ReillyBrown IAPM 11e PPT Ch06

CHAPTER 6
An Introduction
to Portfolio
Management
©2019 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly accessible website, in whole or in part. 6-1
6.1 Some Background Assumptions
• Investors want to maximize from the total

set of investments for a given level of risk
• Portfolio includes all assets and liabilities
• Relationship between the returns for assets in
the portfolio is important
• A good portfolio is not simply a collection of
individually good investments
6.1.1 Risk Aversion
• Given a choice between two assets with equal
rates of return, risk-averse investors will select
the asset with the lower level of risk
• Evidence
• Many investors purchase insurance purchase various types
of insurance, including life insurance, car insurance, and
health insurance
• Yield on bonds increases with risk classifications, which
indicates that investors require a higher rate of return to
accept higher risk
• Not all investors are risk averse
• It may depend on the amount of money involved
• Risking small amounts, but insuring large losses
6.1.2 Definition of Risk
• For most investors, risk means the

uncertainty of future outcomes
• An alternative definition may be the
probability of an adverse outcome
6.2 Markowitz Portfolio Theory
(slide 1 of 2)
• The Markowitz model is based on several assumptions
regarding investor behavior:
1. Investors consider each investment alternative as being
represented by a probability distribution of potential returns
over some holding period
2. Investors maximize one-period expected utility, and their utility
curves demonstrate diminishing marginal utility of wealth
3. Investors estimate the risk of the portfolio on the basis of the
variability of potential returns
4. Investors base decisions solely on expected return and risk, so
their utility curves are a function of expected return and the
variance (or standard deviation) of returns only
5. For a given risk level, investors prefer higher returns to lower
returns. Similarly, for a given level of expected return, investors
prefer less risk to more risk
6.2 Markowitz Portfolio Theory
(slide 2 of 2)
• Using these assumptions, a single asset

or portfolio of assets is considered to be
efficient if no other asset or portfolio of
assets offers higher expected return with
the same (or lower) risk or lower risk with
the same (or higher) expected return
6.2.1 Alternative Measures of Risk
(slide 1 of 2)
• Variance or standard deviation of expected
return
• Range of returns
• Returns below expectations
• Semi-variance – a measure that only
considers deviations below the mean
• These measures of risk implicitly assume that
investors want to minimize the damage from
returns less than some target rate
6.2.1 Alternative Measures of Risk
(slide 2 of 2)
• Advantages of using variance or standard

deviation of returns:
1. Measure is somewhat intuitive
2. Widely recognized risk measure
3. Has been used in most of the theoretical
asset pricing models
6.2.2 Expected Rates of Return
(slide 1 of 3)
• Expected rate of return
• For an individual investment
• Equal to the sum of the potential returns multiplied
with the corresponding probability of the returns
• Exhibit 6.1
• For a portfolio of investments
• Equal to the weighted average of the expected
rates of return for the individual investments in the
portfolio
• Exhibit 6.2
(slide 2 of 3)
(slide 3 of 3)
6.2.3 Variance (Standard Deviation) of Returns
for an Individual Investment (slide 1 of 2)
• The variance, or standard deviation, is a

measure of the variation of possible rates of
return:
• Exhibit 6.3
6.2.3 Variance (Standard Deviation) of Returns
for an Individual Investment (slide 2 of 2)
6.2.4 Variance (Standard Deviation) of
Returns for a Portfolio (slide 1 of 9)
• Covariance of Returns
• A measure of the degree to which two
variables “move together” relative to their
individual mean values over time
• For two assets, i and j, the covariance of rates
of return is defined as:
• Exhibits 6.4, 6.5, 6.6, 6.7, 6.8

• Covariance and Correlation
• The correlation coefficient is obtained by
standardizing (dividing) the covariance by the
product of the individual standard deviations
Where:
rij = correlation coefficient of returns
σi = standard deviation of Rit
σj = standard deviation of Rjt
• The coefficient can vary only in the range +1 to −1
• A value of +1 would indicate perfect positive
correlation. This means that returns for the two
assets move together in a positively and completely
linear manner
• A value of −1 would indicate perfect negative
correlation. This means that the returns for two
assets move together in a completely linear manner,
but in opposite directions
• Exhibit 6.9
6.2.5 Standard Deviation of a Portfolio (slide
1 of 10)
• Portfolio Standard Deviation Formula
where:
σport = standard deviation of the portfolio
wi = weights of an individual asset in the portfolio; where weights
are determined by the proportion of value in the portfolio
σ2i = variance of rates of return for Asset i
Covij = covariance between the rates of return for Assets i and j
Covij = σiσj
2 of 10)
• Impact of a New Security in a Portfolio
• Two effects to the portfolio’s standard deviation when
we add a new security to such a portfolio:
• The asset’s own variance of returns
• The covariance between the returns of this new asset and
the returns of every other asset that is already in the portfolio
• The relative weight of these numerous covariances is
substantially greater than the asset’s unique variance;
the more assets in the portfolio, the more this is true
• The important factor to consider when adding an
investment to a portfolio that contains a number of
other investments is not the new security’s own
variance but the average covariance of this asset with
all other investments in the portfolio
3 of 10)
• Portfolio Standard Deviation

Calculation
• Any asset or portfolio of assets can be
described by two characteristics:
• The expected rate of return
• The standard deviation of returns
4 of 10)
• Equal Risk and Return—Changing Correlations
• The expected return of the portfolio does not change because it
is simply the weighted average of the individual expected returns
• Demonstrates the concept of diversification, whereby the risk
of the portfolio is lower than the risk of either of the assets held
in the portfolio
• Risk reduction benefit occurs to some degree any time the
assets combined in a portfolio are not perfectly positively
correlated (that is, whenever ri,j < +1)
• Diversification works because there will be investment periods
when a negative return to one asset will be offset by a positive
return to the other, thereby reducing the variability of the overall
portfolio return
5 of 10)
• The negative covariance term exactly offsets the
individual variance terms, leaving an overall
standard deviation of the portfolio of zero
• This would be a risk-free portfolio, meaning that
the average combined return for the two
securities over time would be a constant value
(that is, have no variability)
• Thus, a pair of completely negatively correlated
assets provides the maximum benefits of
diversification by completely eliminating variability
from the portfolio
• Exhibit 6.10
6 of 10)
7 of 10)
• Combining Stocks with Different
Returns and Risk
• Consider two assets (or portfolios) with
different expected rates of return and
individual standard deviations
• With perfect negative correlation, the portfolio
standard deviation is not zero
• This is because the different examples have
equal weights, but the asset standard
deviations are not equal
• Exhibit 6.11
8 of 10)
9 of 10)
• Constant Correlation with Changing

Weights
• If the weights of the two assets are changed
while holding the correlation coefficient
constant, a set of combinations is derived that
trace an ellipse
• The benefits of diversification are critically
dependent on the correlation between assets
• Exhibit 6.12
10 of 10)
6.2.6 A Three-Asset Portfolio
• The results presented earlier for the two-asset
portfolio can be extended to a portfolio of n assets
• As more assets are added to the portfolio, more risk
will be reduced (everything else being the same)
• The general computing procedure is still the same,
but the amount of computation has increase rapidly
• For the three-asset portfolio, the computation has
doubled in comparison with the two-asset portfolio
6.2.7 Estimation Issues (slide 1 of 3)
• Results of portfolio allocation depend on

accurate statistical inputs
• Estimates of
• Expected returns
• Standard deviation
• Correlation coefficient
• Among entire set of assets
• With 100 assets, 4,950 correlation estimates
• Estimation risk refers to potential errors
• With the assumption that stock returns can be

described by a single market model, the number
of correlations required reduces to the number
of assets
• Single index market model:
Where:
bi = the slope coefficient that relates the returns for security i to the
returns for the aggregate market
Rm = the returns for the aggregate stock market
• If all the securities are similarly related to the

market and a bi derived for each one, it can be
shown that the correlation coefficient between
two securities i and j is given as:
where:
σ2m = variance of returns for the aggregate stock market
6.3 The Efficient Frontier (slide 1 of 4)
• The efficient frontier represents that set of portfolios with

the maximum rate of return for every given level of risk
or the minimum risk for every level of return
• Every portfolio that lies on the efficient frontier has either
a higher rate of return for the same risk level or lower
risk for an equal rate of return than some portfolio falling
below the frontier
• See Exhibit 6.13
• Portfolio A in Exhibit 6.13 dominates Portfolio C because it has
an equal rate of return but substantially less risk
• Portfolio B dominates Portfolio C because it has equal risk but a
higher expected rate of return
• Markowitz defined the basic problem that

the investor needs to solve as:
• Select {wi} so as to:
• subject to the following conditions:
• The general method for solving the formula is called a

constrained optimization procedure because the task
the investor faces is to select the investment weights that
will “optimize” the objective (minimize portfolio risk) while
also satisfying two restrictions (constraints) on the
investment process:
i. The portfolio must produce an expected return at least as large as the
return goal, R; and
ii. All of the investment weights must sum to 1.0
• The approach to forming portfolios according to this

equation is often referred to as mean-variance
optimization because it requires the investor to minimize
portfolio risk for a given expected (mean) return goal
6.3.1 The Efficient Frontier: An Example
(slide 1 of 3)
• What would be the optimal asset allocation

strategy using these five asset classes?
(slide 2 of 3)
(slide 3 of 3)
6.3.2 The Efficient Frontier and Investor
Utility (slide 1 of 3)
• An individual investor’s utility curve specifies the
trade-offs he is willing to make between
expected return and risk
• The slope of the efficient frontier curve
decreases steadily as you move upward
• The interactions of these two curves will
determine the particular portfolio selected by an
individual investor
• The optimal portfolio has the highest utility for a
given investor
• The optimal lies at the point of tangency
between the efficient frontier and the utility
curve with the highest possible utility
• See Exhibit 6.16
• Investor X with the set of utility curves will achieve
the highest utility by investing the portfolio at X
• With a different set of utility curves, Investor Y will
achieve the highest utility by investing the portfolio
at Y
• Which investor is more risk averse?
6.4 Capital Market Theory: An Overview
• Capital market theory builds directly on the

portfolio theory we have just developed by
extending the Markowitz efficient frontier into a
model for valuing all risky assets
• Capital market theory also has important
implications for how portfolios are managed in
practice
• The development of this approach depends on
the existence of a risk-free asset, which in turn
will lead to the designation of the market portfolio
6.4.1 Background for Capital Market Theory
(slide 1 of 2)
• Assumptions:
1. All investors are Markowitz efficient investors
who want to target points on the efficient frontier
2. Investors can borrow or lend any amount of
money at the risk-free rate of return (RFR)
3. All investors have homogeneous expectations;
that is, they estimate identical probability
distributions for future rates of return
4. All investors have the same one-period time
horizon such as one month, six months, or one
year
6.4.1 Background for Capital Market Theory
(slide 2 of 2)
• Assumptions (Continued)
5. All investments are infinitely divisible, which
means that it is possible to buy or sell fractional
shares of any asset or portfolio
6. There are no taxes or transaction costs involved
in buying or selling assets
7. There is no inflation or any change in interest
rates, or inflation is fully anticipated
8. Capital markets are in equilibrium, which implies
that all investments are properly priced in line
with their risk levels
6.4.2 Developing the Capital Market Line
(slide 1 of 8)
• A risky asset is one for which future

returns are uncertain
• Uncertainty is measured by the standard
deviation of expected returns
• Because the expected return on a risk-free
asset is entirely certain, the standard
deviation of its expected return is zero
• The rate of return earned on such an asset
should be the risk-free
(slide 2 of 8)
• Covariance with a Risk-Free Asset
• Covariance between two sets of returns is
• Because the returns for the risk free asset are certain,
the covariance between the risk-free asset and any
risky asset or portfolio will always be zero
• Similarly, the correlation between any risky asset and
the risk-free asset would be zero
(slide 3 of 8)
• Combining a Risk-Free Asset with a Risky Portfolio
• Expected Return
• Is the weighted average of the two returns:
• Standard Deviation
• Is the linear proportion of the standard deviation of the risky
asset portfolio
(slide 4 of 8)
• The Risk–Return Combination

• Investors who allocate their money between a
riskless security and the risky Portfolio M can
expect a return equal to the risk-free rate plus
compensation for the number of risk units
(σport) they accept
(slide 5 of 8)
• The Capital Market Line
• The risk–return relationship holds for every
combination of the risk-free asset with any
collection of risky assets
• This relationship holds for every combination of
the risk-free asset with any collection of risky
assets
• However, when the risky portfolio, M, is the market
portfolio containing all risky assets held anywhere
in the marketplace, this linear relationship is called
the Capital Market Line (CML)
(slide 6 of 8)
• Risk–Return Possibilities with Leverage
• One can attain a higher expected return than is available
at point M
• One can invest along the efficient frontier beyond point M,
such as point D
• With the risk-free asset, one can add leverage to the
portfolio by borrowing money at the risk-free rate and
investing in the risky portfolio at point M to achieve a point
like E
• Clearly, point E dominates point D
• Similarly, one can reduce the investment risk by lending
money at the risk-free asset to reach points like C
• Exhibit 6.17, 6.18
(slide 7 of 8)
(slide 8 of 8)
6.4.3 Risk, Diversification, and the Market
Portfolio (slide 1 of 8)
• Because portfolio M lies at the point of tangency,
it has the highest portfolio possibility line
• Everybody will want to invest in Portfolio M and
borrow or lend to be somewhere on the CML
• It must include all risky assets
• Because the market is in equilibrium, all assets in
this portfolio are in proportion to their market
values
• Because it contains all risky assets, it is a
completely diversified portfolio, which means that
all the unique risk of individual assets
(unsystematic risk) is diversified away
• Systematic risk
• Only systematic risk remains in the market portfolio
• Systematic risk can be measured by the standard
deviation of returns of the market portfolio and can
change over time
• Systematic risk is the variability in all risky assets
caused by macroeconomic variables:
• Variability in growth of money supply
• Interest rate volatility
• Variability in factors like industrial production, corporate
earnings, cash flow
• Diversification and the Elimination of
Unsystematic Risk
• The purpose of diversification is to reduce the
standard deviation of the total portfolio
• This assumes that imperfect correlations exist among
securities
• As you add securities, you expect the average
covariance for the portfolio to decline
• How many securities must you add to obtain a
completely diversified portfolio?
• Exhibit 6.19
• The CML and the Separation Theorem
• The CML leads all investors to invest in the M
portfolio
• Individual investors should differ in position on the
CML depending on risk preferences
• How an investor gets to a point on the CML is based
on financing decisions
• Risk averse investors will lend at the risk-free rate,
while investors preferring more risk might borrow
funds at the RFR and invest in the market portfolio
• The investment decision of choosing the point on
CML is separate from the financing decision of
reaching there through either lending or borrowing
• A Risk Measure for the CML
• Capital market theory now shows that the only
relevant portfolio is the market Portfolio M.
Together, this means that the only important
consideration for any individual risky asset is
its average covariance with all the risky
assets in Portfolio M or the asset’s covariance
with the market portfolio
• This covariance, then, is the relevant risk
measure for an individual risky asset
• Because all individual risky assets are a part of the
market portfolio, one can describe their rates of return in
relation to the returns to Portfolio M using a linear model:
• The variance of returns for a risky asset can similarly be

described as:
• Note that Var(biRMt) is the variance of return for an asset
related to the variance of the market return, or the
asset’s systematic variance or risk
• Also, Var(ε) is the residual variance of return for the
individual asset that is not related to the market portfolio
• This residual variance is what we have referred to as the
unsystematic or unique risk because it arises from the
unique features of the asset
• Therefore:
6.4.4 Investing with the CML: An Example
(slide 1 of 2)
Suppose you have a riskless security at 4% and a market
portfolio with a return of 9% and a standard deviation of 10%.
How should you go about investing your money so that your
investment will have a risk level of 15%?
• Portfolio Return
• Money invested in riskless security, wRF
• The investment strategy is to borrow 50% and invest 150% of

equity in the market portfolio
• Exhibit 6.20
6.4.4 Investing with the CML: An Example
(slide 2 of 2)

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CHAPTER 6

• Investors want to maximize from the total

• For most investors, risk means the

• Using these assumptions, a single asset

• Advantages of using variance or standard

• The variance, or standard deviation, is a

• Exhibits 6.4, 6.5, 6.6, 6.7, 6.8

• Portfolio Standard Deviation Formula

• Portfolio Standard Deviation

• Constant Correlation with Changing

• Results of portfolio allocation depend on

• With the assumption that stock returns can be

• If all the securities are similarly related to the

• The efficient frontier represents that set of portfolios with

• Markowitz defined the basic problem that

• subject to the following conditions:

• The general method for solving the formula is called a

• The approach to forming portfolios according to this

• What would be the optimal asset allocation

• Capital market theory builds directly on the

• A risky asset is one for which future

• The Risk–Return Combination

• The variance of returns for a risky asset can similarly be

• Money invested in riskless security, wRF

• The investment strategy is to borrow 50% and invest 150% of

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