Markowitz Mean-variance

Sequence Of MPT Material

Basic Return vs Risk
Optimizing the Risky Portfolio
1.

Stocks vs Bonds

2.

Markowitz Mean-Variance Asset

Allocation

Risk Aversion / Utility Function

Allocate Between Risk-free asset and Risky Asset
(CAL)
Going In Reverse: the CAPM
Calculates theoretical expected return for individual
assets based
upon covariance with the market and the risk-free
return.

Evolution of Variance
Measures in Studying MPT
Individual Assets/Asset Class Variance
(Return for Period Mean Return) ^2

Paired Covariances
(Asset 1 Return Mean) x (Asset 2 Return Mean)

Portfolio Variance
For 2 assets: Asset 1 Variance + Asset 2 Variance +
2 x Weighted Covariance

Background Assumptions
As an investor you want to maximize the
returns for a given level of risk.
Your portfolio includes all of your assets,
not just financial assets
The relationship between the returns for
assets in the portfolio is important.
A good portfolio is not simply a collection
of individually good investments.
4

Markowitz Portfolio Theory

Derives the expected rate of return for a
portfolio of assets and an expected risk
measure
Markowitz demonstrated that the
variance of the rate of return is a
meaningful measure of portfolio risk
under reasonable assumptions
The portfolio variance formula shows
how to effectively diversify a portfolio
5

Markowitz Portfolio Theory

Assumptions
Investors consider each investment
alternative as being presented by a
probability distribution of expected returns
over some holding period.
Investors maximize one-period expected
utility, and their utility curves demonstrate
diminishing marginal utility of wealth.
Investors estimate the risk of the portfolio on
the basis of the variability of expected
returns.
6

Markowitz Portfolio Theory

Assumptions
Investors base decisions solely on expected
return and risk, so their utility curves are a
function of expected return and the expected
variance (or standard deviation) of returns
only.
For a given risk level, investors prefer higher
returns to lower returns. Similarly, for a
given level of expected returns, investors
prefer less risk to more risk.
7

Markowitz Portfolio Theory

Under these five assumptions, a single
asset or portfolio of assets is efficient if
no other asset or portfolio of assets
offers higher expected return with the
same (or lower) risk, or lower risk with
the same (or higher) expected return.

Alternative Measures of Risk

Variance or standard deviation of expected
return (main focus)
Based on deviations from the mean
return
Larger values indicate greater risk
Other measures
Range of returns
Returns below expectations
Semivariance measures deviations only
below the mean

Characteristics of Probability
Distributions
1) Mean: most likely value
2) Variance or standard deviation
3) Skewness
* If a distribution is approximately normal,
the distribution is described by
characteristics 1 and 2.
10

Single Factor Mean-Variance

Model
Expected Return
Expected Variance

11

Portfolio Standard Deviation

Formula

12

Portfolio Standard Deviation

Formula
port

2 2
w
i i w i w jCovij
i 1

i 1 j1

where :

port the standard deviation of the portfolio

Wi the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio

i2 the variance of rates of return for asset i

Cov ij the covariance between the rates of return for assets i and j,
where Cov ij rij i j
13

Portfolio Standard Deviation

Calculation
The portfolio standard deviation is a
function of:
The variances of the individual assets
that make up the portfolio
The covariances between all of the
assets in the portfolio
The larger the portfolio, the more the
impact of covariance and the lower the
impact of the individual security variance
14

Constructing Risky Portfolios

E(rp) still as easy as ever simple weighted
average of asset E(r)s
Variance of the risky portfolios for two assets =
p2

wA12 x A12 + wA22 x A22 + 2 x wA1 x wA2 x

COVAR(A1,A2)

Another case of the general formula presented as

a special case

(Its a global conspiracy)

The general rule is just to take the weighted

average of all of the covariances for all possible
15
paired sets in the portfolio

Generalize The Portfolio

Variance Calculation
p 2

wA12 x A12 + wA22 x A22 + 2 x wA1 x wA2 x

COVAR(A1,A2)

Now with the general

rule:

p2

wA1 x wA1 x Covar (A1,A1) + wA2 x wA2 x Covar (A2,A2) +

wA1 x wA2 x Covar (A1,A2)

+ wA1 x wA2 x Covar (A1,A2)

Covar(A1,A1) = A12
Note that there are now 4 terms (2 x 2)
for 2 assets
16

The General Formula Is Easier To

Use In A Worksheet Environment
We use a covariance matrix
Asset 1
Asset 2

Asset 1
Asset 2
Covar(A1,A1) Covar(A1,A2)
Covar(A2,A1) Covar(A2,A2)

Note that this looks just like the Mean-Variance Worksheet

Then we need to weight each covariance term

for the asset weighting in the portfolio
17

Adding Asset Weights

Here is a bordered covariance matrix
for a portfolio with 60% asset 1 and 40%
asset 2 the asset weights are the
borders
Asset 1
Asset 2

Asset 1
Asset 2
.60
.40
.60 .60x.60xCovar(A1,A1) .60x.40xCovar(A1,A2)
.40 .40x.60xCovar(A2,A1) .40x.40xCovar(A2,A2)

Note that this matrix is also on the Mean-Variance

Worksheet

18

One Final Hint

Revisiting Covariance vs Correlation
Coefficient
The formula to calculate

1,2 = Covar (A1,A2) / A1 x A2

If we know 1,2 and need to calculate
Covar(A1,A2) :
Covar (A1,A2) = A1,A2 x A1 x A2
This formula is used in B6 to C12 and B16 to H22 to
calculate the covariance matrix. B16 to H22 should
look familiar.
19

Diversification And Hedging

Diversification

1.0

Hedging

0.0
-1.0
Correlation
Coefficient

20

Implications for Portfolio

Formation
Assets differ in terms of expected rates of
return, standard deviations, and
correlations with one another
While portfolios give average returns, they give
lower risk
Diversification works!

Even for assets that are positively

correlated, the portfolio standard deviation
tends to fall as assets are added to the
portfolio
21

Implications for Portfolio

Formation
Combining assets together with low
correlations reduces portfolio risk more
The lower the correlation, the lower the
portfolio standard deviation
Negative correlation reduces portfolio
risk greatly
Combining two assets with perfect
negative correlation reduces the
portfolio standard deviation to nearly
zero
22

The Efficient Frontier

The efficient frontier represents that set of
portfolios with the maximum rate of return for
every given level of risk, or the minimum risk
for every level of return
Frontier will be portfolios of investments
rather than individual securities
Exceptions being the asset with the highest
return and the asset with the lowest risk
(This is true for Minimum Variance Frontier,
not the Efficient Frontier)

23

Efficient Frontier and Alternative

Portfolios
E(R)

Efficient
Frontier

Standard Deviation of Portfolio Return

24

The Efficient Frontier and

Portfolio Selection
Any portfolio that plots inside the
efficient frontier (such as point C) is
dominated by other portfolios
For example, Portfolio A gives the same
expected return with lower risk, and Portfolio
B gives greater expected return with the same
risk

Would we expect all investors to choose

the same efficient portfolio?
No, individual choices would depend on
relative appetites return as opposed to risk

25

The Portfolio Standard Deviation

Unsystematic
(diversifiable)
Risk
Total
Risk
Systematic Risk

Standard Deviation of
the Market Portfolio
(systematic risk)

Number of Stocks in the Portfolio

26

Optimization
What is it?
What do we optimize?
The efficient frontier is a series of portfolios
optimized (lowest variance) for a series of
possible E(r)s
We graph some sub-optimal portfolios
(below the kink)

The endpoints are the lowest and highest

E(r) assets includable in the portfolio
27

The Two-Asset Example

Easiest to graph and comprehend
Easy to optimize (formula-based)
The graph line is set up by taking
evenly-spaced mixes of two assets
Low end of the graph is 100% the
smaller E(r) asset, top end is 100% the
larger E(r)
Graph is same style as our Utility
graph
28

The Efficient Frontier and

Investor Utility
An individual investors utility curve
specifies the trade-offs she is willing to
make between expected return and risk
Each utility curve represent equal utility;
curves higher and to the left represent
greater utility (more return with lower risk)
The interaction of the individuals utility
and the efficient frontier should jointly
determine portfolio selection
29

The Efficient Frontier and

Investor Utility
The optimal portfolio has the highest
utility for a given investor
It lies at the point of tangency between
the efficient frontier and the utility
curve with the highest possible utility

30

Selecting an Optimal Risky

Portfolio
E(R port )

U3
U2

U1

Y
U3
U2

X
U1

E( port )

31

Utility / Risk Aversion

Utility = E(r new asset) - .005 x Aversion x
2(new asset)
U = E(r new asset) - .005 x A x 2(new asset)
If Utility > Risk Free Return,
Asset Fits Within Your Risk Profile
32

Utility Calculations
For a Risk Aversion Level of 4:
Risk-Free Rate = 5.00

Vanguard S&P 500 (VFINX):

U = 11.24 - .005 x 4 x 430.13 =
2.64

Fidelity Japan (FJPNX):

U = 8.21 - .005 x 4 x 2660.23 =
-45.00
33

Utility Curve
Graph line represents the portfolios with utility equal to
sample Port
Risk aversion level (A) is constant

E(r )

Indifference Curve At One Aversion Level

20.00
18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0.00
0.00

5.00

10.00

15.00

20.00

25.00

30.00

Indifference Asset/Port

34

Utility Level Worksheet

Example VFINX
Expected Return
Variance
Conversion Factor
Risk Aversion Levels:1
2
3
4
5
6
7
8
9
10

22.00
1176.00
0.005
16.12
10.24
4.36
-1.52
-7.40
-13.28
-19.16
-25.04
-30.92
-36.80

11.24
430.14
0.005
9.09
6.94
4.79
2.64
0.49
-1.66
-3.81
-5.97
-8.12
-10.27

DODIX
7.78
43.19
0.005
7.56
7.35
7.13
6.92
6.70
6.48
6.27
6.05
5.84
5.62

FJPNX
8.21
2660.23
0.005
-5.09
-18.39
-31.69
-44.99
-58.30
-71.60
-84.90
-98.20
-111.50
-124.80

Risk Free
5.00
0.00
0.005
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00
5.00

35

Utility Levels Matrix

Full Value Range

40.00
20.00
0.00

Utility

-20.00

10

Example
VFINX

-40.00

DODIX

-60.00

FJPNX

-80.00

RiskfFree

-100.00
-120.00
-140.00
Risk Aversion Factor

36

Utility Levels Matrix

Truncated Value Range

20.00
16.00

Utility

12.00
8.00

Example

4.00

VFINX

0.00

DODIX

-4.00

10

FJPNX
RiskfFree

-8.00
-12.00
-16.00
-20.00
Risk Aversion Factor

37

Investor Differences and

Portfolio Selection
A relatively more conservative investor
would perhaps choose Portfolio X
On the efficient frontier and on the
highest attainable utility curve
A relatively more aggressive investor
would perhaps choose Portfolio Y
On the efficient frontier and on the
highest attainable utility curve
38

Risky Assets Versus The Risk-free

Asset
An Example:
Risk-free rate = 4%
Risky Assets/Portfolio E (r) = 9%
Risky Assets/Portfolio = 8%
What is the risk premium?

39

The Risk-Free Asset Is Not Included

When Calculating Optimal Risky
Portfolios
Because = 0, there is no diversification
benefit
Therefore, adding the risk-free asset cannot
improve the efficient frontier
The risk-free asset plays a critical role AFTER
the optimal risky portfolios and efficient frontier
have been determined
Utility can be improved with the subsequent
addition of the risk-free asset
40

Risky Assets Versus the Risk-free

Asset
Combinations With No Borrowing
RiskyPortfol
io
9%
E (r)
4%

8%

41

Risky Assets Versus the Risk-free

Asset
Combinations With Borrowing at R(f)
RiskyPortfol
io
9%
E (r)
4%

8%

42

Risky Assets Versus the Risk-free

Asset
Combinations With Borrowing at R(f)
RiskyPortfol
io
9%
E (r)
4%
y<1
0

y>1

8%

43

Risky Assets Versus the Risk-free

Asset
Combinations With Borrowing at R(f) + 1%
RiskyPortfol
io
9%
E (r)
4%
y<1
0

y>1

8%

44

Risky Assets Versus the Risk-free

Asset
Combinations With Borrowing at R(f) + 1%
RiskyPortfol
io
9%
This is the Capital
Allocation Line

E (r)

CAL

4%
y<1
0

y>1

8%

45

Risky Assets Versus the Risk-free

Asset
Combinations With Borrowing at R(f) + 1%
RiskyPortfol
io
9%
You can solve for
utility curves that
will intersect the
CAL at the
optimal point

E (r)
4%
y<1
0

y>1

8%

46

Annualization of Variance / S.D.

Quarterly
q2
q

Annual

= .36 x 4

= .60 x SQRT(4)

1.44

1.20

Note: 4=periods

/ year

Monthly

m2

= .12 x 12

Annual
1.44

47