Chapter 2 - Risk, Return, and Portfolio Theory
Chapter 2 - Risk, Return, and Portfolio Theory
Chapter 2 - Risk, Return, and Portfolio Theory
Learning Objectives
The difference among the most important types of returns How to estimate expected returns and risk for individual securities What happens to risk and return when securities are combined in a portfolio What is meant by an efficient frontier Why diversification is so important to investors
Dollar terms.
Percentage terms.
CHAPTER 2 Risk, Return and Portfolio Theory
What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Dollar return: $ Received - $ Invested $1,100 $1,000
= $100.
Measuring Returns
Measuring Returns
Introduction
Ex Ante Returns/ Expected return Return calculations may be done before-the-fact, in which case, assumptions must be made about the future Ex Post Returns/realized Return calculations done after-the-fact, in order to analyze what rate of return was earned.
Measurement of historical rates of return that have been earned on a security or a class of securities allows us to identify trends or tendencies that may be useful in predicting the future.
r
i 1
Where:
ri = the individual returns n = the total number of observations
Most commonly used value in statistics Sum of all returns divided by the total number of observations
Where:
ER = the expected return on an investment Ri = the estimated return in scenario i Probi = the probability of state i occurring
CHAPTER 2 Risk, Return and Portfolio Theory
Example: This is type of forecast data that are required to make an ex ante estimate of expected return.
Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.
(1) (3) (4)=(2)(3) Possible Weighted Returns on Possible Probability of Stock A in that Returns on Occurrence State the Stock 25.0% 30% 7.50% 50.0% 12% 6.00% 25.0% -25% -6.25% Expected Return on the Stock = 7.25% (2)
Example Solution: Sum the products of the probabilities and possible returns in each state of the economy.
(r1 Prob1 ) (r2 Prob2 ) (r3 Prob3 ) (30% 0.25) (12% 0.5) (-25% 0.25) 7.25%
Measuring Risk
Risk
Probability of incurring harm For investors, risk is the probability of earning an inadequate return.
If investors require a 10% rate of return on a given investment, then any return less than 10% is considered harmful.
Risk
Illustrated
The range of total possible returns on the stock A runs from -30% to more than +40%. If the required return on the stock is 10%, then those outcomes less than 10% represent risk to the investor.
Probability
-30% -20%
-10%
0%
Range
The difference between the maximum and minimum values is called the range
-30% -20%
-10%
0%
Range measures risk based on only two observations (minimum and maximum value) Standard deviation uses all observations.
Standard deviation can be calculated on forecast or possible returns as well as historical or ex post returns.
(The following two slides show the two different formula used for Standard Deviation)
Measuring Risk
Ex post Standard Deviation
Ex post
2 ( r r ) i i 1
n 1
Where : the standard deviation r the average return ri the return in year i n the number of observations
_
Measuring Risk
Example Using the Ex post Standard Deviation
Problem Estimate the standard deviation of the historical returns on investment A that were: 10%, 24%, -12%, 8% and 10%. Step 1 Calculate the Historical Average Return
r
i 1
10 24 - 12 8 10 40 8.0% 5 5
(r r )
i 1 i
n 1
Measuring Risk
Ex ante Standard Deviation
Ex ante
2 (Prob ) ( r ER ) i i i i 1
The following two slides illustrate an approach to solving for standard deviation using a spreadsheet model.
Possible Returns on Probability Security A 25.0% -22.0% 50.0% 14.0% 25.0% 35.0% Expected Return =
Squared Deviations
Second, square those deviations from the mean. The sum of the weighted and square deviations is the variance in percent squared terms.
CHAPTER 2 Risk, Return and Portfolio Theory The standard deviation is the square
Ex ante
(Prob ) (r ER )
i 1 i
2 2 2 P 1 (r 1 ER 1) P 2 ( r2 ER2 ) P 1 ( r3 ER3 )
.25(22 10.3) 2 .5(14 10.3) 2 .25(35 10.3) 2 .25(32.3) 2 .5(3.8) 2 .25(24.8) 2 .25(.10401) .5(.00141) .25(.06126) .0420 .205 20.5%
Portfolios
A portfolio is a collection of different securities such as stocks and bonds, that are combined and considered a single asset The risk-return characteristics of the portfolio is obviously different than the characteristics of the assets that make up that portfolio, especially with regard to risk. Combining different securities into portfolios is done to achieve diversification.
ERp ( wi ERi )
i 1
The portfolio weight of a particular security is the percentage of the portfolios total value that is invested in that security.
In a two asset portfolio, simply by changing the weight of the constituent assets, different portfolio returns can be achieved. Because the expected return on the portfolio is a simple weighted average of the individual returns of the assets, you can achieve portfolio returns bounded by the highest and the lowest individual asset returns.
10.50 10.00
ERB= 10%
Expected Return %
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
ERB= 10%
Expected Return %
ERA=8%
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
10.50 10.00
ERB= 10%
Expected Return %
The potential returns of the portfolio are bounded by the highest and lowest returns of the individual assets that make up the portfolio.
ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
10.50 10.00
ERB= 10%
Expected Return %
9.50 9.00 8.50 8.00 The expected return on the portfolio if 100% is invested in Asset A is 8%.
ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
10.50 10.00
ERB= 10%
Expected Return %
ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
10.50 10.00
The expected return on the portfolio if 50% is invested in Asset A and 50% in B is 9%.
ERB= 10%
Expected Return %
9.50
(0.5)(8%) (0.5)(10%) 4% 5% 9%
ERA=8%
7.50 7.00
0.2
0.4
0.6
0.8
1.0
1.2
Portfolio Weight
Relative Expected Weighted Weight Return Return 0.400 8.0% 0.03 0.350 15.0% 0.05 0.250 25.0% 0.06 Expected Portfolio Return = 14.70%
Risk in Portfolios
Risk, Return and Portfolio Theory
Prior to the establishment of Modern Portfolio Theory (MPT), most people only focused upon investment returnsthey ignored risk. With MPT, investors had a tool that they could use to dramatically reduce the risk of the portfolio without a significant reduction in the expected return of the portfolio.
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )(wB )(COVA, B )
Factor to take into account comovement of returns. This factor can be negative.
p ( wA ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( wA )(wB )( A, B )( A )( B )
Factor that takes into account the degree of comovement of returns. It can have a negative value if correlation is negative.
The standard deviation of a two-asset portfolio may be measured using the Markowitz model:
2 2 2 2 p A wA B wB 2 wA wB A, B A B
We need 3 (three) correlation coefficients between A and B; A and C; and B and C. a,b
B A
a,c b,c
C
The data requirements for a four-asset portfolio grows dramatically if we are using Markowitz Portfolio selection formulae.
We need 6 correlation coefficients between A and B; A and C; A and D; B and C; C and D; and B and D. a,b
B A
a,c
a,d
D
b,c
b,d
C
c,d
Covariance
A statistical measure of the correlation of the fluctuations of the annual rates of return of different investments.
Correlation
The degree to which the returns of two stocks comove is measured by the correlation coefficient (). The correlation coefficient () between the returns on two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation -1 is perfect negative correlation
AB
COV AB
A B
COVAB AB A B
Importance of Correlation
Correlation is important because it affects the degree to which diversification can be achieved using various assets. Theoretically, if two assets returns are perfectly positively correlated, it is possible to build a riskless portfolio with a return that is greater than the risk-free rate.
15%
Returns on Stock B
Returns on Portfolio
Time 0
15%
15%
Returns on Stock B
Returns on Portfolio
Time 0
Weight of Asset A = Weight of Asset B = Return on Return on Year Asset A Asset B n ERp 5.0% ( wi ERi ) (.515% ) (.5 5% ) xx07 15.0% i 1 xx08 7.10.0% 5% 2.5% 10% 10.0% xx09 15.0% 5.0%
Diversification Potential
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. 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. This is demonstrated through the following series of spreadsheets, and then summarized in graph format.
Asset A B
Perfect Positive Correlation no diversification Both portfolio returns and risk are bounded by the range set by the constituent assets when =+1
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 17.5% 6.80% 20.0% 7.70% 22.5% 8.60% 25.0% 9.50% 27.5% 10.40% 30.0% 11.30% 32.5% 12.20% 35.0% 13.10% 37.5% 14.00% 40.0%
Asset A B
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 15.9% 6.80% 17.4% 7.70% 19.5% 8.60% 21.9% 9.50% 24.6% 10.40% 27.5% 11.30% 30.5% 12.20% 33.6% 13.10% 36.8% 14.00% 40.0%
When =+0.5 these portfolio combinations have lower risk expected portfolio return is unaffected.
Asset A B
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 14.1% 6.80% 14.4% 7.70% 15.9% 8.60% 18.4% 9.50% 21.4% 10.40% 24.7% 11.30% 28.4% 12.20% 32.1% 13.10% 36.0% 14.00% 40.0%
Asset A B
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 12.0% 6.80% 10.6% 7.70% 11.3% 8.60% 13.9% 9.50% 17.5% 10.40% 21.6% 11.30% 26.0% 12.20% 30.6% 13.10% 35.3% 14.00% 40.0%
Portfolio risk for more combinations is lower than the risk of either asset
Asset A B
Portfolio Components Weight of A Weight of B 100.00% 0.00% 90.00% 10.00% 80.00% 20.00% 70.00% 30.00% 60.00% 40.00% 50.00% 50.00% 40.00% 60.00% 30.00% 70.00% 20.00% 80.00% 10.00% 90.00% 0.00% 100.00%
Portfolio Characteristics Expected Standard Return Deviation 5.00% 15.0% 5.90% 9.5% 6.80% 4.0% 7.70% 1.5% 8.60% 7.0% 9.50% 12.5% 10.40% 18.0% 11.30% 23.5% 12.20% 29.0% 13.10% 34.5% 14.00% 40.0%
Expected Return
AB = -0.5
12%
AB = -1
8%
AB = 0 AB= +1
4%
Standard Deviation
10
Becomes:
p w A (1 w) B
Correlation Coefficient Matrix: Stocks 1 T-bills -0.216 Bonds 0.048 Portfolio Combinations: Weights Combination 1 2 3 4 5 6 7 8 9 10 Stocks 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% T-bills 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% Bonds 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%
-0.216 1 0.380
0.048 0.380 1
Historical averages for returns and risk for three asset Each achievable classes
Portfolio Expected Standard Variance Deviation Return 12.7 0.0283 16.8% 12.1 0.0226 15.0% 11.4 0.0177 13.3% 10.8 0.0134 11.6% 10.1 0.0097 9.9% 9.4 0.0067 8.2% 8.8 0.0044 6.6% 8.1 0.0028 5.3% 7.5 0.0018 4.2% 6.8 0.0014 3.8%
portfolio combination is Historical plotted correlation on expected return, coefficients the asset risk between () space, classes found on the following slide.
Portfolio characteristics for each combination of securities
Achievable Portfolios
Results Using only Three Asset Classes
14.0
Portfolio Expected Return (%)
Efficient Set
The efficient set is that set of achievable portfolio combinations that offer the highest rate of return for a given level of risk. The solid blue line indicates the efficient set.
0.0
5.0
10.0
15.0
20.0
13 12
11 10 9 8 7 6
10
20
30
40
50
60
This line represents the set of portfolio combinations that are achievable by varying relative weights and using two noncorrelated securities.
Expected Return %
Dominance
It is assumed that investors are rational, wealthmaximizing and risk averse. If so, then some investment choices dominate others.
Investment Choices
The Concept of Dominance Illustrated
Return %
10% A B
A dominates B because it offers the same return but for less risk. A dominates C because it offers a higher return but for the same risk.
5%
5%
20%
Risk
To the risk-averse wealth maximizer, the choices are clear, A dominates B, A dominates C.
CHAPTER 2 Risk, Return and Portfolio Theory
Efficient Frontier
The Two-Asset Portfolio Combinations
2 - 10 FIGURE
A is not attainable
B C
E is the minimum
variance portfolio (lowest risk combination)
C, D are E D
attainable but are dominated by superior portfolios that line on the line above E
Efficient Frontier
The Two-Asset Portfolio Combinations
2 - 10 FIGURE
Expected Return %
B C
Rational, risk averse investors will only want to hold portfolios such as B.
E D
Diversification
Risk, Return and Portfolio Theory
Diversification
We have demonstrated that risk of a portfolio can be reduced by spreading the value of the portfolio across, two, three, four or more assets. The key to efficient diversification is to choose assets whose returns are less than perfectly positively correlated. Even with random or nave diversification, risk of the portfolio can be reduced.
This is illustrated in Figure 8 -11 and Table 8 -3 found on the following slides.
As the portfolio is divided across more and more securities, the risk of the portfolio falls rapidly at first, until a point is reached where, further division of the portfolio does not result in a reduction in risk. Going beyond this point is known as superfluous diversification.
Diversification
Domestic Diversification
2 - 11 FIGURE
Average Portfolio Risk January 1985 to December 1997
14 12
10
8 6 4 2 0
50
100
150
200
250
300
Diversification
Domestic Diversification
Table 8-3 Monthly Canadian Stock Portfolio Returns, January 1985 to December 1997 Number of Stocks in Portfolio 1 2 3 4 5 6 7 8 9 10 14 40 50 100 200 222 Average Monthly Portfolio Return (%) 1.51 1.51 1.52 1.53 1.52 1.52 1.51 1.52 1.52 1.51 1.51 1.52 1.52 1.51 1.51 1.51 Standard Deviation of Average Monthly Portfolio Return (%) 13.47 10.99 9.91 9.30 8.67 8.30 7.95 7.71 7.52 7.33 6.80 5.62 5.41 4.86 4.51 4.48 Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock 1.00 0.82 0.74 0.69 0.64 0.62 0.59 0.57 0.56 0.54 0.50 0.42 0.40 0.36 0.34 0.33 Percentage of Total Achievable Risk Reduction 0.00 27.50 39.56 46.37 53.31 57.50 61.35 64.02 66.17 68.30 74.19 87.24 89.64 95.70 99.58 100.00
So urce: Cleary, S. and Co pp D. "Diversificatio n with Canadian Sto cks: Ho w M uch is Eno ugh?" Canadian Investment Review (Fall 1 999), Table 1 .
[8-19]
Nondiversifiable (systematic) risk
Number of Stocks in Portfolio
This graph illustrates that total risk of a stock is made up of market risk (that cannot be diversified away because it is a function of the economic system) and unique, companyspecific risk that is eliminated from the portfolio through diversification.
International Diversification
Clearly, diversification adds value to a portfolio by reducing risk while not reducing the return on the portfolio significantly. Most of the benefits of diversification can be achieved by investing in 40 50 different positions (investments) However, if the investment universe is expanded to include investments beyond the domestic capital markets, additional risk reduction is possible.
(See Figure 8 -12 found on the following slide.)
Diversification
International Diversification
2 - 12 FIGURE
100 80 60 40
Percent risk
U.S. stocks
20
11.7
0
International stocks
10 20 30 40 50 60
Number of Stocks