Chapter 5

Modern Portfolio
Concepts

Required computations (10-12)

Various return concepts (HPR, IRR, realized return, expected
return)
Compute the average return and standard deviation on a
time series using excel.
Compute the mean/expected return and standard deviation
given scenarios with probabilities.
Compute the mean return, beta of a portfolio of multiple
assets
Compute the standard deviation of a two-asset portfolio
Apply CAPM to compute required rate of return, return
sensitivity to market moves, and market risk premium.

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What is a Portfolio?
Portfolio is a collection of investments
assembled to meet one or more investment
goals.
Efficient portfolio
A portfolio that provides the highest return for a
given level of risk
Requires search for investment alternatives to
get the best combinations of risk and return

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Portfolio Return and Risk Measures

The return on a portfolio is simply the
weighted average of the individual assets
returns in the portfolio

The standard deviation of a portfolios

returns is more complicated, and is a
function of the portfolios individual assets
weights, standard deviations, and
correlations with all other assets
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Return on Portfolio

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Correlation:
Why Diversification Works!
Correlation is a statistical measure of the
relationship between two series of numbers
representing data
Positively Correlated items tend to move in the
same direction
Negatively Correlated items tend to move in
opposite directions
Correlation Coefficient is a measure of the
degree of correlation between two series of
numbers representing data
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Correlation Coefficients
Perfectly Positively Correlated describes two
positively correlated series having a
correlation coefficient of +1
Perfectly Negatively Correlated describes
two negatively correlated series having a
correlation coefficient of -1
Uncorrelated describes two series that lack
any relationship and have a correlation
coefficient of nearly zero

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Figure 5.1 The Correlation Between

Series M, N, and P

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Correlation:
Why Diversification Works!
Assets that are less than perfectly positively
correlated tend to offset each others
movements, thus reducing the overall risk
in a portfolio
The lower the correlation the more the
overall risk in a portfolio is reduced
Assets with +1 correlation eliminate no risk
Assets with less than +1 correlation eliminate some risk
Assets with less than 0 correlation eliminate more risk
Assets with -1 correlation eliminate all risk

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Figure 5.2 Combining Negatively

Correlated Assets to Diversify Risk

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Figure 5.3 Portfolios of IBM and Celgene

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Figure 5.4 Risk and Return for Combinations of

Two Assets with Various Correlation Coefficients

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Why Use International

Diversification?
Offers more diverse investment alternatives than
U.S.-only based investing
Foreign economic cycles may move independently
from U.S. economic cycle
Foreign markets may not be as efficient as U.S.
markets, allowing true gains from superior
research

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International Diversification
Advantages of International Diversification
Broader investment choices
Potentially greater returns than in U.S.
Reduction of overall portfolio risk

Disadvantages of International
Diversification

Currency exchange risk

Less convenient to invest than U.S. stocks
More expensive to invest
Riskier than investing in U.S.

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Methods of
International Diversification
Foreign company stocks listed on U.S. stock
exchanges

Yankee Bonds
American Depository Shares (ADSs)
Mutual funds investing in foreign stocks
U.S. multinational companies (typically not
considered a true international investment for
diversification purposes)

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Components of Risk
Diversifiable (Unsystematic) Risk
Results from uncontrollable or random events
that are firm-specific
Can be eliminated through diversification
Examples: labor strikes, lawsuits

Nondiversifiable (Systematic) Risk

Attributable to forces that affect all similar
investments
Cannot be eliminated through diversification
Examples: war, inflation, political events
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Components of Risk

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Beta: A Popular Measure of Risk

A measure of undiversifiable risk
Indicates how the price of a security responds to market
forces
Compares historical return of an investment to the market
return (the S&P 500 Index)
The beta for the market is 1.0
Stocks may have positive or negative betas. Nearly all are
positive.
Stocks with betas greater than 1.0 are more risky than the
overall market.
Stocks with betas less than 1.0 are less risky than the overall
market.

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Beta as a Measure of Risk

Table 5.4 Selected Betas and Associated
Interpretations

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Interpreting Beta
Higher stock betas should result in higher expected
returns due to greater risk
If the market is expected to increase 10%, a stock
with a beta of 1.50 is expected to increase 15%
If the market went down 8%, then a stock with a
beta of 0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained
from Value Line reports or websites such as
yahoo.com

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Interpreting Beta

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Capital Asset Pricing Model (CAPM)

Model that links the notions of risk and
return
Helps investors define the required return
on an investment
As beta increases, the required return for a
given investment increases

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Capital Asset
Pricing Model (CAPM) (contd)
Uses beta, the risk-free rate and the market
return to define the required return on an
investment

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Capital Asset
Pricing Model (CAPM) (contd)
CAPM can also be shown as a graph
Security Market Line (SML) is the picture
of the CAPM
Find the SML by calculating the required
return for a number of betas, then plotting
them on a graph

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Figure 5.6 The Security Market Line

(SML)

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Two Approaches to Constructing

Portfolios
Traditional Approach
versus
Modern Portfolio Theory

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Traditional Approach
Emphasizes balancing the portfolio using a
wide variety of stocks and/or bonds
Uses a broad range of industries to diversify
the portfolio
Tends to focus on well-known companies

Perceived as less risky

Stocks are more liquid and available
Familiarity provides higher comfort levels for
investors

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Modern Portfolio Theory (MPT)

Emphasizes statistical measures to develop
a portfolio plan
Focus is on:

Expected returns
Standard deviation of returns
Correlation between returns

Combines securities that have negative (or

low-positive) correlations between each
others rates of return

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Key Aspects of MPT:

Efficient Frontier
Efficient Frontier
The leftmost boundary of the feasible set of
portfolios that include all efficient portfolios:
those providing the best attainable tradeoff
between risk and return
Portfolios that fall to the right of the efficient
frontier are not desirable because their risk
return tradeoffs are inferior
Portfolios that fall to the left of the efficient
frontier are not available for investments

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Figure 5.7 The Feasible or Attainable

Set and the Efficient Frontier

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Key Aspects of MPT:

Portfolio Betas
Portfolio Beta
The beta of a portfolio; calculated as the
weighted average of the betas of the individual
assets the portfolio includes
To earn more return, one must bear more risk
Only nondiversifiable risk (relevant risk) provides
a positive risk-return relationship

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Figure 5.8 Portfolio Risk and

Diversification

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Key Aspects of MPT: Portfolio Betas

Table 5.6 Austin Funds Portfolios V and W

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Interpreting Portfolio Betas

Portfolio betas are interpreted exactly the same
way as individual stock betas.

Portfolio beta of 1.00 will experience a 10% increase when

the market increase is 10%
Portfolio beta of 0.75 will experience a 7.5% increase
when the market increase is 10%
Portfolio beta of 1.25 will experience a 12.5% increase
when the market increase is 10%

Low-beta portfolios are less responsive and less

risky than high-beta portfolios.
A portfolio containing low-beta assets will have a
low beta, and vice versa.

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Interpreting Portfolio Betas

Table 5.7 Portfolio Betas and Associated Changes in Returns

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Reconciling the Traditional

Approach and MPT
Recommended portfolio management policy uses
aspects of both approaches:
Determine how much risk you are willing to bear
Seek diversification between different types of securities
and industry lines
Pay attention to correlation of return between securities
Use beta to keep portfolio at acceptable level of risk
Evaluate alternative portfolios to select highest return for
the given level of acceptable risk

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Figure 5.9 The Portfolio Risk-Return

Tradeoff

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