In Other Words, Given The Choice Between Two Equally Risky Investments, An Investor Will

Chapter Six, Investment Analysis and Portfolio Management (AcFn 3201), Jig-Jiga University. June, 2021.
(2013
E.C.)
CHAPTER SIX.
Portfolio Theory.
6.1. Diversification and portfolio risk.
A portfolio is simply a collection of financial assets involving investment tools such as bonds,
foreign exchange, stocks, gold, asset-backed securities, real estate certificates and bank deposits
which are held simultaneously by one person or a group of persons. In other word, Portfolio is a
collection of investment vehicles assembled to meet one or more investment goals.
If you own a home and household furnishings and a savings account you already have a
portfolio.
A portfolio can be either;

• Growth-Oriented Portfolio: primary objective is long-term price appreciation, or
• Income-Oriented Portfolio: primary objective is current dividend and interest income.
The ultimate goal of portfolio is to get an efficient portfolio. Efficient Portfolio is a portfolio
with maximum expected return for a given level of risk, or minimum risk for a given expected
return. In other words, given the choice between two equally risky investments, an investor will
chose the one with the highest potential return. And given the choice between two investments
offering the same return, an investor will choice the one that has the least risk.
Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several
stocks. When this is the case, a portion of an individual stock's risk can be
eliminated, i.e., diversified away. Or most portfolios are diversified to protect against the risk of
single securities or class of securities.
Portfolio theory was initially developed by Markowitz (1952) as a normative approach to

investment choice under uncertainty. There are two important assumptions of portfolio theory.
These are:
(a) The returns from investments are normally distributed. Therefore, two parameters, the
expected return and the standard deviation, are sufficient to describe the distribution of returns.
(b) Investors are risk averse (risk averse→ means that investors do not like risk and therefore,
demand more expected return if they take on more risk). Therefore, investors prefer the highest
expected return for a given standard deviation and the lowest standard deviation for a given
expected return.
Given these assumptions, it can be shown that it is rational for a utility-maximizing investor to
hold a well-diversified portfolio of investments. Suppose that an investor holds a portfolio of
securities. This investor will be concerned about the expected return and risk of the portfolio.
The expected return on a portfolio is a weighted average of the expected returns on the securities
in the portfolio.
The Modern Portfolio Theory (MPT) is appreciated by Scientists and it is the most practical
investment model ever introduced by Harry M. Markowitz.
The model and its components shall be fully introduced, also covering the mathematical
development of the model. Diversification is also one method of reducing risks and maximizing
returns by putting all of your investible funds in different investment alternatives.
JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

Page-- 1.
“Mahamedkeder Abdilahi Yusuf”.
Chapter Six, Investment Analysis and Portfolio Management (AcFn 3201), Jig-Jiga University. June, 2021. (2013
E.C.)
Diversification.
The risk of a portfolio depends not only on the risk nature of the securities making up the
portfolio but also on the relationship among the securities. In other words, the potential of an
asset to diversify a portfolio is dependent upon the degree of co-movement of returns of the asset
with those other assets that make up the portfolio i.e.;- In a simple, two-asset case, if the returns
of the two assets are perfectly negatively correlated it is possible (depending on the relative
weighting) to eliminate all portfolio risk. So, this must be considered in calculating the standard
deviation of a portfolio return.
Therefore, an investor can reduce relative risk by selecting securities that have little relationship
with each other. Diversification is the process of combining securities in a way that reduces total
risk without losing portfolio return.
Benefits from Diversification:

1) Perfect Positively Correlation: Here, there is a linear relationship between risk and
return. It is not possible to reduce risk without reducing return. There is no benefit from
diversification when returns of securities are perfect positively correlated.
2) Perfect Negative Correlation: Here one is referring to a Portfolio that has higher
expected return and lower risk. But, at the same level of expected return, the Portfolio
has no risk. Therefore, there are more benefits to be derived from diversification when
securities are negatively correlated.
3) Uncorrelated Returns: At the same level of expected returns, different Portfolios have
different levels of risk. As more assets with uncorrelated returns are included in the
portfolio, the benefit from diversification increases.
6.2. Portfolio Risk and return.

Risk is the probability of the losses one incurred on portfolio investment and the return is the
profit or benefit one derives from portfolio investment.
While there may be different definitions of risk, one widely-used measure is called variance.
Variance measures the variability of realized returns around an average level. The larger the
variance the higher the risk in the portfolio.
Example-1: Oliver’s portfolio holds security A, which returned 12.0% and security B, which
returned 15.0%.
At the beginning of the year 70% was invested in security A and the remaining 30% was
invested in security B.
Given a standard deviation of 10% for security A, 20% for security B and a correlation
coefficient of 0.5 between the two securities, calculate the portfolio variance.
s2 = WA2sA2 + WB2sB2 + 2WAWBsAsBrAB.
PortfolioVariance=(.72x 0.12) + (.32x 0.22) + (2x.7x.3x0.1x0.2x.5).

Page-- 2.
E.C.)
= 0.0127.
Portfolio standard deviation is the square root of the portfolio variance.
s= √ 0.0127 = 0.1127 or 0.1127 X 100 = 11 .27 %.
On the other hand, portfolio return can be calculated as;

RP = W1R1 + W2R2 + W3R3 …………….
Example-2: Oliver’s portfolio holds security A, which returned 12.0%, security B, which
returned 15.0% and security C, which returned –5%.
At the beginning of the year 45% was invested in security A, 25.0% in security B and the
remaining 30% was invested in security C.
Calculate the return of Oliver’s portfolio over the year.
Rp = (.45 x 0.12) + (.25 x 0.15) + (.3 x (-5%)) = 0.0765 or 7.65%.
* note;- W – means weight or the proportion of the portfolio invested in the stocks.
6.3. Capital allocation between risky and risk free assets.

Capital allocation decision = choice of proportion to be invested in risk-free versus risky assets
Asset allocation decision = choice of type of assets to invest in (e.g., bonds, real estate, stocks,
foreign assets etc.)
Security selection decision = choice of which particular security to invest in.
Capital allocation decision may consider the following aspects:
 examine risk/return tradeoff
 demonstrate how different degrees of risk aversion will affect allocations between risky
and risk free assets
 consider the optimal risky portfolio: as given and analyze the allocation decision between
“the” risky portfolio (treated as one asset) and the risk-free asset (T-bills).
 Rate of return: P1-P0 + D1.
P0
Where, D1 = Annual income or dividend at the end of a given time period,
P1 = Closing security price at a given time period.
P0 = Opening security price at a given time period.
The Risk-Free Asset.
 Technically, the risk-free asset is default-free and without inflation risk (a price-indexed
default-free bond)
 in practice, Treasury bills come closest, because:
 They are a Short term, means they have a little interest-rate or inflation risk.
 Their Default risk is practically zero, since the government would no default.
Capital allocation also refers that an investor must decide how to invest all of his/her wealth and
has only two options: a risk-free asset such as Treasury Bills (T-Bills) and a risky portfolio of
stocks (such as a mutual fund).

Page-- 3.
E.C.)
 Since all of her/his wealth must be invested, the decision that she/he makes can be
summarized by one parameter, take “w” to be the fraction of her/his wealth that she/he
invests in the risky portfolio.
 Since she/he must allocate all of her/his wealth to either the mutual fund or T-Bill, the
fraction of her/his wealth invested in T-Bill must be, 1 − w.
 If we assume a functional form for the investors objective (or utility) function, then we
can determine the optimal fraction of wealth for the investor to put into the risky
portfolio, w.
6.4. Optimum risky portfolio.
6.4.1. The Optimal Portfolio.
The optimal portfolio concept falls under the modern portfolio theory.
The theory assumes (among other things) that investors fanatically try to minimize risk while
striving for the highest return possible.
The theory states that investors will act rationally, always making decisions aimed at maximizing
their return for their acceptable level of risk. The optimal portfolio shows us that it is possible for
different portfolios to have varying levels of risk and return.
Each investor must decide how much risk they can handle and then allocate (or diversify) their
portfolio according to this decision. The chart below illustrates how the optimal portfolio works.
The optimal-risk portfolio is usually determined to be somewhere in the middle of the curve
because as you go higher up the curve, you take on proportionately more risk for a lower
incremental return.
On the other end, low risk/low return portfolios are pointless because you can achieve a similar
return by investing in risk-free assets, like government securities.
You can choose how much volatility you are willing to bear in your portfolio by picking any
other point that falls on the efficient frontier. This will give you the maximum return for the
amount of risk you wish to accept. Optimizing your portfolio is not something you can calculate
in your head. There are computer programs that are dedicated to determining optimal portfolios

Page-- 4.
E.C.)
by estimating hundreds (and sometimes thousands) of different expected returns for each given
amount of risk.
Optimal Portfolio Choice.

• Zero-Risk Portfolio: constant return portfolio.
• Efficient Portfolio: portfolio with maximum expected return for a given level of risk, or
minimum risk for a given expected return
• Efficient Frontier: collection of all efficient portfolios.
• Optimal Portfolio: collection of securities that provides an investor with the highest level
of expected utility
• Market Portfolio: all tradable assets.
6.4.2. Portfolios of Two Risky Assets.

If we wish to construct a portfolio with more than one risky asset, we still use the general utility
function approach described above.
However, the combination line indicating the expected return-variance combinations that can be
obtained with more than one risky asset is no longer linear.
We need to consider how portfolio variance changes as we change portfolio proportions.
Let us look at the simple case, where there are exactly two risky assets (or portfolios), D and E.
Then the expected return and variance of returns is given below:
We see below the combination line of the two risky assets, D and E.
Note that the portfolio standard deviation is less than the weighted average of the individual
standard deviations. Also, the slope of the combination line at any point indicates the reward-to-
variability ratio at that point.

Page-- 5.
E.C.)
The minimum variance portfolio of risky assets D and E is given by the following portfolio
proportions:
* Note;- Covariance is a statistical measure of how 1 investment moves in relation to another.

Page-- 6.

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Chapter Six, Investment Analysis and Portfolio Management (AcFn 3201), Jig-Jiga University. June, 2021.

A portfolio can be either;

Portfolio theory was initially developed by Markowitz (1952) as a normative approach to

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

Benefits from Diversification:

6.2. Portfolio Risk and return.

PortfolioVariance=(.72x 0.12) + (.32x 0.22) + (2x.7x.3x0.1x0.2x.5).

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

On the other hand, portfolio return can be calculated as;

Calculate the return of Oliver’s portfolio over the year.

Rp = (.45 x 0.12) + (.25 x 0.15) + (.3 x (-5%)) = 0.0765 or 7.65%.

6.3. Capital allocation between risky and risk free assets.

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

Optimal Portfolio Choice.

6.4.2. Portfolios of Two Risky Assets.

We need to consider how portfolio variance changes as we change portfolio proportions.

Then the expected return and variance of returns is given below:

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

* Note;- Covariance is a statistical measure of how 1 investment moves in relation to another.

JJU, COBE, Dep’t of ACFN, Compiled By Instructor;-

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