Chapter 6

Efficient
Diversificatio
n

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Outline
Diversification and Portfolio Risk
Asset Allocation With Two Risky
Assets
The Optimal Risky Portfolio With A
Risk-Free Asset
Single Index Model

6-2

6.1 Diversification and Portfolio Risk

(Review. Covered in FM)

6-3

6.1 Diversification (Review)

When we put stocks in a
portfolio, p < (Wii) because
the firm-specific risk or unique
risk is diversified away.
The risk that remains is called
systematic risk or market risk.

n = # securities in the portfolio

6-4

6.2 Asset Allocation With Two Risky

Assets

6-5

Two-Security Portfolio Return

E(rp) = W1r1 + W2r2
W1 = 0.6
Wi = % of total money
invested in security i
W2 = 0.4
r1 = 9.28%
r2 = 11.97%
E(rp) = 0.6(9.28%) + 0.4(11.97%) = 10.36%
6-6

Portfolio Variance and Standard

Deviation
2

[W

WJ Cov(r I , rJ )]

I1 J1

WI , W J Percentage of the total portfolio invested in stock I and J respective ly

Q The total number of stocks in the portfolio

Cov(r I , rJ ) Covariance of the returns of Stock I and Stock J

If I J then Cov (rI , rJ ) I 2 & Cov(r I , rJ ) Cov (rJ , rI )

Variance of a Two Stock Portfolio:

p 2 W12 12 2W1W 2 Cov (r1, r2 ) W 2 2 2 2

6-7

Measuring the correlation coefficient

Covariance does not tell us the intensity of the
comovement of the stock returns, only the
direction.
We can standardize the covariance and
calculate the correlation coefficient which tells
us the direction and provides a scale to estimate
the degree to which the stocks move together.
For Stock 1 and Stock 2
(1,2)

Cov(r 1, r2 )

1 2
6-8

 and diversification in a 2-stock portfolio

-1.0 to +1.0 inclusive.
is always in the range __________
What does (1,2) = +1.0 imply?
The two are perfectly positively correlated.
If (1,2) = +1, then (1,2) = W11 + W22
What does (1,2) = -1.0 imply?
The two are perfectly negatively correlated.
If (1,2) = -1, then (1,2) = (W11 W22)
It is possible to choose W1 and W2 such that
(1,2) = 0.
6-9

 and diversification in a 2-stock portfolio

If -1 < (1,2) < 1 then
There are some diversification benefits from combining
stocks 1 and 2 into a portfolio.
p2 = W12 12 + W22 22 + 2W1W2 Cov(r1r2)
And since Cov(r1r2) = 12
p2 = W12 12 + W22 22 + 2W1W2 1,2 1 2
(1,2) = (2,1)
(1,1) = +1.0 by definition
The covariance between any stock such as Stock 1 and
itself is the variance of Stock 1
6-10

Two-Security Portfolio Risk

p2 =W12 12 + 2W1W2 Cov(r1r2) + W22 22

Let W1 = 60% and W2 = 40% (Stock 1 = ABC; Stock 2 = XYZ)
p2 = 0.36(0.15265) +2(.6)(.4)(0.05933) +0.16(0.17543)
p = 33.39%
p < W1 1 + W2 2?

6-11

The effects of correlation &

covariance on diversification

Asset A and B -> Portfolio AB

Asset C and D -> Portfolio CD
6-12

E(r)

TWO-SECURITY PORTFOLIOS WITH

DIFFERENT CORRELATIONS
WA = 0%

13%

WB = 100%

= -1
=0
8%

WA = 100%

50%A
50%B

= .3

= +1

WB = 0%

12%
Stock A

20%
Stock B

St. Dev
6-13

Summary: Portfolio Risk/Return

Two Security Portfolio

Amount of risk reduction depends critically

/covariances
on correlations
_________________________.
<1
Adding securities with correlations _____
will result in risk reduction.

If risk is reduced by more than expected

return, what happens to the return per unit
of risk (the Sharpe ratio)?
6-14

6.4 Efficient Diversification With

Many Risky Assets

6-15

Extending Concepts to All Securities

Consider all possible combinations of securities,
with all possible different weightings and keep track
of combinations that provide more return for less
risk or the least risk for a given level of return and
graph the result.
The set of portfolios that provide the optimal tradeoffs are described as the efficient frontier.
The efficient frontier portfolios are dominant or the
best diversified possible combinations.
All investors should want a portfolio on the efficient
frontier until we add the riskless asset

6-16

E(r)

The minimum-variance frontier of

risky assets
Efficient Frontier is the best diversified set of
investments with the highest returns

Efficient
frontier

Global
minimum
variance
portfolio

Found by forming
portfolios of securities
with the lowest
covariances at a given
E(r) level.

Individual
assets

Minimum
variance
frontier

St. Dev.
6-17

E(r)

The EF and asset allocation

EF including
international &
alternative
investments
80% Stocks
20% Bonds
60% Stocks
40% Bonds
40% Stocks
60% Bonds

100% Stocks

Efficient
frontier

20% Stocks
80% Bonds

St. Dev.
6-18

Recap with a Video

Buzz word: Efficient Frontier
http://www.bloomberg.com/video/bob-s-daily-buzzwordefficient-frontier-YXELG3w5RXuAympdfqhnUw.html

6.3 The Optimal Risky Portfolio With

A Risk-Free Asset

6-20

Adding the Risk-free Asset

with the Efficient Frontier
Create a complete portfolio:
A linear combination of the
risk-free asset and risky
portfolios along the efficient
frontier.

Efficient frontier

Theorem: There is a single

combination of risky and
riskless asset that dominates
all other combinations.

6-21

Potential Capital Allocation Lines

CAL (P)

E(r)

Efficient
Frontier

E(rP&F)

E(rP)
E(rA)

CAL (A)

CAL (G)

A
G

F
Risk Free
A P P&F

6-22

The Capital Market Line (CML)

CAL (P) = CML

E(r)

Efficient
Frontier

E(rP&F)

E(rP)

o P is called the Optimal

Risky Portfolio or
Tangency Portfolio.
o The optimal CAL is called
the Capital Market Line
(CML).

E(rP&F)

o The CML dominates the

Efficient Frontier. Why?

F
Risk Free
P&F

P P&F

6-23

The CML & Sharpe Ratio

The Capital Market Line (CML) is the dominant CAL
because it has the largest slope.
It provides the best reward-to-volatility trade off.
The reward-to-volatility trade off is called the Sharpe
Measure/Sharpe Ratio:

Sharpe Ratio = (E(rp) rf) / p

Regardless of risk preferences, some combinations of P & F
has an equal or higher Sharpe ratio than P alone.

6-24

Practical Implications for Asset

Allocation
A financial planner identifies the optimal risk portfolio
on the efficient frontier (call it P).
The optimal risk portfolio (P) is the tangency portfolio on
the efficient frontier that connects the risk-free rate.
P may include funds, stocks, bonds, international and other
alternative investments.

This tangency portfolio will serve as the starting point

for all their clients.
The planner varies the asset allocation between the risky
portfolio and risk-free investment according to risk tolerance
of client to create a complete portfolio.

6-25

6.5 A Single Index Asset Market

Prelude to Chapter 7. CAPM.

6-26

Individual Securities
It is beneficial to hold individual securities in a
portfolio to diversify away idiosyncratic risk.

A well-diversified portfolio has no idiosyncratic

risk. The remaining risk is called systematic
risk/market risk.

Systematic risk arises from events that effect

the entire economy. These include changes in

interest rates/GDP or financial crises.
How do we measure a stocks systematic risk?

6-27

Individual securities
How do we measure a stocks systematic
risk?
Systematic Factors
Returns
Stock A

Returns
well
diversified
portfolio

interest rates,
GDP,
consumer spending,
etc.

6-28

Index Models: Overview

Index models are statistical models designed to
estimate the two components of risk for a
particular security or portfolio.
Separates the actual return of a security into macro
(systematic) and micro (firm-specific) components.

Advantages:
Practicality: Reduces the number of inputs needed to
account for diversification benefits.
Convenient: Easy reference point for understanding stock
risk using the measure .

Single Factor Index Model

Ri = iRm + i + i
Ri = Actual excess return = ri rf
Rm = rm rf (excess return). Systematic factor or proxy;
in this case M is unanticipated movement in a welldiversified broad market index like the S&P500
i= sensitivity of a securitys particular return to the
systematic factor
i = unanticipated firm specific events
i= Expected return beyond any return induced by
movements in the market index. Typically =0.
6-30

Index Model: Scatter Plot

Excess Returns (i)

Ri = i + iRm + ei

.
.

.
.
. ..

.
.
.
.
. . ..
.. . .

Slope of SCL = beta

y-intercept = alpha

Security
.
.
.
Characteristic
.
.
.
. . .
Line
.
. .. . .
.
. . .
Excess returns
on market index
. . .. .
Variation in R .explained
by the line is
.
.
.
systematic
risk
.
.
the
stocks
_____________
.Variation.in R unrelated to the market
i

risk
(the line) is unsystematic
________________

6-31

Understanding Beta ()
Beta is the sensitivity of a securitys returns to the
systematic or market factor.
> 1 indicates a stock with greater sensitivity to the
economy that the average stock in the market.
< 1 indicates a stock with below-average sensitivity to
the economy.
= 1. By definition, the market portfolio has a beta of 1.

Video: http://www.youtube.com/watch?v=14C6AEubGNw

6-32

Components of Risk
Decompose stock variance into two components.
Variance (Ri) = Variance (iRm + i + i)
= Variance (i Rm) + Variance(i)
= 2i2m

+ 2(i)

= Systematic risk + Firm-specific risk

Systematic risk of each stock depends on both 2m and the
sensitivity i.
Firm-specific risk is measured by i. It has an expected value
of zero as the impact of unanticipated events must average
out to zero.
Variance(i) is zero.

6-33

Components of Risk
Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk / Total Risk

i2 m2 / i2 = 2
i2 m2 / ( i2 m2 + 2(ei)) = 2

6-34

Comparing Security
Characteristic Lines
Describe


e
for each.

6-35