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Efficient Diversification

Bodie, Kane, and Marcus


Essentials of Investments,
9th Edition

McGraw-Hill/Irwin

Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 6 Outline
6.1 Diversification and Portfolio Risk
6.2 Asset Allocation with Two Risky Assets
6.3 The Optimal Risky Portfolio with a Risk-Free

Asset
6.4 Efficient Diversification with Many Risky
Assets
6.5 A Single-Index Stock Market
6.6 Risk of Long-Term Investments

6-2

6.1 Diversification and Portfolio Risk


Spreading an investment across assets (and

thereby forming a portfolio) is diversification.


Why?
This reduction in risk arises because worse than

expected returns from one asset are offset by better


than expected returns from another

Diversifiable vs. systematic risk


Does risky assets always lead to risky portfolio?
Can we diversify systematic risk?
Will diversifiable risk be rewarded?
3
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6.1 Diversification and Portfolio Risk


Systematic
Risk

Unsystematic
Risk

Influence

affect a large
number of
assets

affect a limited
number of assets

Also called

non-diversifiable unique risk and


risk or market
asset-specific risk,
risk
firm-specific risk

Examples

changes in
GDP, inflation,
interest rates,

labor strikes, part


shortages, etc.
4

6-4

Figure 13.1

13-5
6-5

6.2 Asset Allocation with Two Risky Assets


Recall the expected return and variance for

individual securities:
E(r) =

Equation (5.6)

Var(r) =
Equation (5.7)

Where is probability of each economic scenario.

6-6

Spreadsheet 6.1 Capital Market Expectations

E(r) =
E (rS ) .05 (.37) .25 (.11) .40 .14 .30 .30
E (rS ) 10.0%

6-7

Spreadsheet 6.2 Variance of Returns

Var(r) =
Var (rS )
.05 * ( .47 .10) 2 .25 * (.21 .10) 2
.40 * (.04 .10) 2 .30 * (.2 .10) 2
.03471

S .03471 18.63%

6-8

6.2 Asset Allocation with Two Risky Assets: Covariance and


Correlation

Covariance and Correlation


The relation between two securities can be
measured by covariance and correlation.
Covariance Calculations
S

Cov(rS , rB ) p(i )[rS (i ) E (rS )][rB (i ) E (rB )]


i 1

Correlation Coefficient
SB

Cov(rS , rB )

S B

Cov( rS , rB ) SB S B

Equation (6.1)
Equation (6.2)

Equation (6.3)
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Cov(rS , rB )
.05 * (.47 .10)(.14 .05) .25 * (.21 .10)(.10 .05)
.40 * (.04 .10)(.03 .05) .30 * (.2 .10)(.10 .05)
.00748
SB

Cov(rS , rB )

S B

.00748
0.49
.1863 .0827

10

6-10

6.2 Asset Allocation with Two Risky Assets


Portfolio of a two-security
Rate of Return:

rp w1r1 w2 r2

Equation (6.4)

Expected Rate of Return:

E (rp ) w1 E (r1 ) w2 E (r2 )

Variance of Rate of Return:

Equation (6.5

p2 ( w1 1 ) 2 ( w2 2 ) 2 2 w1w2 1 2 12
or

( w1 1 ) ( w2 2 ) 2 w1w2Cov(r1 , r1 )
2
p

Equation (6.6
11

6-11

Approach1: Treating a Portfolio as a Single Security


-20.2=40%*(-37)+ 60%*(-9)

1. Treat the portfolio as a


new fund (one single
security),
2. Calculate the portfolio
return using weighted
average,
3. Calculate expected
return just like that for any
single security.
(See PPT #7,8 example)
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Approach 2: Applying Portfolio Formula

E (rp ) w1 E ( r1 ) w2 E (r2 )

E (rp ) 40% (10%) 60% (5%)


7%

p2 ( w1 1 ) 2 ( w2 2 ) 2 2 w1w2Cov (r1 , r1 )

.4 2 * 0.0347 .6 2 * 0.00443 2 * 0.4 * .6 * ( 0.00748)


0.00443

p 0.00443 6.65%

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6.2 Asset Allocation with Two Risky Assets


Risk-Return Trade-Off
Investment opportunity set
Available portfolio risk-return combinations

Mean-Variance Criterion
If E(rA) E(rB) and A B
Portfolio A dominates portfolio B

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6-14

15

6-15

Figure 6.3 Investment Opportunity Set

16

6-16

Figure 6.3 Investment Efficient Set

17

6-17

Figure 6.4 Opportunity Sets: Various Correlation Coefficients

18

6-18

Figure 6.5 The Opportunity Set of a Portfolio with Stock


and Bond Fund, and a Fisk-free Assets
When we add the risk-free asset to an efficient portfolio,
the resulting opportunity set is the straight line Capital
Allocation Line (CAL) (refer to Chapter 5).

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6.3 The Optimal Risky Portfolio with a Risk-Free Asset


So the question of finding the optimal risky

portfolio given a risk-free asset is equivalent to


looking for the CAL with highest reward-to-risk
ratio or steepest slope.
Slope of CAL is Sharpe Ratio of Risky Portfolio
Equation (6.8)

Optimal Risky Portfolio


Which portfolio leads to the highest Sharpe ratio ( or
steepest slope)?

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Figure 6.6 Bond, Stock and T-Bill Optimal Allocation

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6.3 Finding the Optimal Risky Portfolio O


To find the composition of the optimal risky portfolio

O, we search for the weights in the stock and bond


funds that maximize the portfolios Sharpe ratio.
With only two risky assets, the optimal portfolio
weights:
wB

[ E (rB ) rf ] S2 [ E (rs ) rf ] B S BS
[ E (rB ) rf ] S2 [ E (rs ) r f ] B2 [ E (rB ) rf E (rs ) rf ] B S BS

wS 1 wB

Equation (6.10)
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6.3 Finding the Optimal Risky Portfolio O


Stock Fund Bond Fund
Expected Return

10%

5%

Using formula in the previous


slide, solve weights:

wB
ws

3%

Risk-free
Excess Return

7%

2%

Std.Dev.
Correlation

19%

8%

56.8%
43.2%

0.2

Using portfolio formula (equation 6.4,6.5 or formula in


slide 14), we solve portfolio return and risk for the
optimal risky portfolio O:

Exp.Ret.

E(ro)

7.16%

Std. dev.

o
So

10.15%

Sharpe Ratio

.41

23

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Figure 6.7 The Optimal Portfolio O

Optimal (tangency)

Rf=

55% in portfolio O
45% in risk-free
asset

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The Complete Portfolio C in CALo Line


We can find return and risk for any portfolio in CALo
line.
For example: portfolio C consists of 45% in risk-free
asset, 55% in optimal portfolio O.
From chapter 5, return and risk for portfolio C given the
risky portfolio (y) and risk-free asset (1-y):
E(rC) = rf + y[E(rp) rf ]
C = yrp
E(rC) = 3% +.55*(7.16-3)=5.29%

Equation (5.19)
Equation (5.20)

C = .55*10.15=5.58%

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The Complete Portfolio C in CALo Line


For a portfolio C with 45% in risk-free asset (T-bills)
Weight in risk-free asset
Weight in bond fund
.568*55%
Weight in stock fund
.432*55%
Total

45%
31.24%
23.76%
100%

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Figure 6.7 The Complete Portfolio C

Optimal (tangency)

Rf=

55% in portfolio O
45% in risk-free
asset

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6.4 Efficient Diversification with Many Risky Assets


Efficient Frontier of Risky Assets
Graph representing set of portfolios that
maximizes expected return at each level of
portfolio risk
Three methods
Maximize risk premium for any level standard deviation
Minimize standard deviation for any level risk premium
Maximize Sharpe ratio for any standard deviation or risk
premium

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Figure 6.10 Efficient Frontier: Risky and Individual Assets

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6.4 Efficient Diversification with Many Risky Assets


Choosing Optimal Risky Portfolio
Optimal portfolio CAL tangent to efficient frontier
Preferred Complete Portfolio and

Separation Property
Separation property: implies portfolio choice,

separated into two tasks


Determination of optimal risky portfolio
Personal choice of best mix of risky portfolio and risk-

free asset

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6.4 Efficient Diversification with Many Risky Assets


Optimal Risky Portfolio: Illustration
Efficiently diversified global portfolio using stock
market indices of six countries
Standard deviation and correlation estimated
from historical data
Risk premium forecast generated from
fundamental analysis

31

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Figure 6.11 Efficient Frontiers/CAL: Table 6.1

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6.5 A Single-Index Stock Market


Index model
Is designed to estimate the systematic and firm specific risk

for a particular security or portfolio.

Ri i RM ei i
where R r r is excess return

Equation (6.11)

i
f
is the component
ofi return
due to movements in the overall market

is sensitivity of securitys returns to market factor


is the component due to unexpected events(firm-specific or residual

risk)

Var ( R ) Var ( R e )

i M
i
i
is stocks expected excessi return beyond
that induced
by market

index

i M (ei )
2

Systematic risk Firm - specific risk

33

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6.5 A Single-Index Stock Market


Index model
Is designed to estimate the systematic and firm specific risk

for a particular security or portfolio.

Ri i RM ei i
where Ri ri r f is excess return

Equation (6.11)

Var ( Ri ) Var ( i RM ei i )
i M (ei )
2

Equation (6.12)

Systematic risk Firm - specific risk

34

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6.5 A Single-Index Stock Market


Statistical and Graphical Representation of

Single-Index Model
Security Characteristic Line (SCL)
Plot of securitys predicted excess return from excess
return of market
Algebraic representation of regression line

35

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Figure 6.12 Scatter Diagram for Dell


Ratio of systematic variance to total
variance

36

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Figure 6.13 Various Scatter Diagrams

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6.5 A Single-Index Stock Market


Using Security Analysis with Index Model
Information ratio
Ratio of alpha to standard deviation of residual

Active portfolio
Portfolio formed by optimally combining analyzed stocks

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6.5 Using Security Analysis with Index Model


Suppose that you are a portfolio manager in charge of the

endowment of a small charity. Without the resources to


engage in security analysis, you would choose a passive
portfolio comprising one or more index funds and T-bills.
Denote this portfolio as M. You estimate its standard
deviation as M and risk premium as RM
Now you find that you have sufficient resources to perform

fundamental analysis on one stock, say Google. You


forecast Google's risk premium as RG and estimate its
beta (G) and residual SD, (eG), against the benchmark
portfolio M. How should you proceed?
You can construct the optimal portfolio from M and Google
using Equation 6.10.
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6.5 Using Security Analysis with Index Model


We can simplify and find the position of Google in the

optimal risky portfolio in two steps:


Step 1:

Equation (6.16)

Step 2:
1 Sharpe ratio is improved as seen below:
Where:

Equation (6.17)

Googles alpha: =-

Googles information ratio:

40

6-40

6.5 Using Security Analysis with Index Model


In this case, Google is viewed as the active

portfolio.
If there is more than one stock, then you can form
a portfolio with these stocks as your active
portfolio, then mix it with the passive index.
You can use Equation 6.18-6.20 to find the
weights of the optimal portfolio O, its Sharpe
ratio, composition of the active portfolio, alpha,
beta, etc.

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Table 6.3 Two-Year Risk Premium, Variance, Sharpe Ratio, and


Price of Risk for Three Strategies

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6.6 Risk of Long-Term Investments

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