Part 3

Part 3: Portfolio Theory
FIN 411
Prof. Dmitry Orlov
FIN 411: Portfolio Theory Prof. Dmitry Orlov 1

Introduction
n The portfolio (asset) allocation problem:
q How much of your wealth should you invest in each
security?
q Think of as two pieces:
n Allocating Capital Between Risky and Risk-Free Assets (easier)
n Allocating Capital among Risky Securities (harder)
n Before Markowitz, an investment advisor would have

given you advice like:
If you are young you should be putting money
into a couple of good growth stocks, maybe
even into a few small stocks. Now is the time to
take risks.

The Basic Allocation
Problem
n Suppose that your investment horizon is 1 year
q We are going to work with nominal returns for
simplicity, although we should work with real returns
n You want to split your money between:
q A riskless security (e.g., T-Bills), and
q A risky asset (e.g., the S&P 500 index)
n Well think about multiple risky assets later
n Return characteristics (hypothetical):
q T-bill: 5.5% for sure
q S&P 500: = 7.9%, = 12.1%

How to choose between the two?
n Stocks have:
q Higher expected return
n Good!
q Also more risk
n Bad!
n Formally use utility functions to trade-off the

two forces
q Help tell us how to balance good and bad aspects of
different investments
q U(c) represents how good you feel, typically as a
function of consumption (or wealth)

Quadratic Utility
n Allocation generally uses a quadratic utility
function
U(c) = c a*c2
n Implies mean-variance optimization
q Increasing in : you like higher expected return
Decreasing in : you dont like risk
U(,) = *2
n is the coefficient of risk aversion
n Higher means more risk averse
q Think about setting = 1 or = 100 and see what happens to
U(,) when increases

Binary choice
n First choose between just all T-bills or all S&P:
q Choose = 2
q Utility from investing in the T-Bill
certainty-
U(0.055,0) = 0.055 2 * 02 = 0.055 equivalent
rate of
q Utility from investing in the S&P500 return
U(0.0791,0.121) = 0.0791 2 * 0.1212 = 0.0498

n T-Bills give a higher utility than the S&P500, an investor with
= 2 should go for the T-Bill
n What about more (or less) risk-averse investors?

More generally
n Do not have to choose just one: we can put a fraction

of wealth into one, the rest into the other
n Question: How much utility would the investor get

from a 60/40 split in the S&P500 and T-Bills?
q And how does this compare to our previous results?
q First we need:
n the expected return (60), and

n the standard deviation (60) for this strategy
q Then we can plug these numbers into U(, )

The 60/40 split
n How do we get 60 and 60?
r60 = 0.4 rf + 0.6 rS&P

q Where rf is the risk-free rate (T-Bill return a known constant),
q rS&P is the return
r60on=the0.4
S&P 500,
rf +and0.6 rS&P
q r60 is return on the 60/40 strategy
n
rw = the
More generally, w ) rwhich
(1 strategy rS&Pa weight
f + winvests
in the S&P 500 and the rest into T-Bills has the return
rw = (1 w ) rf + w rS&P
B0,1 B0,2 B0,3 B0,4 B0,5
C1 I.e., Cis1 the
+ the return
q Caverage
+ weighted 1 + of the individual
C1 + asset (F +
100 100
returns 100 100 100
7.09 92.46 87.63 83.06 78.82
B0,1 40 +B0,2 40 +
FIN 411: Portfolio Theory
B0,3 40B+0,4
Prof. Dmitry Orlov 40 +
B0,5 8
rw = (1 w ) rf + w rS&P
Portfolio characteristics
r60 = 0.4 rf + 0.6 rS&P
n For a portfolio with one risky and one riskless asset, we
have
rp ] = (1 w ) rf + w E [
E [ rS&P ]
rw = (1 w ) rf + w rS&P
rp ] = w 2 var [
var [ rS&P ]
q These are based on the following results from statistics:

E [aX + bY ] = a E [X] + b E [Y ]

= a var X
var aX 2
n Note: with two random variables the variance of the sum
also depends on their covariance (that is, how they
comove with each other)

For the 60/40 split
1
AA =E
n Portfolio characteristics:
60 = var [
r60]
= 0.4 rf + 10.6 E [
rS&P ]
AA =E
= 0.4 0.055 + 0.6 0.0791 = 0.0695
2
60 = var [
r60]
2 0 1
= 0.6 var [
rS&P ]
B 1 0.3 0.7 C
= 0.62 = B
0.121 C
B 0.3= 10.00527
0.2 C
B C
@ A
0.7 0.2 1
Utility in the 60/40 split
n So the utility from the 60/40 split is:
U(0.0695, 0.0723) = 0.0695 2*0.00527 = 0.0589
n Investor prefers the 60/40 split to just T-Bills or just

S&P500.
n Can the investor do better?

Other Splits?
n Why not try different values of ?
q What if we invest 10%, 20%, into S&P 500, rest into T-Bills?
q In fact, we could try all values 0 1
q But why stop there?
n We could also borrow/lend money and invest more than 100% into
S&P 500, if that gives higher utility
q could be negative, or bigger than 1
n One goal of asset allocation is to find the optimal

allocation
q Between risky and risk-free assets
n The that maximizes your utility makes you as happy as possible
n This is called the optimal weight
q In this example its 0.41 U(, ) = 0.060
q Other main goal optimal portfolio of risky assets

Tools
n Portfolio Expected Returns:
q Suppose you have a portfolio of N risky assets
n A fraction i of your wealth invested in the ith
q Then the return on the portfolio is given by

N
X
E [ r1] + + wN E [
rp ] = w1E [ rN ] = wi E [
ri ]
i =1
n Just the value-weighted average of the expected returns to the

individual
stocks
S&P rf 0.0791 0.055
w = = = 0.21
q Example. You own 2 $1,000
2
S&P
of IBM
2 4(return =210%) and $3,000 of
0.121
Dell (return = 5%). What is the return on your portfolios?
1000 3000
rp = 0.1 + 0.5 = 0.25 0.1 + 0.75 0.5 = 0.0625
4000 4000
60 = var [
r60]
2
= 0.6
= 12 1 Prof. var [ 0.2 ] 0.3 = 0.018
r S&P
FIN 411: Portfolio Theory 12 2 = 0.3Orlov
Dmitry 13
Tools
n Portfolio Standard Deviations
q This is harder
q Portfolio expected returns only depended on:
n The expected returns on the individual assets
n The weights of the assets in the portfolio
n Knowing portfolio weights and assets standard
deviations isnt enough to calculate portfolios standard
deviation
q E.g., suppose stock A and stock B each have 50% volatilities
q Question: What is the volatility of the 50/50 mix of the A and B?
n We cant say!
n If theyre in the same industry its likely higher than if they are not
q Covariance matters!

Two assets only
n Let 1 and 2 = 1-1 be the wealth fraction in stock 1,
2, then
2

var [
rp ] = E (
rp E [ rp ])
2

= E (w1r1 + w2r1 (w11 + w22))
2

= E (w1(r1 1) + w2( r2 2))
2 2 2 2

= E w1 (
r1 1) + w2 ( r2 2) + 2w1w2(
r1 1)(
r2 2)
= w12var [
r1] + w22var [
r2] + 2w1w2cov [
r1, r2]

Covariance
n Covariance measures the degree to which two
variables, such as stocks, move together
n Covariance positive (>0) two stocks tend to move
together
q If Stock A goes up, Stock B usually also goes up
n Covariance is very similar to variance
q Variance computes expected squared deviations around the
mean
q Covariance computes expected product of two variables
deviations around their means
12 = cov(
r1, r2) = E [(
r1 E [
r1])(
r2 E [
r2])]
n Q: What is a stocks covariance with itself?

Covariance from Historical Data
n Can calculate sample covariances from historical data
XT
1
cov [
r1, r2] = (r1,t r 1)(r2,t r 2)
T t=1
Month IBM Google
n Example. IBM and Google Mar 2007 2.07% 2.81%
Feb 2007 1.42% 1.94%
q April 2006 through March 2007 Jan 2007 -5.98% -10.38%
Dec 2006 2.05% 8.91%
Nov 2006 5.70% -5.02%
h i Oct 2006 -0.12% 1.77%
n Covariance between
2 IBM and Google? Sep 2006 12.67% 18.53%
var [
rp ] = E ( rp E [ rp ]) Aug 2006 1.19% 6.17%
q IBMs average return: 1.53%
h i Jul 2006 5.02% -2.09%
q Googles average return: 1.38%
Jun 2006 0.76% -7.81%
= E (w1r1 + w2r2 (w11 + w22))2 May 2006 -3.86% 12.78%
q Plugging
in gives Apr 2006 -2.61% -11.04%
2
= E w1( r1 1) + w2( r2 w2)
cov [
rIBM , rGOG ] = 0.002

= E w12(
r1 1)2 + w22(
r2 w2)2 + 2w1w2(
r1 1)(
r2 2)
Covariances
n Like variance, can annualize covariance by
multiplying it by the number of periods in a year
q Here, we estimated the covariance from monthly data
q So need to multiply estimate by 12 if we want the annualized
covariance
n Annualized estimate: 12 * 0.002 = 0.024.
n Often want something horizon-independent, use

correlation
q Can think about correlations as standardized covariances

Correlations
n Correlation is covariance divided by product of the
S.D.s: 12
corr [
r1, r2] = 12 =
1 2
n Correlations are always between -1 and 1
q If correlation is 1, returns are perfectly positively correlated
q If correlation is -1, returns are perfectly negatively correlated
n
h
In the IBM / Google
i
example:
2
[
rp ] = E (
rp E [ rp ])
q IBM = 16.9% (annualized)
h
q GOG= 32.0% (annualized)
i
2
=E (w
q So the

r + w
r
1 1correlation (w
2 2 between + w
1 1 IBM and ))
2 2Google is

IBM,GOG 2 0.024
= E corr w1[r1 , r
rIBM
( ] = (
1 ) + w2IBM
GOG w2)= 0.179 0.32 = 0.49
r2 GOG

=
FIN 411: w12(
E Portfolio r1 1)2 + w22Prof.
Theory (r2Dmitry w
Orlov)2
2 + 2w1 w2 (
r1 1)(
r219 2
Diversification
n Two stock portfolios
q Return is a weighted average of the individual stock returns
q Variance of the portfolio return is
rp ] = w12
var [ 2
1 + (1 w1)2 2
2 + 2w1(1 w1)12 1 2
n Example. Two stocks each have volatilities of 40%, and

are 20% correlated. What is the volatility of an equal-
weighted portfolio of the two?
h
Solution.
q We have wi1 = w2 = 0.5, so we can plug in the
numbers: 2
ar [
rp ] = E ( rp E [ rp ])
ph i
p = 0.5 0.4 + 0.5 0.4 + 2 0.5 20.2 0.42 = 31%
2 2 2 2 2
= E (w1r1 + w2r2 (w11 + w22))
2
FIN 411: Portfolio Theory 20
= E w1( r1 1) +Prof.wDmitry
(
2 2 r Orlov
w2 )
Diversification
n Key point:
q Unless two stocks are perfectly positively correlated, there are
always
r ]diversification
var [ = w 2 2 + (1benefits
w )2 to2 +
holding
2w (1both.w )
p 1 1 1 2 1 1 12 1 2
n The volatility of a portfolio of two stocks is less than the

value-weighted average of the two stocks volatilities
q Unless the two are perfectly correlated
rp ] = w12
var [ 2
1 + (1 w1)2 2
2 + 2w1(1 w1)12 1 2
= (w1 1 + (1 w1) 2)2 2w1(1 w1)(1 12) 1 2
(w1 1 + (1 w1) 2)2

rp ] = w12
var [ 2
1 + (1 w1)2 2
2 + 2w1(1 w1)12 1 2
Diversification
n Can see this in the risk/reward trade-off

p = w11 + (1 w1)2
q
p = w12 12 + (1 w1)2 2
2 + 2w1(1 w1)12 1 2
q Lets look at some pictures

n For a range of weights
n And a few different correlations

Feasible Frontier with 2 Assets
=0
Uncorrelated Stock A
Assets long A,
short B
Expected Average
Return
long A
and B
Stock B
long B,
short A
Portfolio Volatility

2 Assets, Different Correlations
The lower the

correlation, the greater
the diversification
benefits
Volatilities only add

(value-weighted) if the
stocks are perfectly
correlated
= 1 = = 0 = - = -1

Adding a Riskless Asset

Minimum Variance
rf = 3% Frontier
A = 9%
n Consider possible allocations between
assets A and B: B = 15%
0 1
0.04 0.03
=@ A
0.03 0.09

d ew
=0
dw w


2 Assets
d
MVE
ew
=0
dw w

n Mathematically, d ew

dw e
=0
d w
w
=0
ew = E [rw rf ] = w eA + dw(1 w )e
w B
q Where
2
e = E [r 2r ] = w2e 2+ (1 w )e 2 2
w = E (
wr
w rw
f ) f
= w AA + (1 wB ) B + 2w (1 w )AB
2
2

w = E (
rw rf ) = w2 2
A + (1 w )2 2
B + 2w (1 w )AB A B
ew = E [rw rf ] = + (1 w eA w )eB
n Just says
2
d e
e 2
w = E ( rw rf )2 = w 2 A2 dw
+w(1 w
w)
2
B + 2w (1 w )AB A
d w
=
dw w
q Incremental additional risk/reward same proportion as original

dw
dw w
=dew
d w ew
2 Assets,
0
pMVE (
dw dw w
d w
dw 0
=
w 2 0
w)
( 2
w) = (p w) =( 2 0
( 0 2 )0 = 2w ) w
w) =( wp ( 2 0
)
n This implies, using 0
( w) = ( 2 2
0
w) =
w w
, that
2 w
(ew )e0 0 ewe e 0 2 0
(w0 )= w ) 2 2 w2 (
e w0 ) = e
e w2 0 w )
(
( w) 0 = w ) 2 w (w ) = w ( w)
( w) w
Or, substituting for the portfolio return and variance,

q
that
2(w 2 2
A + (1 w )2 2
B + 2w (1 w )AB e
A B )(A eB )
2 2
=(eB + w (eA eB ))(2w A 2(1 w) B + (1 2w )AB A B)
qALL 2 terms cancel, leaving a simple linear equation

2(w 2 2
A + (1 w )2 2
B + 2w (1 w )AB A B )(e
A eB )
=(eB + w (eA
2eAssets
))(2w 2 MVE
2(1 w ) 2
+ (1 2w )AB A
B A B
n Solving for yields the optimal weight

0.7 e 2 2 0.12 e0.5 0.2 0.3
0.3
wA = A B B AB 2A B =
A =
w0.7 2
0.3 e 0.12 0.5 0.2 0.3 + 0.12 e0.22 0.07 0.5 0.2 0.3
2 e + e

A B B AB A B B A A AB A B
MV E
q In our example = 0.5.
SRMVHence
E =
rf
MV E
0.7 0.32 0.12 0.5 0.2 0.3 1
wA = 1 =
0.7 0.32 0.12 0.5 0.2 0.3 + 0.12 0.22 0.07 0.5 0.2 0.3 2
n Yields
MV E = 0.5 10% + 0.5 15% = 12.5%
MV E rf
p SR MV E =
MV E = 0.52 0.22 + 0.52 0.32 +MV
2 E 0.52 0.5 0.2 0.3 = 21.8%

MV E rf 0.125 0.03
SRMV E =
Sharpe MV E Ratio
0.7 0.3 2 = = 0.436
0.5 0.2 0.3
0.12 0.218
.7 0.32 0.12 0.5 0.2 0.3 + 0.12 0.22 0.07 0.5 0
n MVE portfolio Sharpe ratio:
MV E = 0.5 10% + 0.5 15% = 12.5%
pSRMV E =
MV E rf 0.125 0.03
= = 0.436
MV E =
2 2
0.5 0.2 + 0.5 2 2 0.218
MVE0.3 + 2 0.5
2 0.5 0.2 0.3 = 21.8%
q This compares favorably to those of the individual

stocks
= 0.5 10% + 0.5 rf =0.10
A 15% 12.5% 0.03
VE SRA = = = 0.35
p A 0.2
= 0.52 SR 0.2 B 2rf 0.30.15
2 +0.5 2 + 2 0.03
0.5 2 0.5 0.2 0.3 =
VE B = = = 0.4
B 0.3

A B A B
eB + w (eA eBSome
))(2w A2 Interpretation
2(1 w ) B2 + (1 2w )AB A
n Remember:
2
eA eB AB A B
wA = 2
B
2
eA B eB AB A B + B
e
A e
A AB A B
q Dividing top and bottom by both assets variances

gives
eA eB
2 AB A B
wA = e A
eB
e
eA

A
2 AB A B
+ B2 AB A B
A B

eA eB
Some Interpretation
AB 2
A B
wA =
eA
A
eB

eB eA
AB + AB
n Can look at the relative exposures
2
A A B B
2
A B
eA eB
wA A A
AB B SRA AB SRB
= eB eA
=
wB B AB A
SRB AB SRA
B
n Risk exposures (as opposed to dollar

exposures) should be:
q Proportional to the assets Sharpe ratios, adjusted for
correlation
q Says more exposure to the higher Sharpe ratio asset
q But lower correlations bring more of the low SR asset into
the portfolio

Some examples
n First, lets assume symmetric assets
q A = 9%, A = 20%
q B = 9%, B = 20%
n Weights must be equal

q Do we even need to think about the covariance?
q Do we need to worry about the risk-free rate?

Some examples
eA eB
AB A B
n Nowwsuppose
rf = 3%, and
e
2
A

A = e eB eA
q A = 6%, A =
A 10% B
2 AB + 2 AB
q B = 9%, B =A 20% A B B A B
eA eB
wA A A
AB B SRA AB SRB
Note:wtwo
= e have the
assets e =
A same Sharpe ratios
n B SR SR
B B AB B AB A
q Relative risk exposures
B have
A to be equal
6 3 9 3
wA A SRA AB SRB 10 20
= = =1
wB B SRB AB SRA 9 3
20 6 3
10

6 3 9 3
wA A SRA AB SRB 10 20
= = =1
wB B SRB AB SRA 9 3
20 6 3
10
n Portfolio must have twice the8
dollar exposure to
asset A > 2
< wA =
wA = 2wB 3
)
: w = 1
>
B
3
q Here asset A could have been a mutual fund that
invested:
n Half its money in the first asset from the first example
q Which had the same expected return and volatility as Stock B
n Half its assets in T-bills
q Actual dollar weights depend arbitrarily on a scaling
n The SR directly tells us something about how assets contribute to
the portfolios return characteristics
q And only indirectly about how many dollars we should invest

Another Example 8
>
< wA =
2
wA = 2wB ) 3
: w = 1
>
q Suppose rf = 4%, and B
3
0 1 0 1 0 1
0.06 0.1 1 0
= @ A = @ A = @ A
0.10 0.2 0 1
q Then
0.06 0.04
wA A SRA AB SRB wA 0.1 0.1 2
= ) = =
wB B SRB AB SRA
wB 0.2 0.1 0.04
0.2
3
n This is a 4/7, 3/7 split. What if the assets returns are more
correlated?

B 20 10
Another Example
8
> 2
< = wA
wA = 2wB ) 3
: w = 1
>
q Suppose rf = 4%, and B
3
0 1 0 1 0 1
0.06 0.1 1 0.5
=@ A =@ A =@ A
0.10 0.2 0.5 1
q Then
0.06 0.04 1 0.1 0.04
wA A SRA AB SRB wA 0.1 0.1 2 0.2 1
= ) = =
wB B SRB AB SRA
wB 0.2 0.1 0.04
0.2
1 0.06 0.04
2 0.1
4
n That is, a 1/3rd / 2/3rd split

Message
n The Sharpe ratios are
q SRA = (64)/10 = 0.2
q SRA = (104)/20 = 0.3
n When the correlation went from 0 0.5

q The weight on higher SR asset went from 43% 67%
n Positive correlation shifts weight to higher SR asset
q Less diversification benefits, go with the performer!
n Negative correlation shifts weight to lower SR asset

0.06 0.04 1 0.1 0.04
SR SR w 0.1 1 0.2
A
Effects of Correlation
AB B A 0.06
0.1 0.04 2 0.1 0.04
wA=wA A SRSR
A A AB SRSR)
BB w
w A
=
0.1
0.1 0.1
0.06
0.04
0.04
0.1 1
1
2
0.1
0.06
0.04
0.2
0.04 =
SR
A =B
= AB SRA
AB )
)wB 0.2
A
= 0.2
= 0.1
0.1
0.04
2
1
21 0.06
0.2
0.06
0.1 =
0.04
wB wBB B SRSR
B B AB SR
AB SRAA w
wB 0.2
B 0.2
0.1 0.04
0.2 2 0.04
0.1
0.2 2 0.1
Suppose
0
n
00
1rf = 3%,0
11 and0
0
1
1
1
0
00 1 1
1
0.15 0.15 0.2 0.2 0.6
0.60.6
@
= = @0.15
A A = @ @ 0.2
A A ) SR = @ A
=@ A =@
= A ) SR = @ A A
) SR = @
0.090.09
0.09 0.2 0.2
0.2 0.3
0.30.3
q Then
wA w
A SR SR
A ABSR SR
B B)
wA

w 2
2
A=A A AB =
A
wB w = ) w 1= 2
B BSRBSRBAB SR
AB SRA
A BwB 1 2
B
q So
2
wA =
3(1 )

Weight on
high Sharpe
ratio asset
Weight on
low Sharpe
ratio asset

wA A SRA AB SRB wA 2
= ) =
wB B Mean-variance efficient
SRB AB SRA wB 1 2
portfolio

of
2
N assets
wA =
n Consider three assets:
3(1 )
0 1 0 1 0 1
B 0.07 C B 0.6 C B 1 0.2 0.2 C
B C B C B C
=B
B 0.03 C
C =B
B 0.5 C
C =B
B 0.2 1 0.1 C C
@ A @ A @ A
0.05 0.4 0.2 0.1 1
q Look as random portfolios

Random
Random
Portfolio
Portfolios
s

Can also add in all
the portfolios that
hold only two assets
Two Asset
Portfolios

Also know how to
calculate the
Minimum Variance
Portfolio:
11
MVP =
1' 11

Want the
Tangency (Mean-
Variance Efficient)
Portfolio!
MVE = ?
Capital
Allocation
Line

Minimum-Variance Frontier
n Together, the MV and MVE portfolios fully
characterize the Minimum-Variance Frontier
q The best portfolios of risky assets only (no risk-free asset)
q The least volatile portfolios for each expected return
n Two-fund separation
q With no risk-free asset:
All investors hold a combination of the same two
portfolios: the risk-free asset and the MVE portfolio.

Capital
Allocation
Line
Minimum
Variance
Frontier

Finding the MVE portfolio
n To find the MVP, look for portfolio weights that
equalize each stocks covariance with the
portfolio
n If each stock contributes the same to marginal portfolio
variance, then cant reduce portfolio variance by selling one/
buying others
n To find the MVE portfolio (the highest Sharpe ratio

portfolio), look for portfolio weights that equalize
marginal risk/return trade-off across all stocks
n If each stock contributes the same marginal expected return
for each unit of marginal portfolio variance then we cant
improve the portfolios risk / reward trade-off by selling one
and buying others

Finding the MVE Portfolio
Can see this condition graphically
n If a stock (D) has:
q Too good a risk / reward trade-off, then add a little D
to the MVE portfolio
q A risk / reward trade-off that isnt good enough, then
short a little D, buy more of the MVE portfolio
n In either case, you improve the Sharpe ratio
q So the MVE wasnt really the MVE
n If you really have the MVE, risk / reward trade-
off must equate across stocks!

Long MVE and a little D,
Outside the CAL

Levered MVE short a little D,
Outside the CAL

Diversification (general)
n Remember, with two stocks, generally
q The lower the correlation
the lower the variance of the resulting portfolio
n This observation could be restated as follows:
q Unless the stocks in a portfolio track each other
perfectly, some of the individual variations cancel
out;
q The portfolio volatility is less than the (weighted) sum
of individual volatilities
n What happens with more stocks?

Covar as Marginal Var
n We often want to think about the following situation:

q What happens to the variance of the portfolio if we add a bit
more of one of the stocks?
n E.g., suppose currently invest in 10 stocks (each weight is 10%)
n What happens if we add a little more of just one?
n Important result: the covariance of the stock with the

portfolio is the only relevant influence on the variance
of the new portfolio
q Technically, this result is true for really, really tiny weight changes
n I.e., at the margin

Covar as Marginal Var
n The covariance between stock k and a portfolio is given
by: N
X
cov [
rp , rk ] = wi ik i k
i =1
q The average of all stocks covariances with stock k, weighted by
the portfolio weights 0
cov [
rA, rB ] = wAwB
n Key implications: N X N
X
q If stock j is positively correlated with
= wiAwjBthe
portfolio,
ij i j
adding more
of stock j to the portfolio increases the portfolios variance
i =1 j=1
q If stock k is negatively correlated with the portfolio, adding
more of stock k to the portfolio decreases the portfolios
variance
n Even if it has super0
high volatility itself! 10 1
B 0.04 0.018 0.05 C B 0.4 C
B CB C
Theory 0.3, 0.3) B
0.015 C B C
0
wPortfolio
w 411:
FIN = (0.4, Prof. Dmitry Orlov
B 0.018 0.09 C B 0.3 C
60
Characterization of the
Tangency Portfolio
Theorem:
Tangency portfolio weights w1, w2, , wN are
such that:
Cov(rMVE, ri) = E(ri) rf for all i = 1,2,...,N
n The marginal cost (variance) of adding more asset i

into the portfolio is equal to the marginal benefit
(return).
n This also holds for adding arbitrary portfolios rp.

Conclusion
n What is wrong with mean-variance analysis?
q Not too much.
n Caveat: remember that you have to include every asset you
have in the analysis; including human capital, real estate, etc.
n Theory tells us nothing about where the prices,
returns, variances or covariances come from
n Next we look at the CAPM

q Takes Markowitz portfolio theory and extends it to
determine how prices must be set in equilibrium

Food for Thought

Part 3

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Part 3: Portfolio Theory

FIN 411: Portfolio Theory Prof. Dmitry Orlov 1

n Before Markowitz, an investment advisor would have

FIN 411: Portfolio Theory Prof. Dmitry Orlov 2

FIN 411: Portfolio Theory Prof. Dmitry Orlov 3

n Formally use utility functions to trade-off the

FIN 411: Portfolio Theory Prof. Dmitry Orlov 4

FIN 411: Portfolio Theory Prof. Dmitry Orlov 5

U(0.0791,0.121) = 0.0791 2 * 0.1212 = 0.0498

FIN 411: Portfolio Theory Prof. Dmitry Orlov 6

n Do not have to choose just one: we can put a fraction

n Question: How much utility would the investor get

n the expected return (60), and

FIN 411: Portfolio Theory Prof. Dmitry Orlov 7

r60 = 0.4 rf + 0.6 rS&P

q These are based on the following results from statistics:

FIN 411: Portfolio Theory Prof. Dmitry Orlov 9

U(0.0695, 0.0723) = 0.0695 2*0.00527 = 0.0589

n Investor prefers the 60/40 split to just T-Bills or just

n Can the investor do better?

FIN 411: Portfolio Theory Prof. Dmitry Orlov 11

n One goal of asset allocation is to find the optimal

q Other main goal optimal portfolio of risky assets

FIN 411: Portfolio Theory Prof. Dmitry Orlov 12

q Then the return on the portfolio is given by

n Just the value-weighted average of the expected returns to the

FIN 411: Portfolio Theory Prof. Dmitry Orlov 14

FIN 411: Portfolio Theory Prof. Dmitry Orlov 15

FIN 411: Portfolio Theory Prof. Dmitry Orlov 16

n Often want something horizon-independent, use

FIN 411: Portfolio Theory Prof. Dmitry Orlov 18

n Example. Two stocks each have volatilities of 40%, and

n The volatility of a portfolio of two stocks is less than the

= (w1 1 + (1 w1) 2)2 2w1(1 w1)(1 12) 1 2

(w1 1 + (1 w1) 2)2

FIN 411: Portfolio Theory Prof. Dmitry Orlov 21

n Can see this in the risk/reward trade-off

q Lets look at some pictures

FIN 411: Portfolio Theory Prof. Dmitry Orlov 22

FIN 411: Portfolio Theory Prof. Dmitry Orlov 23

The lower the

Volatilities only add

FIN 411: Portfolio Theory Prof. Dmitry Orlov 24

FIN 411: Portfolio Theory Prof. Dmitry Orlov 25

FIN 411: Portfolio Theory Prof. Dmitry Orlov 26

q Incremental additional risk/reward same proportion as original

FIN 411: Portfolio Theory Prof. Dmitry Orlov 29

Or, substituting for the portfolio return and variance,

qALL 2 terms cancel, leaving a simple linear equation

FIN 411: Portfolio Theory Prof. Dmitry Orlov 30

n Solving for yields the optimal weight

FIN 411: Portfolio Theory Prof. Dmitry Orlov 31

q This compares favorably to those of the individual

FIN 411: Portfolio Theory Prof. Dmitry Orlov 33

q Dividing top and bottom by both assets variances

FIN 411: Portfolio Theory Prof. Dmitry Orlov 34

n Risk exposures (as opposed to dollar

FIN 411: Portfolio Theory Prof. Dmitry Orlov 35

n Weights must be equal

FIN 411: Portfolio Theory Prof. Dmitry Orlov 36

FIN 411: Portfolio Theory Prof. Dmitry Orlov 37

FIN 411: Portfolio Theory Prof. Dmitry Orlov 38

FIN 411: Portfolio Theory Prof. Dmitry Orlov 39

n That is, a 1/3rd / 2/3rd split