Source: Modern Investment BMAN71171 Portfolio Investment

Management
by
Bob Litterman and QRG Goldman Sachs Lecture 2a: Intuition on Portfolio Selection
Chris Godfrey (christopher.godfrey@manchester.ac.uk)
Office Hours: Wednesdays– Email for an Appointment
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Suggested Reading:

Reading
Modern Investment Management, An Equilibrium Approach,
Bob Litterman and Quant Resources Group of Goldman Sachs, Wiley
2003
Available online through the Library website, MBS username and
password required
Chapter: 2

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Lecture Note Outline

• Intuition on Portfolio Selection

• Comparative statics
• Example

• Maximization of Expected Utility

• Analytics
• Numerical Example

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Risk and Return - 1
• Optimal Portfolio Selection trades-off risk vs. return

• Return is simple:
– Monetary returns of different investment at a point in time are
additive
$10 $20

$30 = 10 + 20

– Percentage returns compound over time

20% 20%

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(1+0.2) x (1+0.2) = 1.44%, C = 44%
Risk and Return - 2
• Risk is not additive, generally
– Independence

– Dependence

why?
correlation: degree and sign of co-movement

– Portfolio: the expected return of each asset is judged on the

basis of its contribution to portfolio risk. Two channels:
• σ
• ρ 5
Comparative Statics - 1
• Consider a portfolio of two assets, then portfolio risk is

 p  w12 12  w22 22  2w1w2 12 1 2

• What is the change in portfolio risk for a unit change of

our investment in asset 1 or 2?

• First derivative of  p with respect to w1

– Marginal contribution of a unit change in w1 to portfolio risk  p
– Recall: an increase in w1 results in an equal decrease in w2 , since
w1  w2  1.
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Comparative Statics - 2
 p
  2w  
1
1 2 2 
 w1  1  w22 22  2w1w2 12 1 2 2 2
 2w2 12 1 2
w1 2
1 1

w1 12  w2 12 1 2 w1 12  w2 12 1 2

 
w   p
1
2
1
2
1  w22 22  2w1w2 12 1 2 2

 p
  2w  
1
1 2 2 
 w1  1  w22 22  2w1w2 12 1 2 2 2
 2w1 12 1 2
w2 2
2 2

w2 22  w1 12 1 2 w2 22  w1 12 1 2

 
w   p
1
2
1
2
1  w22 22  2w1w2 12 1 2 2

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Example - 1
• Our two risky assets correspond to “domestic” and
“foreign” equity and have the following data:
Volatility Expected Excess Return Total Return
Domestic Equity 15% 5.5% 10.5%
International Equity 16% 5% 10%
Cash 0 0 5%
Correlation = 0.65
• Suppose foreign exposure w2  0 . Then marginal
contributions simplify to
 p w1 12
   1  0.15
w1
w  
1
2 2 2
1 1

 p w1 1  2 
   2   0.16  0.65  0.104
w2
w  
1
2 2 2
1 1 8
Example - 2
• Assume the investor aims at the maximization of expected
return for a total portfolio risk (Standard Deviation) of
10%
• Recall: domestic equity volatility is 15%
• So, a portfolio with
• 2/3 domestic equity
• 1/3 cash (zero volatility and zero correlation)
2
2 2
 p    0.152  0  0    0.15  0.10
3 3

• What will happen if the investor starts selling domestic

and buying foreign equity?
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Example - 3
• Suppose the investor sells 1 unit of domestic equity
– What will be the effect on portfolio risk?
 p w1 12
(1)    1  0.15
w1
w  
1
2 2 2
1 1

• Suppose the investor buys 1 unit of foreign equity

– What will be the effect on portfolio risk?
 p w1 1  2 
(1)    2   0.16  0.65  0.104
w2
w  
1
2 2 2
1 1

• What should be the required investment in foreign equity

to keep portfolio risk unchanged, if the investor sells 1
unit of domestic equity? 0.15
 1.442
0.104
 p
• So, (1.442)
w2
 1.442  0.104  0.15 which offsets -0.15 10
Example - 4
• Effects on portfolio returns:
– Sale of 1 unit domestic equity: (-1) × 5.5% = -5.5%
– Purchase of 1.442 foreign equity: 1.442 × 5% = 7.215%

– Net result: 7.215% - 5.5% = 1.715%

• Recall: this strategy keeps portfolio risk constant and

increases portfolio return.

• The investor can keep repeating this strategy as long as

risk remains unchanged and return increases.
• Eventually, the investor will reach the edge of the Efficient
Frontier. 11
Example – 5: the effect of diversification

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Expected Utility – Quadratic Example 1

We wish to maximise the Expected Utility of wealth at t=1

by changing α, the investment in the risky asset.
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Expected Utility – Quadratic Example 2

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Expected Utility – Quadratic Example 3

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Expected Utility – Quadratic Example 4
E (W1 )   [1  E (r )]  (W0   )(1  rf )
E (W1 )   [ E (r )  rf ]  W0 (1  rf )
Var (W1 )  Var  [ E (r )  rf ]  W0 (1  rf ) 
 Var  [ E (r )  rf ]  Var W0 (1  rf )   2Cov  ( [ E (r )  rf ],W0 (1  rf ) 
but Var W0 (1  rf )   0 since all values inside the brackets are constant
and Cov  ( [ E (r )  rf ], W0 (1  rf )   0
since the term after the comma is a constant.
therefore Var (W1 )  Var  [ E (r )  rf ]   2Var [ E (r )  rf ]
Var (W1 )   2 2
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• Substitute into the E(U) equation, to form our portfolio optimisation problem .
Expected Utility – Quadratic Example 5

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Expected Utility – Quadratic Example 6

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Expected Utility – Exponential Example 1

We wish to maximise the Expected Utility of wealth at t=1

by changing α, the investment in the risky asset.
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Expected Utility – Exponential Example 2

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Expected Utility – Exponential Example 3

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 Graphical representation

Higher
E ( Rp ) Expected
Utility

E (U1 )
E (U 2 )
E (U 3 )

p
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 Graphical representation
Higher Expected
E (U1 ) Utility
E ( RP )
E (U 2 )
E (U 3 )

E (r )
Risky Asset
α is the proportion
invested in the risky
asset Combined
portfolio

Rf

r p 23
 If E(r) increases (everything else stays the same)

Higher Expected
E (U1 ) Utility
New
E ( RP ) Combined
portfolio E (U 2 )
E (U 3 )
α increases
E (r ) with
α is the proportion increasing E(r)
invested in the risky
asset

Rf

r p 24
 If Rf increases (everything else stays the same)

Higher Expected
E (U1 ) Utility
E ( RP )
E (U 2 )

New E (U 3 )
Combined α decreases
portfolio
E (r ) with
increasing Rf
Rf
α is the proportion
invested in the risky
asset

r p 25
 If σr increases (everything else stays the same)

Higher Expected
E (U1 ) Utility
E ( RP )
E (U 2 )
E (U 3 )

E (r )
α is the proportion α decreases
invested in the risky
asset Combined with
portfolio
increasing σr
Rf

r p 26
 If b decreases (everything else stays the same)
Higher Expected
E (U1 ) Utility
E ( RP )
E (U 2 )
E (U 3 )
α increases with
E (r ) decreasing b and
Combined
portfolio
vice-versa;
α is the proportion
invested in the risky
remember, b is
asset the risk aversion
coefficient
Rf

r p 27