StrongPCMP4e Ch06 Edited 4

1
Chapter 6

Why Diversification I s a Good I dea
Portfolio Construction, Management, & Protection, 4e, Robert A. Strong
Copyright 2006 by South-Western, a division of Thomson Business & Economics. All rights reserved.
2

The most important lesson learned
is an old truth ratified.

General Maxwell R. Thurman
3
Outline
Introduction
Carrying Your Eggs in More Than One Basket
Role of Uncorrelated Securities
Lessons from Evans and Archer
Diversification and Beta
Capital Asset Pricing Model
Equity Risk Premium
Using a Scatter Diagram to Measure Beta
Arbitrage Pricing Theory
4
Introduction
Diversification of a portfolio is logically a
good idea

Virtually all stock portfolios seek to
diversify in one respect or another
5
Carrying Your Eggs in More
Than One Basket
Investments in Your Own Ego
The Concept of Risk Aversion Revisited
Multiple Investment Objectives
6
Investments in Your Own Ego
Never put a large percentage of investment
funds into a single security
If the security appreciates, the ego is stroked
and this may plant a speculative seed
If the security never moves, the ego views this
as neutral rather than an opportunity cost
If the security declines, your ego has a very
difficult time letting go
7
The Concept of
Risk Aversion Revisited
Diversification is logical
If you drop the basket, all eggs break

Diversification is mathematically sound
Most people are risk averse
People take risks only if they believe they will
be rewarded for taking them

8
The Concept of Risk
Aversion Revisited (contd)
Diversification is more important now
A Journal of Finance article shows that
volatility of individual firms has increased

Investors need more stocks to adequately diversify

9
Multiple Investment Objectives
Multiple objectives justify carrying your
eggs in more than one basket
Some people find mutual funds unexciting
Many investors hold their investment funds in
more than one account so that they can play
with part of the total
e.g., a retirement account and a separate brokerage
account for trading individual securities
10
Role of Uncorrelated Securities
Variance of a Linear Combination: The
Practical Meaning
Portfolio Programming in a Nutshell
Concept of Dominance
Harry Markowitz: The Founder of Portfolio
Theory
11
Variance of a Linear Combination:
The Practical Meaning
One measure of risk is the variance of
return
The variance of an n-security portfolio is:

2
1 1
where proportion of total investment in Security
correlation coefficient between
Security and Security
n n
p i j ij i j
i j
i
ij
x x
x i
i j
o o o
= =
=
=
=
12
The Practical Meaning (contd)
The variance of a two-security portfolio is:

2 2 2 2 2
2
p A A B B A B AB A B
x x x x o o o o o = + +
13
Return variance is a securitys total risk

Most investors want portfolio variance to be
as low as possible without having to give up
any return

2 2 2 2 2
2
x x x x o o o o o = + +
Total Risk Risk from A Risk from B Interactive Risk
14
If two securities have low correlation, the
interactive risk will be small
If two securities are uncorrelated, the
interactive risk drops out
If two securities are negatively correlated,
interactive risk would be negative and
would reduce total risk

15
Portfolio Programming
in a Nutshell
Various portfolio combinations may result
in a given return

The investor wants to choose the portfolio
combination that provides the least amount
of variance
16
in a Nutshell (contd)
Example

Assume the following statistics for Stocks A, B, and C:

Stock A Stock B Stock C
Expected return .20 .14 .10
Standard deviation .232 .136 .195
17
Example (contd)

The correlation coefficients between the three stocks are:

Stock A Stock B Stock C
Stock A 1.000
Stock B 0.286 1.000
Stock C 0.132 0.605 1.000
18
Example (contd)

An investor seeks a portfolio return of 12 percent.

Which combinations of the three stocks accomplish this
objective? Which of those combinations achieves the least
amount of risk?

19
Example (contd)

Solution: Two combinations achieve a 12 percent return:

1) 50% in B, 50% in C: (.5)(14%) + (.5)(10%) = 12%
2) 20% in A, 80% in C: (.2)(20%) + (.8)(10%) = 12%

20
Example (contd)

Solution (contd): Calculate the variance of the B/C
combination:

2 2 2 2 2
2 2
2
(.50) (.0185) (.50) (.0380)
2(.50)(.50)( .605)(.136)(.195)
.0046 .0095 .0080
.0061
x x x x o o o o o = + +
= +
+
= +
=
21
Example (contd)

Solution (contd): Calculate the variance of the A/C
combination:

2 2 2 2 2
2 2
2
(.20) (.0538) (.80) (.0380)
2(.20)(.80)(.132)(.232)(.195)
.0022 .0243 .0019
.0284
x x x x o o o o o = + +
= +
+
= + +
=
22
Example (contd)

Solution (contd): Investing 50 percent in Stock B and 50
percent in Stock C achieves an expected return of 12
percent with the lower portfolio variance. Thus, the
investor will likely prefer this combination to the
alternative of investing 20 percent in Stock A and 80
percent in Stock C.

23
Concept of Dominance
Dominance is a situation in which investors
universally prefer one alternative over
another
All rational investors will clearly prefer one
alternative
24
Concept of Dominance (contd)
A portfolio dominates all others if:
For its level of expected return, there is no
other portfolio with less risk

For its level of risk, there is no other portfolio
with a higher expected return
25
Concept of Dominance (contd)
Example (contd)
In the previous example, the B/C combination dominates the A/C
combination:

0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0 0.005 0.01 0.015 0.02 0.025 0.03
Risk
E
x
p
e
c
t
e
d

R
e
t
u
r
n

B/C combination
dominates A/C
26
Harry Markowitz: The
Founder of Portfolio Theory
Introduction
Terminology
Quadratic Programming
27
Introduction
Harry Markowitzs Portfolio Selection Journal
of Finance article (1952) set the stage for modern
portfolio theory
The first major publication indicating the importance of
security return correlation in the construction of stock
portfolios

Markowitz showed that for a given level of expected
return and for a given security universe, knowledge of
the covariance and correlation matrices is required
28
Terminology
Security Universe
Efficient Frontier
Capital Market Line and the Market
Portfolio
Security Market Line
Expansion of the SML to Four Quadrants
Corner Portfolio
29
Security Universe
The security universe is the collection of all
possible investments
For some institutions, only certain investments
may be eligible
e.g., the manager of a small cap stock mutual fund
would not include large cap stocks
30
Efficient Frontier
Construct a risk/return plot of all possible
portfolios
Those portfolios that are not dominated
constitute the efficient frontier
31
Efficient Frontier (contd)
Standard Deviation
Expected Return
100% Investment in Security
with Highest E(R)
100% Investment in Minimum
Variance Portfolio
Points plotting below the
efficient frontier are dominated
by other portfolios
No points plot above
the line
All portfolios
on the line
are efficient
32
The farther you move to the left on the
efficient frontier, the greater the number of
securities in the portfolio

33
When a risk-free investment is available,
the shape of the efficient frontier changes
The expected return and variance of a risk-free
rate/stock return combination are simply a
weighted average of the two expected returns
and variances
The risk-free rate has a variance of zero

34
Standard Deviation
Expected Return
R
f
A
B
C
35
The efficient frontier with a risk-free rate:
Extends from the risk-free rate to point B
The line is tangent to the risky securities efficient
frontier

Follows the curve from point B to point C
36
Capital Market Line and the
Market Portfolio
The tangent line passing from the risk-free
rate through point B is the capital market
line (CML)
When the security universe includes all possible
investments, point B is the market portfolio
It contains every risky asset in the proportion of its
market value to the aggregate market value of all
assets
It is the only risky asset risk-averse investors will
hold
37
Market Portfolio (contd)
Implications for investors:
Regardless of the level of risk-aversion, all
investors should hold only two securities:
The market portfolio
The risk-free rate
Conservative investors will choose a point near
the lower left of the CML
Growth-oriented investors will stay near the
market portfolio
38
Any risky portfolio that is partially invested
in the risk-free asset is a lending portfolio

Investors can achieve portfolio returns
greater than the market portfolio by
constructing a borrowing portfolio
39
Standard Deviation
Expected Return
R
f
A
B
C
40
Security Market Line
The graphical relationship between
expected return and beta is the security
market line (SML)
The slope of the SML is the market price of
risk

The slope of the SML changes periodically as
the risk-free rate and the markets expected
return change

41
Security Market Line (contd)
Beta
Expected Return
R
f
Market Portfolio
1.0
E(R)
42
Expansion of the SML to
Four Quadrants
There are securities with negative betas and
negative expected returns
A reason for purchasing these securities is their
risk-reduction potential
e.g., buy car insurance without expecting an
accident

e.g., buy fire insurance without expecting a fire
43
Security Market Line (contd)
Beta
Expected Return
Securities with Negative
Expected Returns
44
Corner Portfolio
A corner portfolio occurs every time a new
security enters an efficient portfolio or an
old security leaves
Moving along the risky efficient frontier from
right to left, securities are added and deleted
until you arrive at the minimum variance
portfolio
45
Quadratic Programming
The Markowitz algorithm is an application
of quadratic programming
The objective function involves portfolio
variance

Quadratic programming is very similar to linear
programming
46
Markowitz Quadratic
Programming Problem
47
Lessons from
Evans and Archer
Introduction
Methodology
Results
Implications
Words of Caution
48
Introduction
Evans and Archers 1968 Journal of
Finance article
Very consequential research regarding portfolio
construction

Shows how nave diversification reduces the
dispersion of returns in a stock portfolio
Nave diversification refers to the selection of
portfolio components randomly without any serious
security analysis
49
Methodology
Used computer simulations:
Measured the average variance of portfolios of
different sizes, up to portfolios with dozens of
components

Purpose was to investigate the effects of
portfolio size on portfolio risk when securities
are randomly selected
50
Results
Definitions
General Results
Strength in Numbers
Biggest Benefits Come First
Superfluous Diversification
51
Definitions
Unsystematic risk is the part of total risk
that is unrelated to overall market
movements and can be diversified away
Research indicates up to 75 percent of total risk
is diversifiable
Systematic risk is the risk that remains
after no further diversification benefits can
be achieved
52
Definitions (contd)
Investors are rewarded only for systematic
risk
Rational investors should always diversify

Explains why beta (a measure of systematic
risk) is important
Securities are priced on the basis of their beta
coefficients
53
General Results
Number of Securities
Portfolio Variance
Source: Adapted by Edwin J. Elton and Martin J. Gruber, Risk Production and Portfolio Size: An Analytical Solution, Journal of Business,
October 1977, 415437.
54
Strength in Numbers
Portfolio variance (total risk) declines as the
number of securities included in the
portfolio increases
On average, a randomly selected ten-security
portfolio will have less risk than a randomly
selected three-security portfolio

Risk-averse investors should always diversify
to eliminate as much risk as possible
55
Biggest Benefits Come First
Increasing the number of portfolio
components provides diminishing benefits
as the number of components increases
Adding a security to a one-security portfolio
provides substantial risk reduction

Adding a security to a twenty-security portfolio
provides only modest additional benefits
56
Superfluous Diversification
Superfluous diversification refers to the
addition of unnecessary components to an
already well-diversified portfolio
Deals with the diminishing marginal benefits of
additional portfolio components

The benefits of additional diversification in
large portfolios may be outweighed by the
transaction costs
57
Implications
Very effective diversification occurs even
when the investor owns only a small
fraction of the total number of available
securities
Institutional investors may not be able to avoid
superfluous diversification due to the dollar size
of their portfolios
Mutual funds are prohibited from holding more than
5 percent of a firms equity shares
58
Implications (contd)
Owning all possible securities would
require high commission costs

It is difficult to follow every stock
59
Words of Caution
Selecting securities at random usually gives
good diversification but not always
Industry effects may prevent proper
diversification
Although nave diversification reduces risk,
it can also reduce return
Unlike Markowitzs efficient diversification
60
Diversification and Beta
Beta measures systematic risk
Diversification does not mean to reduce beta
Investors differ in the extent to which they will
take risk, so they choose securities with
different betas
e.g., an aggressive investor could choose a portfolio
with a beta of 2.0
e.g., a conservative investor could choose a portfolio
with a beta of 0.5
61
Capital Asset Pricing Model
Introduction
Systematic and Unsystematic Risk
Fundamental Risk/Return Relationship
Revisited
62
Introduction
The Capital Asset Pricing Model (CAPM)
is a theoretical description of the way in
which the market prices investment assets
The CAPM is a positive theory
63
Systematic and
Unsystematic Risk
Unsystematic risk can be diversified away
and is irrelevant

Systematic risk cannot be diversified and is
relevant
Measured by beta
Beta determines the level of expected return on a
security or portfolio (SML)
64
Fundamental Risk/Return
Relationship Revisited
CAPM
SML and CAPM
Market Model versus CAPM
Note on the CAPM Assumptions
Stationarity of Beta
65
CAPM
The more systematic risk you carry, the
greater the expected return:

( ) ( )
where ( ) expected return on security
risk-free rate of interest
beta of Security
( ) expected return on the market
i f i m f
i
f
i
m
E R R E R R
E R i
R
i
E R
|
|
(
= +

=
=
=
=
66
CAPM (contd)
The CAPM deals with expectations about
the future

Excess returns on a particular stock are
directly related to:
The beta of the stock
The expected excess return on the market

67
CAPM (contd)
CAPM assumptions:
Variance of return and mean return are all
investors care about
Investors are price takers; they cannot influence
the market individually
All investors have equal and costless access to
information
There are no taxes or commission costs

68
CAPM (contd)
CAPM assumptions (contd):
Investors look only one period ahead

Everyone is equally adept at analyzing
securities and interpreting the news

69
SML and CAPM
If you show the security market line with
excess returns on the vertical axis, the
equation of the SML is the CAPM
The intercept is zero

The slope of the line is the expected market risk
premium
70
Market Model versus CAPM
The market model is an ex post model
It describes past price behavior

The CAPM is an ex ante model
It predicts what a value should be
71
Market Model
versus CAPM (contd)
The market model is:

( )
where return on Security in period
intercept
beta for Security
return on the market in period
error term on Security in period
it i i mt it
it
i
i
mt
it
R R e
R i t
i
R t
e i t
o |
o
|
= + +
=
=
=
=
=
72
Note on the
CAPM Assumptions
Several assumptions are unrealistic:
People pay taxes and commissions
Many people look ahead more than one period
Not all investors forecast the same distribution of
returns for the market

Theory is useful to the extent that it helps us learn
more about the way the world acts
Empirical testing shows that the CAPM works
reasonably well
73
Stationarity of Beta
Beta is not stationary
Evidence that weekly betas are less than
monthly betas, especially for high-beta stocks
Evidence that the stationarity of beta increases
as the estimation period increases

The informed investment manager knows
that betas change
74
Equity Risk Premium
Equity risk premium refers to the
difference in the average return between
stocks and some measure of the risk-free
rate
The equity risk premium in the CAPM is the
excess expected return on the market

Some researchers are proposing that the size of
the equity risk premium is shrinking
75
Using A Scatter Diagram to
Measure Beta
Correlation of Returns
Linear Regression and Beta

76
Correlation of Returns
Much of the daily news is of a general
economic nature and affects all securities
Stock prices often move as a group

Some stocks routinely move more than the
others regardless of whether the market
advances or declines
Some stocks are more sensitive to changes in
economic conditions
77
Linear Regression and Beta
To obtain beta with a linear regression:
Plot a stocks return against the market return

Use Microsoft Excel to run a linear regression
and obtain the coefficients
The coefficient for the market return is the beta
statistic
The intercept is the trend in the security price
returns that is inexplicable by finance theory

78
Importance of Logarithms
Introduction
Statistical Significance
79
Introduction
Taking the logarithm of returns reduces the
impact of outliers
Outliers distort the general relationship

Using logarithms will have more effect the
more outliers there are
80
Statistical Significance
Published betas are not always useful
numbers
Individual securities have substantial
unsystematic risk and will behave differently
than beta predicts

Portfolio betas are more useful since some
unsystematic risk is diversified away
81
Arbitrage Pricing Theory
APT Background
The APT Model
Comparison of the CAPM and the APT
82
APT Background
Arbitrage pricing theory (APT) states that a
number of distinct factors determine the market
return
Roll and Ross state that a securitys long-run return is a
function of changes in:
Inflation
Industrial production
Risk premiums
The slope of the term structure of interest rates
Another alternative = Fama & Frenchs 3-Factor Model
83
APT Background (contd)
Not all analysts are concerned with the
same set of economic information
A single market measure (such as beta) does
not capture all the information relevant to the
price of a stock
84
The APT Model
General representation of the APT model:

1 1 2 2 3 3 4 4
( )
where actual return on Security
( ) expected return on Security
sensitivity of Security to factor
unanticipated change in factor
A A A A A A
A
A
iA
i
R E R b F b F b F b F
R A
E R A
b A i
F i
= + + + +
=
=
=
=
85
Comparison of the
CAPM and the APT
The CAPMs market portfolio is difficult to
construct:
Theoretically, all assets should be included (real estate,
gold, etc.)
Practically, a proxy like the S&P 500 index is used

APT requires specification of the relevant
macroeconomic factors
86
Comparison of the
CAPM and the APT (contd)
The CAPM and APT complement each
other rather than compete
Both models predict that positive returns will
result from factor sensitivities that move with
the market and vice versa
APT can be viewed as a more general and more flexible
version of CAPM
Instead of having one all-encompassing measure of systematic
risk, APT breaks down the measure of systematic risk into a
variety of different variables that either drive or reflect
differences in systematic risk

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