V Originally proposed by Harry

Markowitz in 1950·s
V First formal attempt to quantify the
risk
V Diversification reduces the risk
V Round 20 stocks to the portfolio,
unsystematic risk can be reduced to
zero
˜Ê
 


  




 

     

  

  Ê 
V Markowitz, the father of modern portfolio theory,
developed the basic principle of portfolio
diversification in a formal way, in quantified
form, that shows why and how portfolio
diversification works to reduce the risk of a
portfolio to an investor.
V m
 
  
 

  

V Ôs the no. of securities in the portfolio increases,
contribution of individual security·s risk
decreases due to offsetting effect of strong
performing and poor performing securities in the
portfolio and the importance of covariance
relationships among securities increases.
V Holdingtwo stocks is less risky than holding
one stock
Ôssumptions
V Investors decisions are on two
parameters-expected return and variance
V Investors are risk averse
V Investors seek to achieve the highest
expected return at a given level of risk
V Investors have identical expectations
V Common one period investment horizon
½ortfolio Return
V Ôctual ½ortfolio Return
R½
1R1+
2R2 + «
nRn

V Expected Return of a ½ortfolio Return

E(R½
1 E(R1 +
2 E(R2 + «
n E(Rn

½ortfolio Risk
V ðtatesthat among all investments with a
given return, the one with the least risk is
desirable; or given the same level of risk, the
one with the highest return is most
desirable.
V ðecurity E(Ri ˜
Ô
 
ÔC  
C 15 15
FR  
HC 8 12
V Ô
dominates ÔC
V Ô
dominates FR
V 1. Normal Diversification
his occurs when the investor combines more
than one (1 asset in a portfolio

Risk

Unsystematic 75% of Co.

Risk Total Risk

Systematic Risk 25% of Co.

Total Risk
a a




V Dnsystematic Risk
... is that portion of an asset·s total risk which
can be eliminated through diversification
V ðystematic Risk
... is that risk which cannot be eliminated
Inherent in the marketplace
V ðuperfluous or Naive Diversification
Occurs when the investor diversifies in more
than 20-0 assets. Diversification for
diversification·s sake.
a. Results in difficulty in managing such a
large portfolio
b. Increased costs
- ðearch and transaction
V his type of diversification considers the
correlation between individual securities. It is
the combination of assets in a portfolio that are
less then perfectly positively correlated.
a. he two asset case:
- ðtk. Ô ðtk. B
- E(R 5 15
- ˜ 10 20
V Ôssume that the investor invests 50 of
capital stock in stock Ô and 50 in B
1. Calculate E(R
E(Rp º xi E(Ri
E(Rp .5(.05
n + .5(.15

E(Rp .025
i=1 + .05

E(Rp .10 or 10

V 2. raphically

Rp)

15%

10%
ortfolio Ô

5% Ô

5 10 15 20 25 ˜
V ½ortfolio Return of ÔB will always be on line ÔB
depending on the relative fractions invested in
assets Ô and B.
V . Calculating the risk of the portfolio
Consider  possible relationships between Ô
and B
- ½erfect ½ositive Correlation

- Zero Correlation

- ½erfect Negative Correlation

VÔ and B returns vary in identical pattern.
Hence, there is a linear risk-return
relationship between the two assets.
Rp)

15%

5% Ô

10 15 20 ˜p
V herefore,the risk of portfolio ÔB is simply
the weighted value of the two assets· ˜.
In this case:

˜p xÔ2 ˜Ô2 + xB2 ˜B2 + 2 xÔxB˜Ô˜B
ÔB

˜p .25(.102+.25(.202+2(.5(.5(.10(.20

˜p .15 or 15
V Ô·sreturn is completely unrelated to B·s
return.
ith zero correlation, a substantial
amount of risk reduction can be obtained
through diversification.
Rp)

15%

10%
Ô
5%
Ô

10 11.2 20 ˜p
˜p = .25.10)2+.25.20)2

˜p  11.2%
V Ô·s and B·s returns vary perfectly inversely.
he portfolio variance is always at the lowest
risk level regardless of proportions in each
asset.
Rp)

15%
Ô
10%

5%
Ô

5 10 20 ˜p
˜p = .25.10)+.25.20)+2.5).10).20)1)

˜p = .05 or 5%
V Ôlthough there are no securities with
perfectly negative correlation, almost all
assets are less than perfectly correlated.
herefore, you can reduce total risk (˜p
through diversification. If we consider many
assets at various weights, we can generate
the efficient frontier.
Rp)
fficient
Frontier
M

˜p
V he Efficient Frontier represents all the
dominant portfolios in risk/return space.
V here is one portfolio (M which can be
considered the market portfolio if we
analyze all assets in the market. Hence, M
would be a portfolio made up of assets that
correspond to the real relative weights of
each asset in the market.
V Ôssume you have 20 assets.
ith the help of
the computer, you can calculate all possible
portfolio combinations. he Efficient
Frontier will consist of those portfolios with
the highest return given the same level of
risk or minimum risk given the same return
(Dominance Rule
V .Borrowing and lending investment funds
at R to expand the Efficient Frontier.
a.
e keep part of our funds in a saving
account
- *ending, OR

b.
e can borrow funds for a greater

investment in the market portfolio
The efficient frontier is
convex as a result of risk
and return characteristics
of the portfolio, which
changes in a non-linear
fashion as its components·
weighting are changed.
V he capital asset pricing model defines the
relationship between risk and return
V E(RÔ Rf + OÔ(E(RM ² Rf
V If we know an asset·s systematic risk, we can
use the CÔ½M to determine its expected
return
V his is true whether we are talking about
financial assets or physical assets
V ½ure time value of money ² measured by the
risk-free rate
V Reward for bearing systematic risk ²
measured by the market risk premium
V Ômount of systematic risk ² measured by
beta
V Consider the betas for each of the assets given
earlier. If the risk-free rate is 2.1 and the market
risk premium is 8.6, what is the expected return
for each?

ðecurit Beta Ex ected etur

DCLK 2.685 2.13 + 2.6858.6) = 25.22%
KO 0.195 2.13 + 0.1958.6) = 3.81%
INTC 2.161 2.13 + 2.1618.6) = 20.71%
KEI 2.434 2.13 + 2.4348.6) = 23.06%