CHAPTER 7

Optimal Risky Portfolios

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McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

The Investment Decision

Top-down process with 3 steps:
Capital allocation between the risky
portfolio and risk-free asset
Asset allocation across broad asset
classes
Security selection of individual assets
within each asset class

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7-2

Diversification and Portfolio Risk

Market risk
Systematic or non-diversifiable

Firm-specific risk
Diversifiable or non-systemic

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7-3

Fig. 7.1 Portfolio Risk as a Function of

the Number of Stocks in the Portfolio

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1-4

Figure 7.2 Portfolio Diversification

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1-5

Covariance and Correlation

Portfolio risk depends on the correlation
between the returns of the assets in the
portfolio
Covariance and the correlation coefficient
provide a measure of the way returns of two
assets vary

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7-6

A Two-Security Portfolio: Return

= Bond weight
= Equity weight
= Bond return
= Equity return
= Portfolio return

E (rp ) wD E (rD ) wE E (rE )

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7-7

A Two-Security Portfolio: Risk

w w 2wD wE CovrD , rE
2
p

2
D

2
D

2
E

2
E

= Variance of Security D
2
D

2
E

= Variance of Security E

CovrD , rE = Covariance of returns for

Security D and Security E

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7-8

Two-Security Portfolio: Risk

Another way to express variance of the
portfolio is to think of Covariances:

wD wDCovrD , rD
2
p

wE wE CovrE , rE
2wD wE CovrD , rE

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7-9

Covariance

CovrD , rE DE D E
, = Correlation coefficient of returns
= Standard deviation of returns
for Security D
= Standard deviation of returns
for Security E
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Table 7.2 Computation of Portfolio

Variance From the Covariance Matrix

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1-11

A portfolio of 3 Assets
You have three assets with weights
w 1, w 2, w 3
The portfolio return is simply the linear
combination of the returns with same
coefficients:

E (rp ) w1E (r1 ) w2 E (r2 ) w3 E (r3 )

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Bordered Matrix for 3 Assets

Step 1: write the covariance matrix and its weights

w1

w2

w3

w1

Cov(1,1)

Cov(1,2)

Cov(1,3)

w2

Cov(2,1)

Cov(2,2)

Cov(2,3)

w3

Cov(3,1)

Cov(3,2)

Cov(3,3)

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Bordered Matrix for 3 Assets

Step 2: Symmetry!

w1

w2

w3

1, 2

1,3

1, 2

2,3

1,3

2,3

w1

w2
w3

Cova, b Covb, a a ,b

2
1

2
2

2
3

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Bordered Matrix for 3 Assets

Step 3: multiply by the weights around the border

w1
w1

w2
w3

w
2
1

w1w2

w1w3

w2
2
1

1, 2
1,3

w3

w1w2 1, 2
2
2

2
2

w2 w3 2,3

w1w3 1,3
w2 w3 2,3

w
2
3

2
3

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Bordered Matrix for 3 Assets

Step 4: add-up all the pieces

w w w
2
p

2
1

2
1

2
2

2
2

2
3

2
3

2 w1w2 1, 2 2 w1w3 1,3 2 w2 w3 2,3

Covariance terms
Remember

a ,b b ,a a ,b a b b ,a b a
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Bordered Matrix for 3 Assets

All in one step

w1

w2

w3

w1w2 1, 2 1 2 w1w3 1,3 1 3

w1

w2

w1w2 1, 2 1 2

w3

w1w3 1,3 1 3 w3 w3 2,3 2 3

2
1

2
1

w
2
2

w3 w3 2,3 2 3

2
2

w
2
3

2
3

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Bordered Matrix for 3 Assets

Add-up all the pieces

w w w
2
p

2
1

2
1

2
2

2
2

2
3

2
3

2 w1w2 1, 2 1 2
2 w1w3 1,3 1 3
2 w2 w3 2,3 2 3
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Correlation: Possible Values

Range of values for correlation
+ 1.0 >

> -1.0

If = 1.0, the securities are perfectly

positively correlated

If = - 1.0, the securities are perfectly

negatively correlated

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Two-Security Portfolio: Variance

Remember the variance of a two-asset
portfolio

w w
2
p

2
D

2
D

2
E

2
E

2 wD wE DE D E
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Correlation Coefficients
When = 1, there is no diversification

P wE E wD D
When = 1, a perfect hedge is when:

w w 2wD wE D E 0
2
p

2
D

2
D

2
E

2
E

the solution (which also makes wD+wE=1) is:

wD

D E

and wE

D E

1 wD

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Fig 7.3 Portfolio Expected Return as a

Function of Investment Proportions

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Fig 7.4 Portfolio Standard Deviation as a

Function of Investment Proportions

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The Minimum Variance Portfolio

The minimum variance
portfolio is the portfolio
composed of the risky
assets that has the
smallest standard
deviation, the portfolio
with least risk.

If correlation < +1
the portfolio standard
deviation may be
smaller than that of
either of the individual
component assets.
If correlation = -1
the standard deviation
of the minimum
variance portfolio is
zero.INVESTMENTS |
BODIE, KANE, MARCUS

7-24

Fig 7.5 Portfolio Expected Return as a

Function of Standard Deviation

Portfolio
opportunity
set for given
correlation

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Correlation Effects
The amount of possible risk reduction
through diversification depends on the
correlation.
The risk reduction potential increases as the
correlation approaches -1.
If r = +1.0, no risk reduction is possible.
If r = 0, P may be less than the standard
deviation of either component asset.
If r = -1.0, a riskless hedge is possible.

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Fig 7.6 The Opportunity Set of the Debt and

Equity Funds and Two Feasible CALs

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The Sharpe Ratio

Maximize the slope of the CAL for any
possible portfolio, P.
The objective function is the slope:

SP

E rP rf

The slope is also the Sharpe ratio.

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Fig 7.7 The Opportunity Set of Debt and Equity Funds

with the Optimal CAL and the Optimal Risky Portfolio

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Fig 7.8 Determination of the Optimal

Overall Portfolio

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Markowitz Portfolio Selection Model

Security Selection
The first step is to determine the risk-return
opportunities available
All portfolios that lie on the minimum-variance
frontier from the global minimum-variance
portfolio and upward provide the best risk-return
combinations

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Fig 7.10 The Minimum-Variance

Frontier of Risky Assets

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Markowitz Portfolio Selection Model

We now search for the CAL with the highest
reward-to-variability ratio
That means to find that optimal line that
stems from the risk-free point and is tangent
to the efficient frontier

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Fig 7.11 The Efficient Frontier of Risky

Assets with the Optimal CAL

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Markowitz Portfolio Selection Model

Everyone invests in P, regardless of
their degree of risk aversion. However:
More risk averse investors put more in the
risk-free asset.
Less risk averse investors put more in P.

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Capital Allocation, Separation Property

The separation property tells us that the
portfolio choice problem may be
separated into two independent tasks:
1. Determination of the optimal risky portfolio
(purely technical / mathematical)
2. Allocation of the complete portfolio to risk
free asset versus the risky portfolio
(depends on personal preference)

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Fig 7.13 Capital Allocation Lines with

Various Portfolios from the Efficient Set

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The Power of Diversification

Remember:

P2 wi w j Covri , rj
n

i 1 j 1

Consider an equally weighted portfolio:

1
wi
n

Look at covariance the matrix structure:

Rewrite covariance as:
n

1 2
2
P 2 i
i 1 n

11
Cov ri , rj

i 1 j 1 n n
n

j i

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The Power of Diversification

n
n
n
1
1
Rearrange: P2 i2 1 1 Cov ri , rj
n i 1 n
i 1 j 1 n n
j i

Define avg variance and avg covariance as:

n
1
2 i2
n i 1

n
n
1
Cov
Cov ri , rj

nn 1 i 1 j 1
j i

n n 1 terms

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The Power of Diversification

Then we can rewrite portfolio variance:

1
1 2
11
i
Cov ri , rj
n
i 1 n
i 1 j 1 n n

j i
2

2
P

as:

n n 1 terms

1 2 n 1

Cov
n
n
2
P

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The Power of Diversification

Study case where all assets have same
standard deviation and one correlation for all

1 2 n 1
2

n
n
2
P

2
P

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Table 7.4 Risk Reduction of Equally Weighted Portfolios

in Correlated and Uncorrelated Universes

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Optimal Portfolios and Non-normal

Returns
The optimal portfolio approach we just
studied assumes normal returns.
Fat-tailed distributions can result in extreme
values of Value-at-Risk (VaR) and Expected
Shortfall (ES) and encourage smaller
allocations to the risky portfolio.
If other portfolios provide sufficiently better
VaR and ES values than the mean-variance
efficient portfolio, we may prefer these when
faced with fat-tailed distributions.
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Risk Pooling - Insurance Principle

Risk pooling: merging (adding) uncorrelated,
risky projects as a means to reduce risk.
increases the scale of the risky investment by
adding additional uncorrelated assets.

The insurance principle: risk increases less

than proportionally to the number of policies
insured when the policies are uncorrelated
Sharpe ratio increases

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Risk Sharing
As risky assets are added to the portfolio, a
portion of the pool is sold to maintain a risky
portfolio of fixed size.
Risk sharing combined with risk pooling is the
key to the insurance industry.
True diversification means spreading a
portfolio of fixed size across many assets, not
merely adding more risky bets to an evergrowing risky portfolio.

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Investment for the Long Run

Long Term Strategy

Short Term Strategy

Invest in the risky

portfolio for 2 years
Long-term strategy is
riskier.
Risk can be reduced by
selling some of the
risky assets in year 2.
Time diversification is
not true diversification.

Invest in the risky

portfolio for 1 year and
in the risk-free asset for
the second year

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