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Portfolio Management
Lecture 1: A simple model of portfolio
management
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Structure of the course

Investment objective, risk
tolerance & strategy

Stock selection Investment strategy

(Class 3,4,5) (Class 8, 9, 10)

Portfolio construction Riskless investing

(Class 6&7) (Class 11 & 12)

Performance measurement
& evaluation (class 13& 14)
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Utility functions & Risk tolerance

› Risk is probably the most ambiguous element of
modern portfolio theory and asset choice.
› People tend to confuse their risk expectations with
their risk attitude.
› Risk attitude can be modelled using utility functions.
› Risk tolerance is the willingness of people to bear risk
in excange for return (risk premium)
The efficient frontier
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Utility function
Return

The efficient frontier is the

Opportunity set of investment
Alternatives that present
Rational choices for risk
Averse investors

Risk
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Expected utility theorem

› U(W) utility function representing the utility of wealth W

Expected Utility Theorem:

E(U) = Σ U(W) P(W)

A utility function is nothing more than a weighting function or a scoring

system
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Example: Soccer scores

› In the past, the following was used in counting soccer
scores in a tournament:

Outcome of game Points

Win 2
Tie 1
Loss 0
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Example: Soccer scores

› A common way of counting soccer scores in a
tournament is by using the following system:

Outcome of game Points

Win 3
Tie 1
Loss 0
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Example: Soccer scores (2)

› Consider two equally strong teams, that use a
different strategy:
1. The first team plays a risky strategy involving an
offensive playing style
2. This team plays a conservative strategy involving a
defensive playing style.
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Example: Soccer scores (3)

› Suppose that team 1 has a 50% probability of winning and a 50%
probability of losing
› Suppose that team 2 has a 10% probability of winning, an 80%
probability of an equal outcome, and a 10% probability of
loosing.

› On average, after 10 games:

› Team 1: has 5*3 = 15 points (old score: 10)
› Team 2: has 1*3 + 8*1 = 11 points (old score: 10)
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A simple utility function

σ 2

f = E[ R] −
T
where T represents the risk tolerance, R is the
return on a portfolio and σ is its standard deviation
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A simple portfolio problem

› We like to choose a portfolio of stocks and riskless bonds
that maximizes our utility.
› Rs is the return on stocks, Rf is the return on bonds, and σs
is the standard deviation of stock returns.
› Let x be the fraction of assets in stocks.
› We want to choose x in such a way that we maximize our
utility f:

x 2σ 2
max f = ( xRs + (1 − x ) R f ) −
s s

T
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The solution to the problem

For example:
= ( Rs − R f ) − x σ 2 = 0
df 2
s s Rs 12%
dx T
T Rs − R f Rf 8%
xs =
2 σ2 s Sigma 20%
T=1

x=5
0%
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Allocation to risky assets

1.2

0.8
Risky asset

0.6

0.4

0.2

0
0 0.5 1 1.5 2 2.5
Risky tolerance
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How to measure risk tolerance

› Design questionairres and interview individuals
(expected)
› Implicitly derive it from portfolio data (realized)
› We need to know the
1. Risk of the risky assets
2. The risk premium
3. The allocation to risky assets
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What is a reasonable value for risk tolerance?

› Following the implicit method
› According to Dimson et al, the equity risk premium is
somewhere between 3.5% and 5.25%.
› Risk estimates for the stock market index are between
18% and 25%.
For a fully invested investor
σ2
=T
s
2 xs

Alloca
Rs − R f
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Important determinants of decision to take risk:

Rational:
› Risk tolerance (or inversely risk aversion)
› Risk premium
› Riskiness of the asset

Psychological:
› Perception of risk
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Risk premium
› 1990-1999: US investor achieved total return of 14.2%
per annum
› 1926-2000: US investor achieved an equity risk
premium of 7.3%
› UK, 1919-1999: UK investor achieved an equity risk
premium of 6.4%

› Doubts concerning these numbers:

• survivorship bias
• only 2 markets from the 36.
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Dimson et al. (2002)

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Estimates of the risk premium

› Risk premium:
• Lowest: 2.2% (gmt) or 4.4% (arm) for Belgium
• Highest 6.8% (gmt) or 8.3% (arm) for Australia
› So estimates range from 16.5% to 35.5% for the
standard deviation
 0.00
10.00
20.00
30.00
40.00
50.00
60.00
70.00
3-1-2000

3-4-2000

3-7-2000

3-10-2000

3-1-2001

3-4-2001

3-7-2001

3-10-2001

3-1-2002

3-4-2002

3-7-2002

3-10-2002

3-1-2003

3-4-2003

3-7-2003

3-10-2003
VAEX

3-1-2004

3-4-2004

3-7-2004

3-10-2004

3-1-2005

3-4-2005

3-7-2005

3-10-2005

3-1-2006

3-4-2006

3-7-2006
Expected risk: implied volatility

3-10-2006

3-1-2007

3-4-2007

3-7-2007
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Different beliefs
› Even persons with the same risk tolerance could hold
very different portfolios if their expectations are
different.
T 1 1 1 1
Rs-Rf 4% 8% 2% 4%
Sigma 15% 20% 25% 25%

Risky asset 89% 100% 16% 32%

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Distinction between risk expectation and

risk tolerance

T 0.25 1 Is it really possible to

Rs-Rf 4% 4% distinguish between
Sigma 15% 30% these two concepts?
Risky asset 22% 22% Is risk tolerance
affected by previous
high volatility on the
stock market?
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Strategy
› Brinson & Fachler: study of pension fund
performance measurement
› What factors impact the realized performance?
› Top down model
1. Strategic asset allocation
2. Tactical asset allocation
3. Security selection (stock picking)
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Strategic asset allocation

› The long-term asset allocation choosen by an investor in
terms of
• the allocation over stocks, bonds, real estate
• different geographical regions
› Reflects the main risk-profile of the investor
• This is the asset allocation that is recommended by
banks to their customers after filling in the risk-
questionaire
• Pension funds use an ALM study to find out what asset
allocation serves their long-term goals.
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Tactical asset allocation

› Reflects the actual current asset allocation
› Differs from the strategical asset allocation because
• Asset classes perform differently (so you have to
rebalance to maintain the strategic asset
allocation)
• Reflect the market view of the investor (US stocks
will recover in the next period, so we increase the
weight to profit from this.
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The analysis is based on four different portfolios:

1. The benchmark portfolio;
2. The stock-selected portfolio;
3. The timing portfolio;
4. The actual portfolio.
› Portfolio 1 is the overall benchmark portfolio, which
is derived directly from the general investment
plan.
› Portfolios 2 and 3 are the outcomes of a ‘what if
analysis’ that measure the impact of decisions in
isolation from other decisions.
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Measurement:
R(I) = ∑ w ip R ip R(III) = ∑ w ia R ip
i i

R(II) = ∑ w ip R ia R(IV) = ∑ wia Ria

i i

Source Calculation
Timing R(III) -R(I) Σ (wip - wia) Rip
Selection R(II) -R(I) Σ (Ria - Rip) wip
Interaction R(I)-R(II)-R(III) + R(IV) Σ wip (Rip - Ria) +wia (Ria-Rip)
Total contribution R(IV) -R(I) Ra- Rp
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Example
An investor utilizes a strategic asset allocation of
• 50% bonds
• 20% domestic stocks
•30% foreign stocks

actual allocation Return Return actual

benchmark portfolio
Bond 30% 8% 7%
Domestic stocks 20% 12% 15%
Foreign stocks 50% 24%* 22%*
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Outcome:

Portfolio Return
I 13.6% Timing 3.2%
II 13.1% Selection -0.5%
III 16.8% Interaction -0.2%
IV 16.1% Total contribution 2.5%
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Brinson, Hood & Fachler (1986)

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Lessons to be learned
› Strategic asset allocation / the allocation to choose the
level of risk is the most important decision in the
investment portfolio and explains more than 90% of
differences in return between portfolios.
› Tactical asset allocation and stock selection contribute
little to total outperformance.
› Decision to choose level of risk depends on a number
of subjective variables, such as risk tolerance,
expected return, and risk.