Chapter Seven Optimal Risky Portfolios INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter Overview • The investment decision: • Capital allocation (risky vs. risk-free) • Asset allocation (construction of the risky portfolio) • Security selection • Optimal risky portfolio • The Markowitz portfolio optimization model • Long- vs. short-term investing 7-2 INVESTMENTS | BODIE, KANE, MARCUS The Investment Decision • Top-down process with 3 steps: 1. Capital allocation between the risky portfolio and risk-free asset 2. Asset allocation across broad asset classes 3. Security selection of individual assets within each asset class 7-3 INVESTMENTS | BODIE, KANE, MARCUS Diversification and Portfolio Risk • Market risk • Risk attributable to marketwide risk sources and remains even after extensive diversification • Also call systematic or nondiversifiable • Firm-specific risk • Risk that can be eliminated by diversification • Also called diversifiable or nonsystematic 7-4 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.1 Portfolio Risk and the Number of Stocks in the Portfolio Panel A: All risk is firm specific. Panel B: Some risk is systematic or marketwide. 7-5 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.2 Portfolio Diversification 7-6 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets • Portfolio risk (variance) depends on the correlation between the returns of the assets in the portfolio • Covariance and the correlation coefficient provide a measure of the way returns of two assets move together (covary) 7-7 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets: Return • Portfolio return: rp = wDrD + wErE • • • • wD = Bond weight rD = Bond return wE = Equity weight rE = Equity return E(rp) = wD E(rD) + wEE(rE) 7-8 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets: Risk • Portfolio variance: p2 wD2 D2 wE2 E2 2wD wE Cov rD , rE • D2 = Bond variance • 2 E = Equity variance • Cov rD , rE = Covariance of returns for bond and equity 7-9 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets: Covariance • Covariance of returns on bond and equity: Cov(rD,rE) = DEDE • D,E = Correlation coefficient of returns • D = Standard deviation of bond returns • E = Standard deviation of equity returns 7-10 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets: Correlation Coefficients • Range of values for 1,2 - 1.0 > > +1.0 • If = 1.0, the securities are perfectly positively correlated • If = - 1.0, the securities are perfectly negatively correlated 7-11 INVESTMENTS | BODIE, KANE, MARCUS Portfolios of Two Risky Assets: Correlation Coefficients • When ρDE = 1, there is no diversification P wE E wD D • When ρDE = -1, a perfect hedge is possible wE 7-12 D D E 1 wD INVESTMENTS | BODIE, KANE, MARCUS Table 7.2 Computation of Portfolio Variance From the Covariance Matrix 7-13 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.3 Portfolio Expected Return 7-14 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.4 Portfolio Standard Deviation 7-15 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.5 Portfolio Expected Return as a Function of Standard Deviation 7-16 INVESTMENTS | BODIE, KANE, MARCUS The Minimum Variance Portfolio • The minimum variance portfolio is the portfolio composed of the risky assets that has the smallest standard deviation; the portfolio with least risk • The amount of possible risk reduction through diversification depends on the correlation: • If = +1.0, no risk reduction is possible • If = 0, σP may be less than the standard deviation of either component asset • If = -1.0, a riskless hedge is possible 7-17 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.6 The Opportunity Set of the Debt and Equity Funds and Two Feasible CALs 7-18 INVESTMENTS | BODIE, KANE, MARCUS The Sharpe Ratio • Maximize the slope of the CAL for any possible portfolio, P • The objective function is the slope: Sp E rp rf p • The slope is also the Sharpe ratio 7-19 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.7 Debt and Equity Funds with the Optimal Risky Portfolio 7-20 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.8 Determination of the Optimal Overall Portfolio 7-21 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.9 The Proportions of the Optimal Complete Portfolio 7-22 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • Security selection • The first step is to determine the risk-return opportunities available • All portfolios that lie on the minimum-variance frontier from the global minimum-variance portfolio and upward provide the best risk-return combinations 7-23 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.10 The Minimum-Variance Frontier of Risky Assets 7-24 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • Search for the CAL with the highest reward-tovariability ratio • Everyone invests in P, regardless of their degree of risk aversion • More risk averse investors put more in the riskfree asset • Less risk averse investors put more in P 7-25 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.11 The Efficient Frontier of Risky Assets with the Optimal CAL 7-26 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • Capital Allocation and the Separation Property • Portfolio choice problem may be separated into two independent tasks • Determination of the optimal risky portfolio is purely technical • Allocation of the complete portfolio to risk-free versus the risky portfolio depends on personal preference 7-27 INVESTMENTS | BODIE, KANE, MARCUS Figure 7.13 Capital Allocation Lines with Various Portfolios from the Efficient Set 7-28 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • The Power of Diversification • Remember: wi w j Cov ri , rj n 2 p n i 1 j 1 • If we define the average variance and average covariance of the securities as: 1 n 2 i n i 1 2 n n 1 Cov Cov ri , rj n n 1 j 1 i 1 j i 7-29 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • The Power of Diversification • We can then express portfolio variance as 1 2 n 1 Cov n n 2 p • Portfolio variance can be driven to zero if the average covariance is zero (only firm specific risk) • The irreducible risk of a diversified portfolio depends on the covariance of the returns, which is a function of the systematic factors in the economy 7-30 INVESTMENTS | BODIE, KANE, MARCUS Table 7.4 Risk Reduction of Equally Weighted Portfolios 7-31 INVESTMENTS | BODIE, KANE, MARCUS Markowitz Portfolio Optimization Model • Optimal Portfolios and Nonnormal Returns • Fat-tailed distributions can result in extreme values of VaR and ES and encourage smaller allocations to the risky portfolio • If other portfolios provide sufficiently better VaR and ES values than the mean-variance efficient portfolio, we may prefer these when faced with fat-tailed distributions 7-32 INVESTMENTS | BODIE, KANE, MARCUS Risk Pooling and the Insurance Principle • Risk pooling • Merging uncorrelated, risky projects as a means to reduce risk • It increases the scale of the risky investment by adding additional uncorrelated assets • The insurance principle • Risk increases less than proportionally to the number of policies when the policies are uncorrelated • Sharpe ratio increases 7-33 INVESTMENTS | BODIE, KANE, MARCUS Risk Sharing • As risky assets are added to the portfolio, a portion of the pool is sold to maintain a risky portfolio of fixed size • Risk sharing combined with risk pooling is the key to the insurance industry • True diversification means spreading a portfolio of fixed size across many assets, not merely adding more risky bets to an evergrowing risky portfolio 7-34 INVESTMENTS | BODIE, KANE, MARCUS Investment for the Long Run Long-Term Strategy Short-Term Strategy • Invest in the risky portfolio for 2 years • Invest in the risky portfolio for 1 year and in the risk-free asset for the second year • Long-term strategy is riskier • Risk can be reduced by selling some of the risky assets in year 2 • “Time diversification” is not true diversification 7-35 INVESTMENTS | BODIE, KANE, MARCUS