PORTFOLIO CONSTRUCTION & SELECTION
INTRODUCTION TO THE CONCEPTS OF OPTIMAL RISKY AND
OVERALL OPTIMAL PORTFOLIO
The Benefits of Diversification
DR. A.K MISHRA
IIM LUCKNOW
SESSION PLAN
INTRODUCTION
PORTFOLIO MANAGEMENT – STEPS
THEORIES – TRADITIONAL, MODERN
MARKOVITZ MEAN VARIANCE THEORY
PORTFOLIO EXPECTED RETURN – ONE & TWO ASSET CASE
RELATIONSHIP BETWEEN DIVERSIFICATION & RISK
PORTFOLIO RISK & MEASUREMENT – TWO ASSET CASE
EXPECTED RETURN , DEVIATION, COVARIANCE, COVARIANCE
CALCULATION MATRIX, PORTFOLIO VARIANCE
PORTFOLIO RISK RETURN ANALYSIS
INTRODUCTION
A portfolio is a bundle or a combination of individual
3 assets or securities.
Portfolio theory provides a normative approach to
investors to make decisions to invest their wealth in
assets or securities under risk
Portfolio theory can be extended to derive a
framework for valuing risky assets. This framework is
referred to as the capital asset pricing model (CAPM).
An alternative model for the valuation of risky assets
is the arbitrage pricing theory (APT).
The return of a portfolio is equal to the weighted
average of the returns of individual assets (or
PORTFOLIO MANAGEMENT- STEPS
Constructing all possible portfolios of risky assets, offering
highest return for a given level of risk or lowest risk for a
given level of return (risk-aversion);
Selecting ‘Optimal Risky Portfolio’ from all possible
portfolios of risky securities;
Capital Allocation, i.e., to allocate capital amongst different
asset classes (say, between equity and risk-free assets)
tailored to the risk appetite of investor.
Maintaining & rebalancing/ churning the portfolio;
Review of the performance;
THEORIES FOR
PORTFOLIO CONSTRUCTION AND SELECTION
Traditional Portfolio Theory;
do not put all the eggs in one basket
Modern Portfolio Theory;
PORTFOLIO CONSTRUCTION AND SELECTION
TRADITIONAL PORTFOLIO THEORY
Popularised concept of diversification, builds on the
notion that ‘do not put all the eggs in one basket’;
Argues that a portfolio should be constructed by
combining unrelated or least related securities;
Advocates that the securities should be picked up
from different unrelated/ less correlated industries
to reduce the risk associated with expected returns
from the portfolio;
However, it does not delineate a proper method
(mathematical framework) to pick up such
securities.
PORTFOLIO CONSTRUCTION AND
SELECTION
MODERN PORTFOLIO THEORY (MPT)
The Modern Portfolio Theory (MPT) started with
Harry Markowitz’s work on portfolio construction;
Later, Sharpe developed another approach to
overcome some problems associated with
Markowitz’s theory.
PORTFOLIO CONSTRUCTION AND
SELECTION
MODERN PORTFOLIO THEORY (MPT)
The seminal work of Markowitz and Sharp is widely
recognized as the two popular approaches to
constructing portfolios of risky assets and selecting
the best risky portfolio from them. These approaches
are known as:
Markowitz’s Mean-Variance Optimization
(MVO);
Sharpe’s Single Index Model;
More recent approaches: Re-sampled MVO,
CVaR based MVO (Non-normality), MVO pure
MARKOWITZ’S MEAN VARIANCE FRAMEWORK
Assumes that
Investors make their decision regarding portfolio
selection based on only two parameters, namely,
expected return and risk.
Investors are risk-averse, i.e., they seek
high return in order to take higher amount
of risk.
Try to maximize return for a given level of
risk.
They have homogeneous expectations
MPT & SOME IMPORTANT CONCEPTS
Portfolio Risk and Return (with Diversification);
Constructing different Portfolios using two securities &
multiple (n) securities- Feasibility Set; Supply side of
Portfolio
Construction
Minimum Variance Portfolio;
Zero Variance Portfolio;
Efficient Portfolio & Efficient Frontier;
Optimal Risky Portfolio; Demand side of
Portfolio
Measuring Risk Aversion Level of Investor; Construction
Matching
supply &
Overall Optimal Portfolio; demand
UNDERSTANDING PORTFOLIO RISK
& RETURN
FOR THIS WE NEED TO KNOW
Computation of expected return for individual
assets
One Asset Case
Two or More Asset Case
Computation of expected portfolio return
Diversification with portfolio expected return
Computation of portfolio risk
How diversification influences risk
Measuring Comovements
I. UNDERSTANDING PORTFOLIO
RETURN
FOR THIS WE NEED TO KNOW
Computation of expected return for individual
assets
One Asset Case
Two or More Asset Case
Computation of expected portfolio return
Diversification with portfolio expected return
PORTFOLIO EXPECTED RETURN: ONE-ASSET CASE
Expected rate of return of individual asset is
13
calculated:
Note that is the expected return on asset X, is
return and isStthe
of probability of Areturn.
Probabilit Stock
Economy y Return
Example
1 0.2 15%
2 0.2 -5%
3 0.2 5
4 0.2 35
5 0.2 25
Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) +
0.2(25%)
PORTFOLIO EXPECTED RETURN: TWO-ASSET CASE
14
Expected Portfolio Return (E(RP) is equal to the
weighted average of the returns of individual assets
(or securities) in the portfolio with weights being
equal to the proportion of investment value in each
asset.
In case of 2 asset portfolio, expected rate of return
given by
E(RP) = weight of security X x expected return on security X +
weight of security Y x expected return on security Y…….or
E(RP) =nw x E(Rx) + (1-w) x E(Ry)
Portfolio return Can be changed by
wE(R ) = wi E(R
is Pproportion in investment
i)
depends on in asset
weight X and (1-w) is remaining
changing
(investment proportionate
i=1
investment in asset proportion)
Y of assets investment in each
where
Or E(RP) = expected portfolio return asset
wi = weight assigned to security i
E(Ri) = expected return on security i
n = number of securities in the portfolio
PORTFOLIO EXPECTED RETURN: TWO-ASSET CASE
15
Example
A portfolio consists of four securities with
expected returns of 12%, 15%, 18%, and 20%
respectively.
The proportions of portfolio value invested in
these securities are 0.2, 0.3, 0.3, and 0.20
respectively.
The expected return on the portfolio is:
E(RP) = 0.2(12%) + 0.3(15%) + 0.3(18%) + 0.2(20%)
= 16.3%
DIVERSIFICATION WITH PORTFOLIO EXPECTED
RETURN
You have an opportunity to invest your wealth in either asset X or Y
Possible outcome of 2 assets in different state of economy is as under:
State of Probability Return X Return (Y)
Economy (%) %
A 0.10 -8 14
B 0.20 10 -4
C 0.40 8 6
D 0.20 5 15
E 0.10 4 20
Calculate expected return of X & Y.
Calculate Portfolio Return
Comment on expected return on shift of wealth from X to Y.
Assume you decide 50% of wealth in X & 50% in & Y. What is expected
rate of return on portfolio consisting of both X & Y . How it compares
with expected return of Y once you invest entire wealth in Y
Is probability of negative return eliminated when X & Y are combined
How much would you earn if you invested 20% of your wealth in X &
remaining wealth in Y?
(Workout Q 1 Handout Session 5-6)
DIVERSIFICATION WITH PORTFOLIO EXPECTED RETURN
Expected
return on X
Expected return on Y
E ( R y ) = (14 ´ 0.1) + (- 4 ´ 0.2) + (6 ´ 0.4) + (15´ 0.2)
+ (20´ 0.1) = 8% Expected Return
would be 5% if
Expected Portfolio Return entire wealth
State of Probability Combined Return (%) ExpectedReturn (%) was invested in
Economy X (50%) & Y (50%) X (i.e. w = 1.0)
(1) (2) (3) 4 = (2) x (3)
A 0.10 (-8 x 0.5) + (14 x 0.5) = 3.0 0.10 x 3.0 = = 0.3
B 0.20 (10 x 0.5) + (-4 x 0.5) = 3.0 0.20 x 3.0 = = 0.6
Expected return
C 0.40 (8 x 0.5) + (6 x 0.5) = 7.0 0.40 x 7.0 = = 2.8
would be 8% if
D 0.20 (5 x 0.5) + (15 x 0.5) = 10.0 0.20 x 10.0 = = 2.0 entire wealth
E 0.10 (-4 x 0.5) + (20 x 0.5) = 8.0 0.10 x 8.0 = = 0.8 invested in Y (i.e.,
Expected Return on Portfolio 6.5 1 – w =1 since w =
0)
=(0.5 x 5) + (0.5 x 8) = 6.5%
Expected return
= 0.2 x 5 + (1 – 0.2)x 8 = 7.4% increases as you shift
7.4% return higher wealth from X to Y. Thus,
Equal investment in X & Y than earnings by expected portfolio return
though yields 6.5% lower depends on % of wealth
investing equal amount
than 100% investment in Y invested in each asset in
in X & Y = 6.5% portfolio
for 8% but is safe as Y may
yield negative return of 4% Thus probability of negative returns
under unfav economic eliminated when X & Y are
II. UNDERSTANDING PORTFOLIO RISK
FOR THIS WE NEED TO KNOW
Computation of portfolio risk
How diversification influences risk
Measuring Comovements
PORTFOLIO RISK: TWO ASSET CASE
Risk of individual assets /a portfolio measured by
variance or std. dev of its return.
Risk of portfolio would be less than risk of individual securities,
& risk of a security should be judged by its contribution to
portfolio risk.
Why---?? Although the expected return on a portfolio is the
weighted average of the expected returns on the individual
securities in the portfolio, portfolio risk is not the weighted
average of the risks of the individual securities in the portfolio
n
(except whenE(R
the) returns from the securities are uncorrelated).
= wi E(Ri)
P
In symbols i=1 But p2 wi 2i 2
Thanks to the inequality shown in above Eq., investors can
achieve the benefit of risk reduction through diversification.
DIVERSIFICATION & PORTFOLIO
Diversification and RISK
Portfolio Risk
• WE NEED TO UNDERSAND HOW DIVERSIFICATION INFLUENCES RISK
You want to invest Rs.100,000 equally in two stocks, A and B. The return on
these stocks depends on the state of the economy. Your assessment suggests
that the probability distributions of the returns on stocks A and B are as
shown in Exhibit. For the sake of simplicity, all the five states of the
economy are assumed to be equiprobable. The last column shows the return
on a portfolio consisting of stocks A and B in equal proportions.
Graphically, the returns are shown in NEXT SLIDE.
(Workout Q 2 Handout Session 5-6)
COMPUTE PORTFOLIO RETURN & RISK
Probability Distribution of Returns
State of the Probability Return on Return on Return on
Economy Stock A Stock B Portfolio
1 0.20 15% -5% 5%
2 0.20 -5% 15 5%
3 0.20 5 25 15%
4 0.20 35 5 20%
5 0.20 25 35 30%
DIVERSIFICATION & PORTFOLIO RISK
Returns on Individual Stocks and the
Portfolio
Expected Return and
DIVERSIFICATION Standard Deviati
& PORTFOLIO RISK
Expected Return
Stock A : 0.2(15%) + 0.2(-5%) + 0.2(5%) +0.2(35%) + 0.2(25%) = 15%
Stock B : 0.2(-5%) + 0.2(15%) + 0.2(25%) + 0.2(5%) + 0.2(35%) = 15%
Portfolio of
A and B : 0.2(5%) + 0.2(5%) + 0.2(15%) + 0.2(20%) + 0.2(30%) = 15%
Standard Deviation
Stock A : σ2A = 0.2(15-15)2 + 0.2(-5-15)2 + 0.2(5-15)2 + 0.2(35-15)2 + 0.20
(25-15)2 = 200
σA = (200)1/2 = 14.14%
Stock B : σ 2B = 0.2(-5-15)2 + 0.2(15-15)2 + 0.2(25-15)2 + 0.2(5-15)2 + 0.2
(35-15)2= 200
σB = (200)1/2 = 14.14%
Portfolio : σ2(A+B) = 0.2(5-15)2 + 0.2(5-15)2 + 0.2(15-15)2 + 0.2(20-15)2
+ 0.2(30-15)2 = 90
σA+B = (90) = 9.49%
1/2
If you invest in Stock If you invest in Stock A & B in
A expected return is In technical terms
equal proportion expected diversification reduces
15% & std dev is return remains same as 15%
14.14% risk if returns are not
If you invest in Stock but std dev is 9.49% much perfectly positive
B expected return is lower than each individual correlated
15% & std dev is stock
RELATION BETWEEN DIVERSIFICATION &
PORTFOLIO RISK
Risk
Unique risk of a security represents
that portion of total risk which stems
from firm-specific factors. Can be
washed away by combining with
other stocks
Basic insight of
modern portfolio Unique Risk (diversifiable
or unsystematic Risk)
theory:
Total risk = Unique Market Risk Market risk of a stock represents that
portion of its risk which is attribute to
risk + Market risk (systematic or non
diversifiable risk economy wide factors. Investors can’t
avoid
1 5 10 20
Empirical research
No. of Securities
suggest that bulk of
When portfolio has just benefit of diversification,
As more & more in form of risk reduction
one security risk of securities are added is achieved by forming a
portfolio p is the risk of portfolio risk portfolio of 20 securities.
single stock in it i decreases Thereafter gain from
But portfolio risk diversification tends to
decreases at be negligible
decreasing rate &
reaches a limit
PORTFOLIO RISK: TWO ASSET CASE
You have A & B invest opportunities
Investor invests in both assets equally
(Workout Q 3 Handout Session 5-6)
Calculate Expected rate of return, variance & std dev
Comment on results if portfolio with equal amount constructed.
What happens in economic conditions are good & bad.
PORTFOLIO RISK: TWO ASSET CASE
You have A & B invest opportunities
Investor invests in both assets equally
Expected rate of return, variance & sdev
A B
B
Both have same expected return 20% and same variance 400
Thus they are equally profitable & equally risky. How combining investments A& B
helps?
If portfolio with equal amount constructed portfolio return is
Returns (20%) same as expected return but without risk …..why?
If the economic conditions are good, then A
yields 40% % B 0% & portfolio return will be:
If the economic conditions are bad, then A
yield 0% % B 40% & portfolio return would still be same
Thus, by investing equal amounts in A and B, rather than the entire
amount only in A or B, the investor is able to eliminate the risk
altogether.
He is assured of a return of 20 percent with a zero standard deviation
Although expected return on a portfolio is the weighted average of the expected
