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Motivation Mean Variance Theory Mean Variance Theory

Lecture 2.1: Mean Variance Portfolio Theory
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Motivation Mean Variance Theory Mean Variance Theory
Motivation
The process of constructing an investor portfolio consists of a sequence
of two steps:
1
selecting the composition of ones portfolio of risky assets (e.g.,
stocks, long term bonds)
2
deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills)
the investor needs to know the risk-return trade-off for the above
risky portfolio
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Motivation Mean Variance Theory Mean Variance Theory
Motivation
The process of constructing an investor portfolio consists of a sequence
of two steps:
1
selecting the composition of ones portfolio of risky assets (e.g.,
stocks, long term bonds)
2
deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills)
the investor needs to know the risk-return trade-off for the above
risky portfolio
CMU-logo
Motivation Mean Variance Theory Mean Variance Theory
Motivation
The process of constructing an investor portfolio consists of a sequence
of two steps:
1
selecting the composition of ones portfolio of risky assets (e.g.,
stocks, long term bonds)
2
deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills)
the investor needs to know the risk-return trade-off for the above
risky portfolio
CMU-logo
Motivation Mean Variance Theory Mean Variance Theory
Motivation
The process of constructing an investor portfolio consists of a sequence
of two steps:
1
selecting the composition of ones portfolio of risky assets (e.g.,
stocks, long term bonds)
2
deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills)
the investor needs to know the risk-return trade-off for the above
risky portfolio
CMU-logo
Motivation Mean Variance Theory Mean Variance Theory
Mean Variance Portfolio Theory
A risky asset offers a return that can take any one of a set of possible
values along with their associated probability of occurrence:
Return Distribution
Return Probability
R
i 1
P
i 1
R
i 2
P
i 2
. .
. .
. .
R
iM
P
iM
Mean Variance Portfolio Theory all the relevant information about a
return distribution can be captured by two summary measures:
1
Expected Return: that measures the average value
2
Variance: that measures the risk or dispersion around the mean
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Motivation Mean Variance Theory Mean Variance Theory
Mean Variance Portfolio Theory
A risky asset offers a return that can take any one of a set of possible
values along with their associated probability of occurrence:
Return Distribution
Return Probability
R
i 1
P
i 1
R
i 2
P
i 2
. .
. .
. .
R
iM
P
iM
Mean Variance Portfolio Theory all the relevant information about a
return distribution can be captured by two summary measures:
1
Expected Return: that measures the average value
2
Variance: that measures the risk or dispersion around the mean
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Motivation Mean Variance Theory Mean Variance Theory
Mean Variance Portfolio Theory contd
Mean-Variance (M-V) or Mean-Standard Deviation criterion
Portfolio A dominates Portfolio B if
E (r
A
) E (r
B
)
and

A

B
Portfolio A is preferable to Portfolio B if its expected return is equal to
or greater than Bs and its standard deviation is equal to or smaller than
Bs
in the expected return-standard deviation space, the preferred
direction is northwest, because in this direction we simultaneously
increase the expected return and decrease the variance of the rate of
return
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Motivation Mean Variance Theory Mean Variance Theory
Mean Variance Portfolio Theory contd
Mean-Variance (M-V) or Mean-Standard Deviation criterion
Portfolio A dominates Portfolio B if
E (r
A
) E (r
B
)
and

A

B
Portfolio A is preferable to Portfolio B if its expected return is equal to
or greater than Bs and its standard deviation is equal to or smaller than
Bs
in the expected return-standard deviation space, the preferred
direction is northwest, because in this direction we simultaneously
increase the expected return and decrease the variance of the rate of
return
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Motivation Mean Variance Theory Mean Variance Theory
Mean Variance Portfolio Theory contd
Mean-Variance (M-V) or Mean-Standard Deviation criterion
Portfolio A dominates Portfolio B if
E (r
A
) E (r
B
)
and

A

B
Portfolio A is preferable to Portfolio B if its expected return is equal to
or greater than Bs and its standard deviation is equal to or smaller than
Bs
in the expected return-standard deviation space, the preferred
direction is northwest, because in this direction we simultaneously
increase the expected return and decrease the variance of the rate of
return
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Motivation Mean Variance Theory Mean Variance Theory
Solution to the Mean Variance Portfolio Problem
Steps:
1
Identication of the Efcient Frontier and the optimal portfolio of
risky assets
2
Deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills) based on the investors
preferences
CMU-logo
Motivation Mean Variance Theory Mean Variance Theory
Solution to the Mean Variance Portfolio Problem
Steps:
1
Identication of the Efcient Frontier and the optimal portfolio of
risky assets
2
Deciding how much to invest in that risky portfolio versus in a safe
asset (e.g., short-term Treasury bills) based on the investors
preferences