at all.

Diversification of Markowitz Theory:

Markowitz postulated that diversification should not only aim at reducing the risk of a security
by reducing its variability or standard deviation, but by reducing the covariance or interactive
risk of two or more securities in a portfolio. As by combination of different securities, it is
theoretically possible to have a range of risk varying from zero to infinity.

Markowitz theory of portfolio diversification attaches importance to standard deviation, to

reduce it to zero, if possible, covariance to have as much as possible negative interactive effect
among the securities within the portfolio and coefficient of correlation to have – 1 (negative) so
that the overall risk of the portfolio as a whole is nil or negligible.

Parameters of Markowitz Diversification:

Based on his research, Markowitz has set out guidelines for diversification on the basis of the
attitude of investors towards risk and return and on a proper quantification of risk. The
investments have different types of risk characteristics, some called systematic and market
related risks and the other called unsystematic or company related risks. Markowitz
diversification involves a proper number of securities, not too few or not too many which have
no correlation or negative correlation. The proper choice of companies, securities, or assets
whose return are not correlated and whose risks are mutually offsetting to reduce the overall risk.

For building up the efficient set of portfolio, as laid down by Markowitz, we need to look
into these important parameters:

(1) Expected return.

(2) Variability of returns as measured by standard deviation from the mean.

(3) Covariance or variance of one asset return to other asset returns.

In general the higher the expected return, the lower is the standard deviation or variance and
lower is the correlation the better will be the security for investor choice. Whatever is the risk of
the individual securities in isolation, the total risk of the portfolio of all securities may be lower,
if the covariance of their returns is negative or negligible.

Limitations of Markowitz model:

1. Large number of input data required for calculations: An investor must obtain
estimates of return and variance of returns for all securities as also covariances of returns
for each pair of securities included in the portfolio. If there are N securities in the
portfolio, he would need N return estimates, N variance estimates and N (N-1) / 2
covariance estimates, resulting in a total of 2N + [N (N-1) / 2] estimates. For example,
analysing a set of 200 securities would require 200 return estimates, 200 variance
estimates and

19,900 covariance estimates, adding upto a total of 20,300 estimates. For a set of 500 securities,
the estimates would be 1,25,750. Thus, the number of estimates required becomes large because
covariances between each pair of securities have to be estimated.

2. Complexity of computations required: The computations required are numerous and

complex in nature. With a given set of securities infinite number of portfolios can be
constructed. The expected returns and variances of returns for each possible portfolio
have to be computed. The identification of efficient portfolios requires the use of
quadratic programming which is a complex procedure.

3. Single Index Model

4. To simplify analysis, the single-index model assumes that there is only 1
macroeconomic factor that causes the systematic risk affecting all stock returns and this
factor can be represented by the rate of return on a market index, such as the S&P 500.
According to this model, the return of any stock can be decomposed into the expected
excess return of the individual stock due to firm-specific factors, commonly denoted by
its alpha coefficient (α), which is the return that exceeds the risk-free rate, the return due
to macroeconomic events that affect the market, and the unexpected microeconomic
events that affect only the firm. Specifically, the return of stock i is:
5. ri = αi + βirm + ei
6. The term βirm represents the stock’s return due to the movement of the market modified
by the stock’s beta (βi), while ei represents the unsystematic risk of the security due to
firm-specific factors.
7. Macroeconomic events, such as interest rates or the cost of labor, causes the systematic
risk that affects the returns of all stocks, and the firm-specific events are
the unexpected microeconomics events that affect the returns of specific firms, such as
the death of key people or the lowering of the firm’s credit rating, that would affect the
firm, but would have a negligible effect on the economy. The unsystematic risk due to
firm-specific factors of a portfolio can be reduced to zero by diversification.
8. The index model is based on the following:
9. Most stocks have a positive covariance because they all respond similarly to
macroeconomic factors.
10. However, some firms are more sensitive to these factors than others, and this firm-
specific variance is typically denoted by its beta (β), which measures its variance
compared to the market for one or more economic factors.
11. Covariances among securities result from differing responses to macroeconomic factors.
Hence, the covariance (σ2) of each stock can be found by multiplying their betas by the
market variance:
12. Cov(Ri, Rk) = βiβkσ2
13. This last equation greatly reduces the computations, since it eliminates the need to
calculate the covariance of the securities within a portfolio using historical returns and
the covariance of each possible pair of securities in the portfolio. With this equation, only
the betas of the individual securities and the market variance need to be estimated to
calculate covariance. Hence, the index model greatly reduces the number of calculations
that would otherwise have to be made for a large portfolio of thousands of securities.