The Portfolio Management Process

1. Policy statement - Focus: Investor’s short-term and long-

term needs, familiarity with capital market history, and
expectations
2. Examine current and project financial, economic, political,
and social conditions - Focus: Short-term and intermediate-
term expected conditions to use in constructing a specific
portfolio
3. Implement the plan by constructing the portfolio - Focus:
Meet the investor’s needs at the minimum risk levels

4. Feedback loop: Monitor and update investor needs,

environmental conditions, portfolio performance
 The Portfolio Management Process
1. Policy statement

– specifies investment goals and acceptable risk levels

– should be reviewed periodically

– guides all investment decisions

2. Study current financial and economic conditions

and forecast future trends
– determine strategies to meet goals

– requires monitoring and updating

3. Construct the portfolio

– allocate available funds to minimize investor’s risks and meet investment goals
4. Monitor and update

– evaluate portfolio performance

– Monitor investor’s needs and market conditions

– revise policy statement as needed

– modify investment strategy accordingly

The Need For A Policy Statement

• Helps investors understand their own

needs, objectives, and investment
constraints
• Sets standards for evaluating portfolio
performance
• Reduces the possibility of inappropriate
behavior on the part of the portfolio
manager
 Constructing A Policy Statement

Questions to be answered:
• What are the real risks of an adverse financial
outcome, especially in the short run?
• What probable emotional reactions will I have to
an adverse financial outcome?
• How knowledgeable am I about investments and
the financial markets?
 Constructing A Policy Statement
• What other capital or income sources do I
have? How important is this particular
portfolio to my overall financial position?
• What, if any, legal restrictions may affect
my investment needs?
• What, if any, unanticipated consequences of
interim fluctuations in portfolio value might
affect my investment policy?
 An Introduction to Portfolio
Management
Questions to be answered:
• What do we mean by risk aversion and what
evidence indicates that investors are generally risk
averse?
• What are the basic assumptions behind the
Markowitz portfolio theory?
• What is meant by risk and what are some of the
alternative measures of risk used in investments?
 An Introduction to Portfolio
Management
• How do you compute the expected rate of return
for an individual risky asset or a portfolio of
assets?
• How do you compute the standard deviation of
rates of return for an individual risky asset?
• What is meant by the covariance between rates of
return and how do you compute covariance?
 An Introduction to Portfolio
Management
• What is the relationship between covariance and
correlation?
• What is the formula for the standard deviation for
a portfolio of risky assets and how does it differ
from the standard deviation of an individual risky
asset?
• Given the formula for the standard deviation of a
portfolio, why and how do you diversify a
portfolio?
 An Introduction to Portfolio
Management
• What happens to the standard deviation of a
portfolio when you change the correlation
between the assets in the portfolio?
• What is the risk-return efficient frontier?
• Is it reasonable for alternative investors to select
different portfolios from the portfolios on the
efficient frontier?
• What determines which portfolio on the efficient
frontier is selected by an individual investor?
 Background Assumptions

• As an investor you want to maximize the

returns for a given level of risk.
• Your portfolio includes all of your assets and
liabilities
• The relationship between the returns for assets
in the portfolio is important.
• A good portfolio is not simply a collection of
individually good investments.
 Risk Aversion
Given a choice between two assets
with equal rates of return, most
investors will select the asset with the
lower level of risk.
 Markowitz Portfolio Theory
• Quantifies risk
• Derives the expected rate of return for a
portfolio of assets and an expected risk measure
• Shows that the variance of the rate of return is a
meaningful measure of portfolio risk
• Derives the formula for computing the variance
of a portfolio, showing how to effectively
diversify a portfolio
 Assumptions
1. Investors consider each investment alternative as being presented by a probability distribution of
expected returns over some holding period.

2. Investors maximize one-period expected utility, and their utility curves are different from one another

3. Investors estimate the risk of the portfolio on the basis of the variability of expected returns.

4. Investors base decisions solely on expected return and risk, so their utility curves are a function of
expected return and the expected 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 returns, investors prefer less risk to more risk.
Markowitz Portfolio Theory
Using these five assumptions, a single
portfolio of assets is considered to be
efficient if no other portfolio of assets offers
higher expected return with the same (or
lower) risk, or lower risk with the same (or
higher) expected return.
 Alternative Measures of Risk
• Variance or standard deviation of expected
return
• Range of returns
• Returns below expectations
– Semivariance – 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
 Expected Rates of Return
• For an individual asset - sum of the
potential returns multiplied with the
corresponding probability of the returns
• For a portfolio of investments - weighted
average of the expected rates of return for
the individual investments in the portfolio
Computation of Expected Return for
an Individual Risky Investment

Possible Rate of Expected Return

Probability Return (Percent) (Percent)
0.35 0.08 0.0280
0.30 0.10 0.0300
0.20 0.12 0.0240
0.15 0.14 0.0210
E(R) = 0.1030
Computation of the Expected Return
for a Portfolio of Risky Assets
Weight (W i ) Expected Security Expected Portfolio
(Percent of Portfolio) Return (R i ) Return (W i X R
0.20 0.10 0.0200
0.30 0.11 0.0330
0.30 0.12 0.0360
0.20 0.13 0.0260
E(Rport) 0.1150

n
E(R port ) = ∑Wi R i
i =1

where :
Wi = the percent of the portfolio in asset i
E(R i ) = the expected rate of return for asset i
 Variance (Standard Deviation) of
Returns for an Individual Investment
Variance is a measure of the variation of possible rates
of return Ri, from the expected rate of return [E(Ri)]
Standard deviation is the square root of the variance
n
Variance (σ ) = ∑ [R i - E(R i )] Pi
2 2

i =1

where Pi is the probability of the possible rate of return,

Ri
 Variance (Standard Deviation) of
Returns for an Individual Investment

Standard Deviation
n
(σ ) = ∑ [R
i =1
i
2
- E(R i )] Pi
 Variance (Standard Deviation) of
Returns for an Individual Investment
Possible Rate Expected
2 2
of Return (R i) Return E(R i) R i - E(R i ) [R i - E(R i )] Pi [R i - E(R i )] Pi

0.08 0.103 -0.023 0.0005 0.35 0.000185

0.10 0.103 -0.003 0.0000 0.30 0.000003
0.12 0.103 0.017 0.0003 0.20 0.000058
0.14 0.103 0.037 0.0014 0.15 0.000205
0.000451

Variance (σ 2) = .000451
Standard Deviation (σ ) = .021237
 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:
Covij = E{[Ri - E(Ri)] [Rj - E(Rj)]}
 Covariance and Correlation
The correlation coefficient is obtained by standardizing (dividing) the
covariance by the product of the individual standard deviations

Correlation coefficient varies from -1 to +1

Cov ij
rij =
σ iσ j
• A value of +1 would indicate perfect positive correlation. This
means that returns for the two assets move together in a
completely linear manner
• A value of –1 would indicate perfect negative correlation. This
means that the returns for two assets have the same percentage
movement, but in opposite directions
 Correlation Coefficient
• A value of ‘0’ means that returns for the two assets are
independent are not correlated at all.

• A value of –1 would indicate perfect correlation. This

means that the returns for two assets have the same
percentage movement, but in opposite directions

• A value less than 1 or greater than -1 curvilinear

relationship between the returns of two assets
 Portfolio Standard Deviation
n n n
σ port = ∑ i σ i + ∑ ∑ w i w jCovij
w 2 2

i =1 i =1 i =1

where:
σ port = the standarddeviationof the portfolio
Wi = the weightsof the individualassetsin the portfolio,where
weightsare determinedby theproportionof valuein the portfolio
σ i2 = the varianceof rates of return for asset i
Covij = the covariancebetween the rates of return for assetsi and j,
whereCovij = rijσ iσ j
 Portfolio Standard Deviation
Calculation
• Any asset of a portfolio may be described by
two characteristics:
– The expected rate of return
– The expected standard deviations of returns
• The correlation, measured by covariance,
affects the portfolio standard deviation
• Low correlation reduces portfolio risk while
not affecting the expected return
 Combining Stocks with Different
Returns and Risk
Asset E(R i ) Wi σ 2
i σi
1 .10 .50 .0049 .07
2 .20 .50 .0100 .10
Case Correlation Coefficient Covariance
a +1.00 .0070
b +0.50 .0035
c 0.00 .0000
d -0.50 -.0035
e -1.00 -.0070
 Combining Stocks with
Different Returns and Risk
• Assets may differ in expected rates of return
and individual standard deviations
• Negative correlation reduces portfolio risk
• Combining two assets with -1.0 correlation
reduces the portfolio standard deviation to
zero only when individual standard
deviations are equal
 Constant Correlation
with Changing Weights
Asset E(R i )
1 .10 rij = 0.00

2
Case 2 W1 .20 W E(Ri )

f 0.00 1.00 0.20

g 0.20 0.80 0.18
h 0.40 0.60 0.16
i 0.50 0.50 0.15
j 0.60 0.40 0.14
k 0.80 0.20 0.12
l 1.00 0.00 0.10
 Constant Correlation
with Changing Weights

Case W1 W2 E(Ri ) E( port)

f 0.00 1.00 0.20 0.1000

g 0.20 0.80 0.18 0.0812
h 0.40 0.60 0.16 0.0662
i 0.50 0.50 0.15 0.0610
j 0.60 0.40 0.14 0.0580
k 0.80 0.20 0.12 0.0595
l 1.00 0.00 0.10 0.0700
Portfolio Risk-Return Plots for
Different Weights
E(R)
0.20 2
With two perfectly
correlated assets, it
0.15
is only possible to Rij = +1.00
create a two asset
0.10 portfolio with risk- 1
return along a line
0.05 between either
single asset
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 g 2
With uncorrelated h
assets it is possible i
0.15 j
to create a two Rij = +1.00
asset portfolio with
k
0.10 lower risk than 1
either single asset Rij = 0.00
0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 g 2
With correlated h
assets it is possible i
0.15 j
to create a two Rij = +1.00
asset portfolio
k Rij = +0.50
0.10 between the first 1
two curves Rij = 0.00
0.05

-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) With Rij = -0.50 f
0.20 negatively g 2
correlated h
assets it is i
0.15 j
possible to Rij = +1.00
create a two
0.10 asset portfolio
k Rij = +0.50
1
with much Rij = 0.00
0.05 lower risk than
either single
asset
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
Portfolio Risk-Return Plots for
Different Weights
E(R) Rij = -0.50 f
0.20 Rij = -1.00 g 2
h
0.15 i
j Rij = +1.00
0.10
k Rij = +0.50
1
Rij = 0.00
0.05 With perfectly negatively correlated
assets it is possible to create a two asset
portfolio with almost no risk
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11 0.12
Standard Deviation of Return
 The Efficient Frontier

• 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
• Frontier will be portfolios of investments rather
than individual securities
– Exceptions being the asset with the highest return
and the asset with the lowest risk
 Efficient Frontier
for Alternative Portfolios
Efficient
E(R) B
Frontier

A C

Standard Deviation of Return

Efficient Frontier and Investor Utility

• Utility: relationship between portfolio return

and portfolio risk
• Utility = Expected return ~ Risk penalty

• Risk penalty = Risk squared/Risk tolerance

• Risk tolerance is a number from 0 to 100

Efficient Frontier and Investor Utility
• 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
• These two interactions will determine the particular portfolio
selected by an individual investor
• The optimal portfolio has the highest utility for a given investor

• It lies at the point of tangency between the efficient frontier and

the utility curve with the highest possible utility
Selecting an Optimal Risky
Portfolio
E(R port )
U3’
U2’
U1’

U3 X

U2
U1

E(σ port )
 Estimation Issues
• 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