Investments

Lecture 1: Introduction to Financial Markets

and Portfolio Choice
2
Course based around Bodie Kane Marcus
Supplementary readings available on QMPlus
Assessment:
75% final exam
25% based on mid-term (probably given on
the last lecture of the term)
In principle, two hours of lecture, one hour of
class each week.
Depending on needs, well use the class time
for differing things.

Overview
3
Finance - Module Overview (Topics by Week)
IV.Behavioural
Finance (8)
Predictability in
Returns

V. Other Markets (9)
- FX, Futures,
Swaps.
II Expected
Return Models
- Equity Markets
CAPM, APT, Mkt.
Efficiency (3-4)

III Fixed Income
Markets (5-7)
-Money Markets,
Bonds

VI. Portfolio Mant
Hedge and
Pension Funds,
Perf. Measurement
(10)
Finance Key Insights
I. Introduction to
Financial Markets
-Asset Allocation
& Modern Portfolio
Theory (1-2)
4
Lecture 1 Overview
Introduction

1. Asset Management Industry: Size and Main Players

2. A few Definitions

3. Return History of Different Asset Classes

4. Portfolio Diversification - Total Risk versus Un-Diversifiable Risk

5. Optimal Asset Allocation

Reading
BKM Chapter 6 and 7
5
Composition and Growth of the Global Stock of Financial Assets
Source McKinsey
0
50
100
150
200
250
1990 1995 2000 2005 2006 2007 2008 2009 2010
$

T
r
i
l
l
i
o
n

Equity Securities
Government Debt Securities
Private Debt Securities
Bank Deposits
Total Assets 261 263 321 334 360 376 309 356 356
% of GDP
6
Asset Management Industry - The Supply and Demand
of Assets
Source: Morgan Stanley (2001)
Global Equity Market Capitalization in July 2008 (50tr) and in October 2008 (35 tr)
Source (http://www.world-exchanges.org/files/file/Focus1108.pdf)
7
Sovereign Wealth Funds have been growing fast
COUNTRY FUND NAME FOUNDING DATE EST. VALUE ($BN)
ABU DHABI - UAE ADIA 1976 $600
CHINA CIC 2007 $322
KUWAIT KIA 1953 $295
NORWAY GPF-GLOBAL 1990 $507
SINGAPORE GIC 1981 $185
RUSSIA NATIONAL WEALTH FUND 2008 $87
Some Major Sovereign Wealth Funds
The total value of assets held by all SWFs is estimated to be over $4 trillion
SOURCE: SOVEREIGN WEALTH FUND NEWS.COM (2011)

8
INTRODUCTION TO ASSET ALLOCATION
9
Percentage Return to an Investment
The Percentage Return is the percentage increase in the value
of an investment at the end of the period on its value at the
beginning.
Thus if one pays P
t
for an investment, receives a dividend D
t
during the period and sells it for P
t+1
at the end

1 1
1
Dividend
Price Return
Yield
or Capital Gain
or Income
t t t t t t
t
t t t
Div P P Div P P
R
P P P
+ +
+
+
= = +
10
Example Calculating Returns
You bought a stock for $35 in Jan 1
st
and you received
dividends of $1.25 during the year and the stock is selling
for $40 on Dec 31
st

What is your annual percentage return?

Dividend yield = 1.25 / 35 = 3.57%
Capital gains yield = (40 35) / 35 = 14.29%
Total percentage return = 3.57 + 14.29 = 17.86%
11
Arithmetic vs. Geometric Mean
Arithmetic average return earned in an average period over multiple periods.
Answers the question: What is the typical (average) return in any given period?
Geometric average average compound return per period over multiple periods.
Answers the question: What is the average return over time on an investment, when
the proceeds (i.e., the dollar profits) are re-invested every period.
The geometric average will be less than the arithmetic average unless all the
returns are equal
Which is better?
Depends on purpose. No obvious answer. Geometric mean generally better for really
long investment horizons.
Are we trying to choose assets (stocks) for an active investment strategy with relatively
short holding periods? Arithmetic mean more informative.
For a long-term strategy (e.g., buy and hold stocks until retirement), the geometric mean
is more informative.
Arithmetic mean is typically what is reported.
Make sure to compare like with like when evaluating investments.
12
Example: Computing Averages
What is the arithmetic and geometric average for the following
returns?
Year 1 5%
Year 2 -3%
Year 3 12%
Arithmetic average = (5 + (3) + 12)/3 = 4.67%
Geometric average =
[(1+.05)*(1-.03)*(1+.12)]
1/3
1 = .0449 = 4.49%
13
Geometric vs. Arithmetic with Normal Returns
If returns are normally distributed with variance
2
the following holds:

Geometric mean = Arithmetic mean 0.5*
2

The S&P 500 has an annual volatility around 20%. If the arithmetic
average is 10% it follows that

Annual geometric mean = 0.10 0.5* 0.2
2
= 0.08 = 8%


14
Real and Nominal Returns
Nominal return is the percentage increase in money value, the real
return is the percentage increase in purchasing power.
Nominal Return denoted as before (slide 12); denote the price
index in period t as I
t
, implying the inflation rate is h
t+1
=(I
t+1
-I
t
)/I
t
,
then the real rate of return is



((1+R
t+1
)/(1+h
t+1
))-1 R
t+1
- h
t+1

15
A History of US Assets
0.1
1
10
100
1000
10000
100000
1000000
1
8
7
1
1
8
7
6
1
8
8
1
1
8
8
6
1
8
9
1
1
8
9
6
1
9
0
1
1
9
0
6
1
9
1
1
1
9
1
6
1
9
2
1
1
9
2
6
1
9
3
1
1
9
3
6
1
9
4
1
1
9
4
6
1
9
5
1
1
9
5
6
1
9
6
1
1
9
6
6
1
9
7
1
1
9
7
6
1
9
8
1
1
9
8
6
1
9
9
1
1
9
9
6
2
0
0
1
2
0
0
6
D
o
l
l
a
r
s

Stocks $104,091
Bonds $550
Bills $346
Gold $59
CPI $17
Source: Shiller
16
HIGHER RETURN COMPENSATES FOR HIGHER RISK,
Source: Harvey (2004)
Total Returns For Different Assets (Rolling 1.5 Year Window) 1940-2004
17
HIGHER RETURN COMPENSATES FOR HIGHER RISK
Source: Harvey (2004)
18
RISK AND RETURN OF BONDS AND EQUITY
Source: Harvey (2004)
Which Portfolio
Should We Choose
as a Long-term
Investor?
US BONDS AND EQUITY PORTFOLIOS (Jan. 1926 Dec. 2004)
19
With a simple quadratic utility function, expected utility of portfolio
returns is a function of expected return and expected return
squared.
So to a reasonable approximation can write


U = Utility
E(r) = Expected portfolio Return

2
= Portfolio Variance

A = index of risk aversion (<0 = risk loving >0 = risk averse)
The Risk/Return Trade-off
( )
2
2
1
o A r E U =
20
Indifference Curves
Trade-off between return and variance is linear but for standard
deviation (standard deviation=square-root of variance).
0
2
4
6
8
10
12
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n

Portfolio Standard Deviation
A=1
A=2
Investor with A=1 is
equally happy
(indifferent) with these
different combinations of
return and variance.
Investor with A=2
is indifferent
between these.
21
Lower Risk Aversion leads to riskier portfolios
Less Risk-Averse
Direction of
Higher
Utility
Same
Utility
(Indifference
Curves)
Highly Risk-Averse
22
When Is Mean Variance Analysis Justified?
Mean-variance analysis is justified if the investor has quadratic utility or if
returns are Gaussian (details in Lecture 2).
(Gaussian distribution=Normal distribution)

In either case, agents choices do not depend on higher moments so the
tradeoff between portfolio mean and variance is sufficient for an agent to
select his optimal portfolio.

Everyone should be aware that this description is a considerable simplification
of peoples true preferences.
23
DIVERSIFICATION QUIZ
Example: Two stocks A and B have the same individual risk of
24% return std. deviation; the expected return of stock A is
14% and that of stock B only 6%.

Question: Would anyone ever hold stock B?

Answer:
24
Portfolio Diversification Miracle
Stock A
E(R
A
) = 14%

A
= 24%
Portfolio Weight
x
A

Stock B
E(R
B
) = 6%

B
= 24%
Portfolio Weight
x
B

Expected
Return of
Portfolio,
E(R
p
)
Std. Dev. of
Portfolio
(if correlation

AB
= 0),
p


Std. Dev. of
Portfolio
(if correlation

AB
= 1),
p
1.00 0.00 14% 24% 24%
0.75 0.25 12% 19% 24%
0.50 0.50 10% 17% 24%
0.25 0.75 8% 19% 24%
0.00 1.00 6% 24% 24%
( ) ( )
AB B A B A B B A A p
x x x x p o o o o o 2
2 2 2 2
+ + =
) ( ) ( ) (
B B A A p
R E x R E x R E + =
25
Two Risky Assets (same Std Dev.) Nobel Prize # 1
Given two assets, we can plot the expected returns and standard
deviation of all possible portfolio combinations.
The risk return trade-off depends on the correlation of the two assets
Negative return correlation between assets increases the
diversification benefit
26
Two Risky Assets (different Std. Dev.)
In case of perfect negative correlation we can obtain a riskless portfolio.
In case of perfect positive correlation portfolio risk is the same as average
risk: NO risk reduction from diversification, only risk averaging.
27

Gold has a lower return and a higher variability than the S&P 500.


Is Gold a bad investment?
Asset Return Variability
Gold 8.8% 20.8
S&P 500 12.8% 18.3
Asset Allocation Example: Why Buy Gold?
Coefficient of correlation between S&P 500 and Gold = -0.4

28
Hold a portfolio of gold and stocks: a fraction of
x% in gold and (100 - x)% in the S&P 500:















Conclusion: Even if gold is risky and has low average returns, when you hold it as part of a portfolio, it
reduces significantly the total portfolio risk since it works as an insurance against some forms of risk (inflation,
exchange rate risk etc.).
Weight x% Return Variability
100% 8.8% 20.8 Hold only Gold
80% 9.6% 15.5
60% 10.4% 11.7
45.4 10.6% 10.7 Minimum Var Portfolio
40% 11.2% 10.8
20% 12.0% 13.5
0% 12.8% 18.3 Hold only S&P 500
Create a Portfolio with Gold
29
With Many Assets Can Strategically Choose Assets with Best Correlation:
The Mean-Variance Efficient Frontier
E(r
p
)
o
p
Find portfolio weights, w
1
, w
2
,,
w
N
that minimize portfolio variance
for given target return.
The solutions for different target
returns trace out the (Mean-
Variance) Efficient Frontier.















Target
Return
Minimum-variance
for the Target Return
Individual
Stocks
Efficient Frontier
30
| |
| | ; 1 %), 5 ., . ( . . = =

i
i P
P X
X g e r r E t s
r Var Min
i
Mean-Variance weights
This is how the portfolio weights are determined:











NOTE: NOTHING TO SAY THAT ALL Xs ARE POSITIVE
In matrix form: min ww s.t. wr =rtarget and w1=1 where =vcov matrix

Need to find X
i
for your portfolio. Can be done in Excel:
1. Estimate the cov(r
i
, r
j
) for all assets.
2. Set r = 1, 2, 10%, for example.
3. Calculate portfolio variance and return given any X
i
.
4. Use solver in Excel to solve out optimal X
i
.




31
How can you profit from a decline in the price of a stock?
Sell it short ! Here is how
How to short-sell a stock:
1. borrow it from your broker

2. Sell the borrowed shares (the proceeds are
credited to your account).

3. Sooner or later you must "close" the short
by buying back the same number of shares
and returning them to your broker.

4. If the price drops, you buy back the stock at
the lower price and make a profit on the
difference.

If the price of the stock rises, you have to buy
it back at the higher price, and you lose
money.


?
Now
Later
32
SHORT-SELLING EXAMPLE
Suppose that, after hours of painstaking research and
analysis, you decide that General Motors is dead in
the water. GM is trading at $65. You short 100 stocks.

The Stock Price Sinks (stock goes to $40)
Borrowed 100 GM shares and sold at $65: $6,500
Bought Back 100 GM shares at $40: -$4,000
Your Profit: $2,500

The Stock Price Rises (stock goes to $90)
Borrowed 100 GM shares and sod at $65: $6,500
Bought Back 100 GM shares at $90: -$9,000
Your Profit: -$2,500


Why Short?

1. To speculate
Short to profit from an overpriced stock or
market.
Probably the most famous example of this was
when George Soros "broke the Bank of
England" in 1992. He risked $10 billion that the
British pound would fall and he was right. The
following night, Soros made $1 billion from the
trade. His profit eventually reached almost $2
billion.
2. To hedge
protecting other long positions with offsetting
short positions.

Note: no limited liability when shorting
(losses can be indefinitely large)

33
Practical Example

Consider investing in the DJIA stocks:
3M (MMM), Procter & Gamble (PG), IBM (IBM), United Technologies (UTX), Merck (MRK),
Alcoa, Amex, ATT, Boeing, Caterpillar, Citigroup (C), Coca Cola (KO), Dupont (D), Eastman
Kodak, Exxon-Mobil (XOM) GE, GM, HD, Honeywell, HP, Intl, International Paper (IP)
Johnson and Johnson (JNJ), MacDonalds, Microsoft, Phillip Morris SBC, Walmart (WMT),
Walt Disney

What does minimum variance frontier look like?

When do we achieve diversification?
Do we have to buy all 30 stocks to achieve full diversification?
Do we have to buy more than these 30 stocks to achieve diversification?
34
Diversification with Two Stocks
35
Diversification with Three Stocks
36
Diversification with Four Stocks
37
Diversification with Five Stocks
38
Dow Jones Industrial Average
39
S&P 500
40
Systematic Risk
(AKA non-diversifiable
risk)
Number of stocks in the portfolio
P
o
r
t
f
o
l
i
o

V
a
r
i
a
n
c
e

Idiosyncratic Risk
(AKA diversifiable
risk)
Diversification Benefit: Illustration
Why is there a limit to diversification?

Which risk matters?
41
Diversification Benefit: Intuition
( )
2
( ) ( )
,
( ) cov( , )
P i i
i
i j i j
i j
i i j i i j
i i j i
Var r Var X r
X X Cov r r
X Var r X X r r
=
=
=
= +

VAR COV COV COV
COV VAR COV
COV COV COV
COV .. COV VAR
The Variance-Covariance Matrix
As number of assets
rises this term go to
zero (in an equal-
weighted portfolio,
X
i
=1/n)

This term remains
even with large
number of assets so
long as average
covariance is
positive
42
How standard deviation of a portfolio of average NYSE stocks
changes as we change the number of assets in the portfolio
Average (annual) return
standard deviation is 49%.
Average (annual)
covariance between stocks
is 0.037, and the average
correlation is about 39%.
Since average covariance
positive, even very large
portfolio of stocks will be
risky.
43
Impact of Diversification on Portfolio Risk in Different Countries
Average standard deviation falls as number of stocks increases

For well-diversified portfolio:
Variance of each asset contributes little to portfolio risk.
Covariances among assets determine portfolio risk.
Market
Index
Standard Deviation (%)
US (S&P 500) 13.4
UK 14.5
Japan 18.2
France 21.5
Germany 24.1
Finland 43.2
44
Efficient Frontier with a risk-free asset
Portfolio Standard Deviation
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n

(
r
)

Risk Free Rate
(Cash)
Efficient Frontier with
a risk-free asset = Capital
Markets Line (CML)
Aggressive
Balanced
Conservative
45
Efficient Frontier and the Sharpe Ratio (SR)
Portfolio Standard Deviation
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n

(
r
)

Risk Free Rate
A
B C
f P
r r
P
r
o
P
r
f P
r r
Ratio Sharpe
o

=
5%
Sharpe Ratios are
equal to the slopes
of the lines
If this is the efficient
frontier, it has the
highest possible
slope=highest
possible SR
46
Mean-Variance Analysis and Two Fund Separation
Portfolio Standard Deviation
P
o
r
t
f
o
l
i
o

R
e
t
u
r
n

(
r
)

Portfolio of Risky Assets
(Tangency Portfolio)
Risk Free Rate
Optimal portfolio for
aggressive investor.
CML
Optimal portfolio for
conservative investor.
A
B
Both portfolios A and B
are linear combinations
of the Tangency Portfolio
and the Risk-Free asset.
47
Where on the Capital Market Line will an investor choose?
Depends on risk aversion




Here r
p
is the return on the tangency portfolio,
A is the coefficient of risk aversion
Risk Aversion and Efficient Frontier
2
( )
P f
P
E r r
Share of portfolio in risky assets
A

=
48
Mean Variance Analysis and Conclusions So Far
49

All the results derived use expected returns and variance-
covariances as inputs.
These are not known in practice, and are difficult to estimate.
Practical implementation of mean-variance analysis therefore not
trivial.
Well talk more about this in subsequent lectures.




Caveat
50
ANNEX: Understanding Diversification: Mathematical Details
A. Start with our equation for variance:


B. Then make the simplifying assumption that for all assets:


C. Next note that:
1. The average variance and covariance of the securities are:


o
p
2
= w
i
2
o
i
2
+ w
i
w
j
cov r
i
, r
j
( )
j=1
i = j
N

i=1
N

i=1
N

o
p
2
=
1
N
1
N
o
i
2
+
1
N
2
cov r
i
, r
j
( )
i=1
N

j=1
j =i
N

i=1
N

w
i
=
1
N

op
2
=
1
N
|
\

|
.
|
o
i
2
; cov =
1
N N-1
( )
cov r
i
, r
j
( )
i=1
N

j=1
j =i
N

i=1
N

51
ANNEX :Understanding Diversification: Details Understanding
Diversification: Details
2. Plugging these into our equation gives:


3. What happens as N becomes large?


4. Only the average covariance matters for large portfolios.

If the average covariance is zero, then the portfolio variance is close
to zero for large portfolios

o
p
2
=
1
N
|
\

|
.
|
o
2
+
N 1
N
|
\

|
.
|
cov

1
N
|
\

|
.
|
0 and
N 1
N
|
\

|
.
|
1