The Mathematics of Diversification

Introduction
The reason for portfolio theory mathematics:

To show why diversification is a good idea

To show why diversification makes sense logically

Harry Markowitz is considered to be the father of modern portfolio theory.

Markowitzs work centres on the quest for efficient portfolios; that is those providing
the maximum return for their level of risk, or the minimum risk for a certain level of
return.

Linear Combinations
A portfolios performance is the result of the performance of its components. When
an investor distributes money across a handful of securities:

The return realised on a portfolio is a linear combination of the returns

on the individual investments;

The variance of the portfolio is not a linear combination of component

variances.

Return
The expected return of a portfolio is a weighted average of the expected returns of
the components:

E ( R p )

i 1

x i E ( R i )

(1 .1 )

w h e re x i p ro p o rtio n o f p o rtfo lio in v e s te d in s e c u rity i a n d

n

xi 1

i 1

Subscript indicates portfolio.

Cash is a portfolio component with an expected

return of 0.

Example
Assume the following statistics for Stock A and Stock B:
Stock A

Stock B

Expected return

.015

.020

Variance

.050

.060

Standard deviation

.224

.245

Weight

40%

60%

Correlation coefficient

.50

Table 1
What is the expected return of this two-security portfolio?

Solution: The expected return of this two-security portfolio is:

n

E ( Rp ) xi E ( Ri )
i 1

x A E ( RA ) xB E ( RB )
0.4(0.015) 0.6(0.020)
0.018 1.80%

Variance
Understanding portfolio variance is the essence of understanding the mathematics of
diversification. The variance of a linear combination of random variables is not a
weighted average of the component variances.

For an n-security portfolio, the portfolio variance is:

n

2p xi xj iji j

(1.2)

i 1 j 1

where xi proportion of total investment in Security i

ij correlation coefficient between Security i and Security j

Two Security Case

For a two-security portfolio containing Stock A and Stock B, the variance is:

2p xA2 A2 xB2 B2 2 xA xB AB A B (1.3)

Example (contd)
What is the variance of the two-security portfolio in Table 1?

Solution (contd): The variance of this two-security portfolio is:

2p x A2 A2 xB2 B2 2 xA xB AB A B
(.4) 2 (.05) (.6) 2 (.06) 2(.4)(.6)(.5)(.224)(.245)
.0080 .0216 .0132
.0428
Minimum Variance Portfolio
The minimum variance portfolio is the particular combination of securities that will
result in the least possible variance. Solving for the minimum variance portfolio
requires basic calculus

Consider equation (1.3) and x A xB 1 - this means that xB 1 xA , substitute this

expression into equation (1.3) and take the minimum value of the equation by taking
the first derivative with respect to either x A or x B .

Set the first derivative

(differentiating with respect to x A ) equal to zero and solve for x A

For a two-security minimum variance portfolio, the proportions invested in stocks A

and B are:

B2 A B AB
xA 2
A B2 2 A B AB

(1.4)

xB 1 x A
3

Example (contd)
Assume the same statistics for Stocks A and B as in the previous example. What are
the weights of the minimum variance portfolio in this case?

Solution: The weights of the minimum variance portfolios in this case are:

xA

B2 A B AB
.06 (.224)(.245)(.5)

59.07%
A2 B2 2 A B AB .05 .06 2(.224)(.245)(.5)

xB 1 xA 1 .5907 40.93%

Figure 1: Two-Security Portfolio Variance

Correlation and Risk Reduction

Portfolio risk decreases as the correlation coefficient in the returns of two securities
decreases. Risk reduction is greatest when the securities are perfectly negatively
correlated.

If the securities are perfectly positively correlated, there is no risk

reduction.

The n-Security Case

For an n-security portfolio, the variance is:
n

p2 xi x j ij i j

(1.2)

i 1 j 1

where xi proportion of total investment in Security i

ij correlation coefficient between Security i and Security j

From a portfolio construction perspective, the important feature of this equation lies
in the fact that it includes the correlation coefficient between all pairs of securities in
the portfolio. Because ij i j COV (ij ) , equation (1.2) can be expressed in either
covariance or correlation terms, and it is common to see it either way.

A covariance matrix is a tabular presentation of the pairwise combinations of all

portfolio components. The covariance between two variables is the product of their
expected deviations from their respective means.
covariances to compute a portfolio variance is

The required number of

n 2.

For a five-security

portfolio, (25 5)/2 = 10 covariances are necessary, plus the five variances. You
can convert a covariance matrix into a correlation matrix by dividing each covariance
by the product of the two standard deviations. Any portfolio construction technique
using the full covariance matrix is called a Markowitz model

Single-Index Model
While the Markowitz model makes use of the full covariance matrix with all its
pairwise statistics, the single-index model simplifies matters by comparing all
securities to a single benchmark.

Computational Advantages
A fifty-security portfolio requires the calculation of 1,225 covariances to forecast
portfolio variance. Thousands of stocks exist, and a pairwise comparison of them all
would be a very unwieldy task. Instead of comparing a security with each of the
others, why not compare each of the securities with a single benchmark?

By

observing how two independent securities behave relative to a third value, we learn
something about how the securities are likely to behave relative to each other.
5

This is one of the merits of beta. Beta is a measure of how a security moves relative
to overall market movements and that linear regression is a convenient way to
estimate this statistic. If beta is greater than one, the security tends to show price
swings greater than the market average. A beta less than one means that the
security moves less than average.

A securitys beta is a function of the market returns and the securitys covariance
with them. See equation (1.5):

COV ( Ri , Rm )
i
(1.5)
m2
where R return on the market index
m

m2 variance of the market returns

Ri return on Security i
Using a single index drastically reduces the number of preliminary calculations
needed to determine portfolio variance, for example a fifty-security portfolio requires
only 50 betas rather than 1,225 covariances.

Portfolio Statistics with the Single-Index Model

n

Beta of a Portfolio: p xi i (1.6)

i 1

n
n

xi i m2 xi2 ei2
i 1

i 1
2 2
2
p m ep
Variance of a Portfolio:
(1.7)
2
p

p2 m2
Variance of a Portfolio Component: i2 i2 m2 ei2 (1.8)

Covariance of Two Portfolio Components: AB A B m2 (1.9)

Where m2 = variance of the market index;

6

 ei2 = variance of the error term for Security I;

ep2 = variance of the error term for the portfolio; and
xi = proportion of total investment in Security i.

Equation (1.7) shows that if we know the variance of return on the market index and
the betas of the portfolio components, we can calculate the portfolio variance. The
last term in equation (1.7) reflects the unsystematic risk in the portfolio; this term
approaches zero as the number of portfolio components increases. Unsystematic
risk is the variance of the error term in the market model. For all practical purposes,
this term is small after the portfolio size reaches about twenty securities.

Equation (1.8) shows a method for determining the variance of a portfolio

component.

The last term of the equation indicates that some of the risk of a

security is company specific and unrelated to market movements. This is the type of
risk that diversification seeks to reduce. The first term on the right-hand side of
equation (1.8) measures systematic risk, whereas the second term measures
unsystematic risk.
Multi-Index Model
Although beta is a very useful statistic in the construction of portfolios and in security
analysis, it does not completely explain why security prices change.

In fact,

sometimes security price behaviour deviates drastically from what is supposed to

happen.

A multi-index model considers independent variables other than the performance of

an overall market index. Of particular interest include an industry effect, which
refers to factors associated with a particular line of business. We know that while
stocks tend to move as a group, sub-groups also tend to moves together, and these
sub-groups often share industry characteristics. Retail food chains, for instance, are
less susceptible to changes in the economy than firms such as steel companies.

Multi-index models generally have the form of equation (1.10):

Ri ai im Im i1I1 i 2 I2 ... in In

(1.10)

where ai constant
Im return on the market index
I return on an industry index
j

ij Security i's beta for industry index j

im Security i's market beta
Ri return on Security i

Although the idea of a multi-index model employing industry (or other) effects is
appealing, financial research has not uncovered much evidence that such models
are particularly useful in forecasting security price behaviour. There is ongoing work
in this area, but the traditional market model, with its single index, continues to be
the method of choice for the bulk of current portfolio management purposes.