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# Chapter 5

Modern Portfolio
Concepts

## Modern Portfolio Concepts

Learning Goals
1. Understand portfolio management objectives and
calculate the return and standard deviation of
a portfolio.
2. Discuss the concepts of correlation and diversification,
and the effectiveness, methods, and benefits of
international diversification.
3. Describe the two components of risk, beta, and the
capital asset pricing model (CAPM).

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## Modern Portfolio Concepts

Learning Goals (contd)
4. Review traditional and modern approaches to portfolio
management and reconcile them.
5. Describe the role of investor characteristics and
objectives and of portfolio objectives and policies in
constructing an investment portfolio.
6. Summarize why and how investors use an asset
allocation scheme to construct an investment portfolio.

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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

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## The Ultimate Goal:

An Efficient Portfolio
Efficient portfolio
A portfolio that provides the highest return for a given
level of risk
Given the choice between two equally risky
investments, an investor will chose the one with the
highest potential return.
Given the choice between two investments offering the
same return, an investor will choice the one that has the
least risk.

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## 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.

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Return on Portfolio

Proportionof
Proportionof

portfolio'stotal
portfolio'stotal
Return
Return
Return

on
dollarvalue
onasset
dollarvalue
onasset L

portfolio
representedby
1
representedby
2

asset1
asset2
Proportionof

portfolio'stotal
Return
dollarvalue
onasset

n
representedby

assetn

j 1

Proportionof
portfolio'stotal
Return
dollarvalue
onasset

j
representedby

assetj

rp w1 r1 w2 r2 L wn rn

w
j 1

rj

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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.

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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

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## Figure 5.1 The Correlation

Between Series M, N, and P

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Correlation:
Why Diversification Works!
To reduce overall risk in a portfolio, it is best to
combine assets that have a negative (or
low-positive) correlation.
Uncorrelated assets reduce risk somewhat, but
not as effectively as combining negatively
correlated assets.
Investing in different investments with high
positive correlation will not provide sufficient
diversification.

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## Figure 5.2 Combining Negatively

Correlated Assets to Diversify Risk

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## Table 5.3 Correlation, Return,

and Risk for Various Two-Asset
Portfolio Combinations

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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

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International Diversification
Potentially greater returns than in U.S.
Reduction of overall portfolio risk

## Currency exchange risk

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

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Methods of
International Diversification
Foreign company stocks listed on U.S.
stock exchanges

Yankee Bonds
Mutual funds investing in foreign stocks
U.S. multinational companies (typically not
considered a true international investment for
diversification purposes)

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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

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Components of Risk

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## 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.

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## Beta: A Popular Measure of Risk

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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

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Interpreting Beta
Stock
Amazon.com

Beta
1.60

Beta
1.10

0.60
1.25

Stock
Intl Bus
iness
Machines
Merrill Lynch & Co.
Microsoft

Anheuser Busch
Bank of America
Corp.
Dow Jones & Co.
Disney
eBay
ExxonMobil Corp.
Gap (The), Inc.
General Motors Corp.
Intel

1.00
1.25
1.55
0.80
1.35
1.20
1.35

Nike, Inc.
PepsiCo, Inc.
Qualcomm
Sempra Energy
Wal-Mart Stores
Xerox
Yahoo! Inc.

0.90
0.65
1.20
0.85
1.00
1.45
1.85

1.60
1.15

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## 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

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Capital Asset
Pricing Model (CAPM) (contd)
Uses beta, the risk-free rate and the market
an investment
Requiredreturn
Betafor
Riskfree
Market
Riskfreerate

return
oninvestmentj
rate
investmentj

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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

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Figure 5.5
The Security Market Line (SML)

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Two Approaches
to Constructing Portfolios
versus
Modern Portfolio Theory

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

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## 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

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## 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

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## Figure 5.7 The Feasible or Attainable

Set and the Efficient Frontier

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## 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

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## Key Aspects of MPT: Portfolio Betas

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Figure 5.8
Portfolio Risk and Diversification

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## Interpreting Portfolio Betas

Portfolio betas are interpreted exactly same way as
individual stock betas.
Portfolio beta of 1.00 will experience a 10% increase when the
market increase is 10%
Portfolio beta of 0.75 will experience a 7.5% increase when the
market increase is 10%
Portfolio beta of 1.25 will experience a 12.5% increase
when
the market increase is 10%

## Low-beta portfolios are less responsive and less risky than

high-beta portfolios.
A portfolio containing low-beta assets will have a low beta,
and vice versa.

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## Interpreting Portfolio Betas

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Approach and MPT
Recommended portfolio management policy uses
aspects of both approaches:
Determine how much risk you are willing to bear
Seek diversification between different types of
securities and industry lines
Pay attention to correlation of return between securities
Use beta to keep portfolio at acceptable level of risk
Evaluate alternative portfolios to select highest return
for the given level of acceptable risk

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Figure 5.9

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Constructing a Portfolio
Using Asset Allocation
Asset Allocation is the process of dividing
an investment portfolio into various asset
classes to preserve capital by protecting
against negative developments while taking
In other words, dont put all of your
eggs in one basket, and choose your

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Constructing a Portfolio
Using Asset Allocation (contd)
Individual investor characteristics and objectives
determine relative income needs and ability to bear risk
Investor characteristics to consider:

## Level and stability of income, net worth

Age and family factors
Investment experience and ability to handle risk
Tax considerations

## Investor objectives to consider:

High level of current income
Significant capital appreciation

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## Portfolio Objectives and Policies

Capital Preservation Objective
Low-risk, conservative investment strategy
Emphasis on current income and capital preservation
Normally contains low-beta securities

## Capital Growth Objective

Higher-risk investment strategy
Emphasis on more speculative investments
Normally contains higher-beta securities

## Tax Efficient Objective

Emphasis on capital gains and longer holding periods to
defer income taxes

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## Approaches to Asset Allocation

Fixed-Weightings Approach: asset allocation plan in
which a fixed percentage of the portfolio is allocated to
each asset category
Flexible-Weightings Approach: asset allocation plan in
which weights for each asset category are adjusted
periodically based on market analysis
Tactical Approach: asset allocation plan that uses stockindex futures and bond futures to change a portfolios asset
allocation based on market behavior

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## Applying Asset Allocation

Consider impact of economic and other factors on
Design your asset allocation plan for the long haul
(at least 7 to 10 years).
Stress capital preservation.
Provide for periodic reviews to maintain
consistency with changing investments goals.
Consider using mutual funds, especially for
portfolios under \$100,000.

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Chapter 5 Review
Learning Goals
1. Understand portfolio management objectives and
calculate the return and standard deviation of a
portfolio.
2. Discuss the concepts of correlation and diversification,
and the effectiveness, methods, and benefits of
international diversification.
3. Describe the two components of risk, beta, and the
capital asset pricing model (CAPM).

5-47

## Chapter 5 Review (contd)

Learning Goals (contd)
4. Review traditional and modern approaches to portfolio
management and reconcile them.
5. Describe the role of investor characteristics and
objectives and of portfolio objectives and policies in
constructing an investment portfolio.
6. Summarize why and how investors use an asset
allocation scheme to construct an investment portfolio.