Modern Portfolio Concepts

Modern Portfolio Concepts

 Learning Goals
1. Understand portfolio objectives and the procedures used to calculate portfolio return and standard deviation. 2. Discuss the concepts of correlation and diversification, and the key aspects of international diversification. 3. Describe the components of risk and the use of beta to measure risk.

Modern Portfolio Concepts

 Learning Goals (contd)
4. Explain the capital asset pricing model (CAPM) conceptually, mathematically, and graphically. 5. Review the traditional and modern approaches to portfolio management. 6. Describe portfolio betas, the risk-return tradeoff, and reconciliation of the two approaches to portfolio management.

What is a Portfolio?
 Portfolio is a collection of investment vehicles assembled to meet one or more investment goals.  Growth-Oriented Portfolio: primary objective is long-term price appreciation  Income-Oriented Portfolio: primary objective is current dividend and interest income

The Ultimate Goal: An Efficient Portfolio

 Efficient portfolio
 A portfolio that provides the highest return for a given level of risk, or  Has the lowest risk for a given level of return

Portfolio Return and Risk Measures

 Return on a Portfolio is the weighted average of returns on the individual assets in the portfolio  Standard Deviation of a portfolios returns is calculated using all of the individual assets in the portfolio

Return on Portfolio
Proportion of Proportion of portfolio's total Return Return portfolio's total Return v on asset    v on asset  dollar value on ! dollar value 2 1 represented by portfolio represented by asset 2 asset 1 Proportion of portfolio's total Return n dollar value ! v on asset j !1 n represented by asset n  Proportion of portfolio's total Return dollar value v on asset j represented by asset j

rp ! w1 v r1  w2 v r2    wn v rn ! 

w
j !1

v rj

Correlation: Why Diversification Works!

    Correlation is a statistical measure of the relationship between two series of numbers representing data Positively Correlated items move in the same direction Negatively Correlated items move in opposite directions Correlation Coefficient is a measure of the degree of correlation between two series of numbers representing data

Correlation Coefficients
 Perfectly Positively Correlated describes two positively correlated series having a correlation coefficient of +1  Perfectly Negatively Correlated describes two negatively correlated series having a correlation coefficient of -1  Uncorrelated describes two series that lack any relationship and have a correlation coefficient of nearly zero
9

Figure 5.1 The Correlation Between Series M, N, and P

10

Table 5.3 Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations

11

Why Use International Diversification?

    Offers more diverse investment alternatives than U.S.-only based investing Foreign economic cycles may move independently from U.S. economic cycle Foreign markets may not be as efficient as U.S. markets, allowing true gains from superior research Study done between 1984 and 1994 suggests that portfolio 70% S&P 500 and 30% EAFE would reduce risk 5% and increase return 7% over a 100% S&P 500 portfolio

12

International Diversification
 Advantages of International Diversification
 Broader investment choices  Potentially greater returns than in U.S.  Reduction of overall portfolio risk

 Disadvantages of International Diversification

    Currency exchange risk Less convenient to invest than U.S. stocks More expensive to invest Riskier than investing in U.S.

13

Methods of International Diversification

 Foreign company stocks listed on U.S. stock exchanges
    Yankee Bonds American Depository Shares (ADSs) Mutual funds investing in foreign stocks U.S. multinational companies (typically not considered a true international investment for diversification purposes)

14

Components of Risk
 Diversifiable (Unsystematic) Risk
 Results from uncontrollable or random events that are firm-specific  Can be eliminated through diversification  Examples: labor strikes, lawsuits

 Nondiversifiable (Systematic) Risk

 Attributable to forces that affect all similar investments  Cannot be eliminated through diversification  Examples: war, inflation, political events

15

Beta: A Popular Measure of Risk

       A measure of nondiversifiable risk Indicates how the price of a security responds to market forces Compares historical return of an investment to the market return (the S&P 500 Index) The beta for the market is 1.00 Stocks may have positive or negative betas. Nearly all are positive. Stocks with betas greater than 1.00 are more risky than the overall market. Stocks with betas less than 1.00 are less risky than the overall market.

16

Beta: A Popular Measure of Risk

Table 5.4 Selected Betas and Associated Interpretations

17

Interpreting Beta
 Higher stock betas should result in higher expected returns due to greater risk  If the market is expected to increase 10%, a stock with a beta of 1.50 is expected to increase 15%  If the market went down 8%, then a stock with a beta of 0.50 should only decrease by about 4%  Beta values for specific stocks can be obtained from Value Line reports or online websites such as yahoo.com
18

Interpreting Beta

19

Capital Asset Pricing Model (CAPM)

 Model that links the notions of risk and return  Helps investors define the required return on an investment  As beta increases, the required return for a given investment increases

20

Capital Asset Pricing Model (CAPM) (contd)

 Uses beta, the risk-free rate and the market return to define the required return on an investment
Risk-free Required return Beta for Market v  ! Risk-free rate  investment j return rate on investment j

21

Capital Asset Pricing Model (CAPM) (contd)

 CAPM can also be shown as a graph  Security Market Line (SML) is the picture of the CAPM  Find the SML by calculating the required return for a number of betas, then plotting them on a graph

22

Figure 5.6 The Security Market Line (SML)

23

Two Approaches to Constructing Portfolios

Traditional Approach versus Modern Portfolio Theory

24

Traditional Approach
 Emphasizes balancing the portfolio using a wide variety of stocks and/or bonds  Uses a broad range of industries to diversify theportfolio  Tends to focus on well-known companies
 Perceived as less risky  Stocks are more liquid and available  Familiarity provides higher comfort levels for investors

25

Modern Portfolio Theory (MPT)

 Emphasizes statistical measures to develop a portfolio plan  Focus is on:
 Expected returns  Standard deviation of returns  Correlation between returns

 Combines securities that have negative (or lowpositive) correlations between each others rates of return
26

Key Aspects of MPT: Efficient Frontier

 Efficient Frontier
 The leftmost boundary of the feasible set of portfolios that include all efficient portfolios: those providing the best attainable tradeoff between risk and return  Portfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferior  Portfolios that fall to the left of the efficient frontier are not available for investments

27

Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier

28

Key Aspects of MPT: Portfolio Betas

 Portfolio Beta
 The beta of a portfolio; calculated as the weighted average of the betas of the individual assets the portfolio includes  To earn more return, one must bear more risk  Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship

29

Key Aspects of MPT: Portfolio Betas

Table 5.6 Austin Funds Portfolios V and W

30

Figure 5.8 Portfolio Risk and Diversification

31

Figure 5.9 The Portfolio Risk-Return Tradeoff

32

Table 5.1 Expected Return, Average Return, and Standard Deviation of Returns for Portfolio XY

33

Table 5.2 Expected Returns, Average Returns, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ

34

Table 5.5 The Growth Fund of America, August 31, 2005

35