Chapter Notes are an

outline of class lectures.

Take notes in-class to Chapter 5 Notes
increase the effectiveness
of your learning.
Modern Portfolio Concepts

Beta - A measure of the volatility of a security (or portfolio) in comparison to the market as a
whole.

Capital Asset Pricing Model (CAPM) - A method of valuing assets & calculating the cost of
capital.

Correlation - A statistic that measures the degree to which two securities move in relation to
each other.

Modern Portfolio Theory (MPT) - Uses several basic statistical measures to develop a portfolio
plan.

Traditional Portfolio Management - Emphasizes “balancing” the portfolio by assembling a wide

variety of stocks and/or bonds.

What is a Portfolio?

 Portfolio - A collection of investments assembled to meet one or more investment goals.

 Growth-Oriented Portfolio - Primary objective is long-term price appreciation.

 Income-Oriented Portfolio - Primary objective is to produce regular dividend & interest

income.

Ultimate Goal - An Efficient Portfolio

 Efficient Portfolio

- A portfolio that provides the highest return for a given level of risk.

- Requires search for investment alternatives to get the best combinations of risk &
return.

1 Fin 2100 - Professor Joe Howell

Portfolio Return & Risk Measures

 The return on a portfolio is simply the weighted average of the individual assets’ returns
in the portfolio.

 The standard deviation of a portfolio’s returns is more complicated & is a function of the
portfolio’s individual assets’ weights, standard deviations & correlations with all other
assets.

Return on Portfolio

Correlation - Why Diversification Works

 Correlation - A statistical measure of the relationship between two series of numbers

representing data.

 Positively Correlated - Items tend to move in the same direction.

 Negatively Correlated - Items tend to move in opposite directions.

 Correlation Coefficient - A measure of the degree of correlation between two series of

numbers representing data.

Correlation Coefficients

 Perfectly Positively Correlated - Describes two positively correlated series having a

correlation coefficient of +1.

 Perfectly Negatively Correlated - Describes two negatively correlated series having a

correlation coefficient of -1.

2 Fin 2100 - Professor Joe Howell

  Uncorrelated - Describes two series that lack any relationship & have a correlation
coefficient of nearly zero.

Correlation Between Series M, N & P

Correlation - Why Diversification Works

 Assets that are less than perfectly positively correlated tend to offset each other’s
movements, thus reducing the overall risk in a portfolio.

 The lower the correlation the more the overall risk in a portfolio is reduced.

- Assets with +1 correlation eliminate no risk.

- Assets with less than +1 correlation eliminate some risk.

- Assets with less than 0 correlation eliminate more risk.

- Assets with -1 correlation eliminate all risk.

Correlation Between Series M, N & P

3 Fin 2100 - Professor Joe Howell

 Risk & Return for Combinations of Two Assets
With Various Correlation Coefficients

Why Use International Diversification?

 Offers more diverse investment alternatives than US-only based investing.

 Foreign economic cycles may move independently from US economic cycle.

 Foreign markets may not be as efficient as US markets, allowing true gains from superior
research.

International Diversification

Methods of International Diversification

 Foreign company stocks listed on US stock exchanges.

- Yankee Bonds

- American Depository Shares (ADS)

- Mutual Funds investing in foreign stocks.

- US Multinational Companies - typically not considered a true international investment

for diversification purposes.

4 Fin 2100 - Professor Joe Howell

 Capital Asset Pricing Model (CAPM) - Two Components of Risk

Beta - A Popular Measure of Risk

 A measure of undiversifiable risk.

 Indicates how the price of a security responds to market forces.

 Compares historical return of an investment to the market return - S&P 500 Index.

 The beta for the market is 1.0.

 Stocks may have positive or negative betas. Nearly all are positive.

 Stocks with betas greater than 1.0 are more risky than the overall market.

 Stocks with betas less than 1.0 are less risky than the overall market.

 The higher the beta, the greater its expected return.

Components of Risk

5 Fin 2100 - Professor Joe Howell

 Beta as a Measure of Risk

Interpreting Beta

 Higher stock betas should result in higher expected returns due to greater risk.

 If the market is expected to increase 10%, a stock with a beta of 1.50 is expected to
increase 15%.

 If the market went down 8%, then a stock with a beta of 0.50 should only decrease by
about 4%.

 Beta values for specific stocks can be obtained from Value Line reports or websites such
as finance.yahoo.com.

6 Fin 2100 - Professor Joe Howell

Capital Asset Pricing Model (CAPM)

 Model that links the notions of risk & return.

 Helps investors define the required return on an investment.

 As beta increases, the required return for a given investment increases.

 Uses beta, the risk-free rate & the expected return on the overall market to define the
required return on an investment.

 CAPM can also be shown as a graph.

 Security Market Line (SML) is the “picture” of the CAPM.

 Find the SML by calculating the required return for a number of betas, then plotting them
on a graph.

The Security Market Line (SML)

7 Fin 2100 - Professor Joe Howell

 Two Approaches to Constructing Portfolios

Traditional Approach

 Less quantitative.

 Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds.

 Uses a broad range of industries to diversify the portfolio - called Interindustry

Diversification.

 Tends to focus on well-known companies.

- Perceived as less risky.

- Stocks are more liquid & available.

- Familiarity provides higher “comfort” levels for investors.

Modern Portfolio Theory (MPT)

 Emphasizes statistical measures to develop a portfolio plan.

 Focus is on:

- Expected returns
- Standard deviation of returns

- Correlation between returns

 Combines securities that have negative (or low-positive) correlations between each
other’s rates of return.

8 Fin 2100 - Professor Joe Howell

Key Aspects of MPT - Efficient Frontier

 Efficient Frontier

- The leftmost boundary of the feasible set of portfolios that include all efficient
portfolios, those providing the best attainable tradeoff between risk & return.

- Portfolios that fall to the right of the efficient frontier are not desirable because their
risk return tradeoffs are inferior.

- Portfolios that fall to the left of the efficient frontier are not available for investments.

The Feasible or Attainable Set

& The Efficient Frontier

Key Aspects of MPT - Portfolio Betas

 Portfolio Beta

- The beta of a portfolio; calculated as the weighted average of the betas of the
individual assets the portfolio includes.

- To earn more return, one must bear more risk.

- Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship.

9 Fin 2100 - Professor Joe Howell

 Portfolio Risk & Diversification

Interpreting Portfolio Betas

 Portfolio betas are interpreted exactly the same way as individual stock betas.

- Portfolio beta of 1.00 will experience a 10% increase when the market increase is 10%.

- Portfolio beta of 0.75 will experience a 7.5% increase when the market increase is
10%.

- Portfolio beta of 1.25 will experience a 12.5% increase when the market increase is
10%.

 Low-beta portfolios are less responsive & less risky than high-beta portfolios.

 A portfolio containing low-beta assets will have a low beta, & vice versa.

Portfolio Betas & Associated Changes in Returns

10 Fin 2100 - Professor Joe Howell

Reconciling The Traditional Approach & MPT

 Recommended portfolio management policy uses aspects of both approaches:

- Determine how much risk you are willing to bear.

- Seek diversification between different types of securities & industry lines.

- Pay attention to correlation of return between securities.

- Use beta to keep portfolio at acceptable level of risk.

- Evaluate alternative portfolios to select highest return for the given level of
acceptable risk.

The Portfolio Risk-Return Tradeoff

Did You Know?

The Dutch East India Company (founded in 1602) was the first to
issue shares of stock to the general public. The company funded
international trade, exploratory voyages (such as Henry Hudson),
shipbuilding, etc. They remained in business for nearly 200 years
paying an 18% annual dividend for almost the entire time.

11 Fin 2100 - Professor Joe Howell