Lecture 5: Portfolio

Diversification and Supporting

Financial Institutions

Portfolio Diversification
All that should matter to an investor is the
performance of the entire portfolio.
Mean and variance of portfolio matter
Law of large numbers means that spreading
over many independent assets reduces risk,
has no effect on expected return.

Equally-Weighted Portfolio
When Asset Returns are
Independent & Same Variance

Same dollar value in each asset

Rebalancing each period
Portfolio expected return equals average of
asset expected returns
Portfolio standard deviation equals asset
standard deviation divided by n
Square root rule

Investment Companies as
Providers of Diversification

Investment trusts (before 1940s)

Mutual funds (especially index funds)
Closed end investment companies
Unit investment trusts
All these institutions can enable small
investors to overcome transactions cost and
lumpiness problems in achieving diversified
portfolios

Doubts about Diversification

Complete diversification would imply
holding much in fixed incomes, real estate,
etc. But hasnt stock market outperformed
these?

Equity Premium Puzzle

Geometric average real stock market return
1871-1997: 7.0% (Siegel Table 1-1).
Geometric average real fixed-income return
1871-1997: 1.7% (Siegel Table 1-2)
Equity premium = 7.0%-1.7%=5.3%
Puzzle: Why has equity premium been so
high?

Dominance of Stocks over Fixed

Incomes?
No thirty-year period since 1831-1861
when the return on either long-term or
short-term bonds exceeded that on equities.
(Siegel p. 15)

Survey of Institutional Investors,

Shiller, 1993
There is no thirty-year period since 1860 in
which US government bonds have
outperformed stocks. Have you heard
roughly this claim (even if details, such as
the use of 30 years) are different?
1. Yes, often 52%
2. Yes, once or twice 22%
3. No 26%

But is Equity Premium Robust?

Geometric average US real stock market
return 1802-1997: 7.0% (Siegel Table 1-1)
Geometric average real fixed income return
1802-1870: 5.1% (Siegel, Table 1-2)
Equity premium = 7.0% - 5.1% = 1.9%
Equity premium was much smaller then.

International Evidence
Median real stock market appreciation rate for 39
countries 1926-96: 0.8% per year.
Real stock market appreciation rate for US 192696: 4.3% per year.
(Philippe Jorion and William Goetzmann,
Journal of Finance 54:953-80, 1999.)
So, US equity premium may reflect a selection bias.

Optimal Portfolio Diversification

in General Case
Drop assumption of equal weighting,
independence and equal variance
Put xi dollars in ith asset, I=1,..,n, where the
xi sum to $1.
Portfolio expected value = x E(return )
Portfolio variance (two assets) =
n

i 1

x12 var(return1 ) (1 x1 ) 2 var(return 2 ) 2 x1 (1 x1 ) cov(return1 , return 2 )

Portfolio Variance, Three Assets

Portfolio variance =
2

x12 var(return1 ) x2 var(return 2 ) x32 var(return3 )

2 x1 x2 cov(return1 , return 2 ) 2 x1 x3 cov(return1 , return3 )
2 x2 x3 cov(return 2 , return3 )
3

( where xi 1)
i 1

Efficient Portfolio Frontier with

Two Assets
Frontier expresses portfolio standard
deviation in terms of portfolio expected
return r rather than in terms of x1.

r r2
x1

2 (

r1 r2
r r2 2 2
r r 2 2
) 1 ( 1
) 2
r1 r2
r1 r2

(r r2 )(r1 r )
2
12
2
(r1 r2 )

Efficient Portfolio Frontier

Risk-Return Trade-Off and

Holding Periods

Mutual Fund Theorem

All investors, regardless of risk preferences,
will hold a combination of the riskless asset
and the tangency portfolio of all risky
assets.
Therefore, only one asset need be made
available to investors: a mutual fund that
holds the tangency portfolio.

Capital Asset Pricing Model

(CAPM)
CAPM Asserts that all investors hold their
optimal portfolio
Consequence of the mutual fund theorem:
all investors hold the same portfolio of risky
assets, the tangency portfolio
Therefore the CAPM says that the tangency
portfolio equals the market portfolio

Beta
The CAPM implies that the expected return
on the ith asset is determined from its beta.
Beta (i) is the regression slope coefficient
when the return on the ith asset is regressed
on the return on the market.
Fundamental equation of the CAPM:

ri rf i (rm rf )

Do Mutual Funds Hold Optimal

Portfolio?
Completely diversified funds do not exist
Mutual funds are classified into equity
funds, fixed-income funds, etc
Mutual funds are further classified into
styles: growth, income, blue-chip, etc.
Index funds account invest in stock price
indexes, such as S&P 500

Index Funds
$350 billion, or 8% of stock market
invested in equity index funds in 2000.
Much of this is in specialty index funds,
such as Internet funds.
Some other broadly diversified funds,
however, may substitute for market index
funds.

Alfred Cowles 1891-1984

Yale 13
Investment advisor,
NYC
Founded Econometric
Society, Cowles
Foundation
Econometrica 1933
Can Stock Market
Forecasters Forecast?

Survey of Individual Investors

1999
Trying to time the market, to get out before it
goes down and in before it goes up, is:
1. A smart thing to do; I can reasonably
expect to be a success at it. 11%
2. Not a smart thing to do; I cant
reasonably expect to be a success at it. 83%
3. No opinion 5%

Persistence of Mutual Fund

Performance
Mutual funds that performed well last year
tend to a little better than average this year.
Effect is weak.
William Goetzmann and Roger Ibbotson,
Journal of Finance, 54:953-80, 1999.

Survey of Individual Investors

1999
Trying to pick individual stocks, for
example, if and when Ford Motor stock will
go up, or IBM stock will go up, is:
1. A smart thing to do; I can reasonably
expect to be a success at it. 40%
2. Not a smart thing to do; I cant
reasonably expect to be a success at it. 51%
3. No opinion 8%

Survey of Individual Investors

1999
Trying to pick mutual funds, trying to figure
out which funds have experts who can
themselves pick which stock will go up, is:
1. A smart thing to do; I can reasonably
expect to be a success at it. 50%
2. Not a smart thing to do; I cant
reasonably expect to be a success at it. 27%
3. No opinion 23%

Growth of Mutual Funds

In 1982 there was one mutual fund account
per ten US households
In 1998 there were almost two mutual fund
accounts per US household
Flow of Funds Accounts published by
Federal Reserve: Flow tables, level tables,
and reconciliation tables.