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Portfolio Theory and the

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We have learned from last chapter risk and

return: (that for an individual investor)
Combining stocks into portfolios can reduce
standard deviation, below the level obtained
from a simple weighted average calculation.
Rational investors maximize the expected
return given risks. Or minimize risks given
expected return.
2

Markowitz Portfolio Theory

Efficient portfolio provides the
highest return for a given level of risk,
or least risk for a given level of return.
The market portfolio is the one that
has the highest Sharpe ratio with the
return and risk.
The Sharpe ratio is a measure of risk
premium per unit of risk in an
investment asset or a rtrading
strategy
p rf

Sharpe Ratio

Effect of diversification on
variance
the following:
Assuming

N independent assets, i.i.d. with

covariance=0,
= std of the return
r= expected return
Equally weighted portfolio,
Then, we have: the more the assets are in,
the lower the standard deviation .
portfolio =
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Markowitz Portfolio Theory

Price changes vs. Normal distribution

Proportion of Days

Daily % Change
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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

%
probability

Investment A

% return
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Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

%
probability

Investment B

% return
7

Markowitz Portfolio Theory

Standard Deviation VS. Expected Return

%
probability

Investment C

% return
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Markowitz Portfolio Theory

Expected Returns and Standard Deviations vary given different
weighted combinations of the stocks
10
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Boeing

Expected Return (%)

8
7
6

40% in Boeing

5
4
3

Campbell Soup

2
1
0
0.00

5.00

10.00

15.00

20.00

25.00

Standard Deviation
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A two asset portfolio constructed with % of

both assets, allow short selling of one assets
0.03
0.03

Capital Market Line

0.02
0.02
0.02

Market

0.02
0.02
0.05

Market
volatility
0.07

0.09

0.11

0.13

0.15

0.17

0.19

0.21

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Efficient Frontier

TABLE 8.1 Examples of efficient portfolios chosen from 10 stocks.

Note: Standard deviations and the correlations between stock returns were estimated from monthly returns January 2004-December 2008. Efficient
portfolios are calculated assuming that short sales are prohibited.

Amazon.com

Stock

Expected Return
22.8%

Standard Deviation
50.9%

Ford

19.0

Dell

A

19.1

10.9

47.2

19.9

11.0

13.4

30.9

15.6

10.3

Starbucks

9.0

30.3

13.7

10.7

Boeing

9.5

23.7

9.2

10.5

Disney

7.7

19.6

8.8

11.2

Newmont

7.0

36.1

9.9

10.2

ExxonMobil

4.7

19.1

9.7

18.4

3.8

12.6

7.4

33.9

Soup

3.1

15.8

8.4

33.9

10.5

4.2

100

22.8

14.1

3.6

Portfolio standard deviation

22.0
16.0
8.8
Try
graph the efficient frontier and find50.9the market
portfolio
with
the
highest Sharpe Ratio!
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Efficient Frontier
4 Efficient Portfolios all from the same 10 stocks

12

Efficient Frontier
Lending or Borrowing at the risk free rate ( rf) allows us to exist outside the
efficient frontier.
Expected Return (%)

Le

in
nd

Bo

wi
o
r
r

ng

rf
Minimum variance portfolio

Standard Deviation

The red line is the Capital Market Line, where you can hold a
combination of the risk free assets and the market portfolio

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Efficient Frontier
Another Example
Correlation
Coefficient = .4
Stocks
% of Portfolio
Avg Return
ABC Corp 28
60%
15%
Big Corp 42
40%
21%

Standard Deviation = weighted avg = 33.6

Standard Deviation = Portfolio = 28.1
Return = weighted avg = Portfolio = 17.4%

Lets Add stock New Corp to the portfolio

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Efficient Frontier
Return

Risk
(measured
as )
15

Efficient Frontier
Return

B
AB
A
Risk

16

Efficient Frontier
Return

B
AB

A
Risk

17

Efficient Frontier
Return

B
ABN

AB

A
Risk

18

Efficient Frontier
Goal is to move up
and left.

Return

WHY?

B
ABN

AB

A
Risk

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Efficient Frontier
The ratio of the risk premium to the standard
deviation is the Sharpe ratio.
In a competitive market, the expected risk
premium varies in proportion to portfolio standard
deviation. P denotes portfolio. Along the Capital
Market Line one holds the risky assets and a risk
free loan.

Sharpe Ratio

rp rf

rp rf

rm rf

m
20

ri rf i (rm rf )

im
i 2
m

CAPM
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Stock
Return
r
i

Market Return =

rm

.
Market Portfolio

Risk Free Return =f

(Treasury bills)
1.0

2,0

BETA
risk

22

Efficient Frontier
Return
Low Risk

High Risk

High Return

High Return

Low Risk

High Risk

Low Return

Low Return

Risk

23

Capital Market Line

Return

Tangent portfolio

Market Return =

rm

Market Portfolio

(Treasury bills)

Risk

24

Return

Market Return =

rm

.
Market Portfolio

(Treasury bills)
1.0

BETA

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Example:
Let,
rf 4%

market risk premium 8%

Market Portfolio
(market return = 12%)

rm 12%
Market Risk Premium = 8%

rf 4%

According to CAPM, the expected return on the asset is

r rf (rm rf ) 4% 1.2 (8%) 13.6%

Return
CAPM
SML

Security Market Line

rf
1.0

BETA

SML Equation = rf + ( rm
- rf )

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Expected Returns
These estimates of the returns expected by investors in
February 2009 were based on the capital asset pricing
model. We assumed 0.2% for the interest rate r f and 7 %
for the expected risk premium r m r f .
Stock

Beta ()

Amazon
Ford
Dell
Starbucks
Boeing
Disney
Newmont
ExxonMobil
Johnson & Johnson
Soup

2.16
1.75
1.41
1.16
1.14
.96
.63
.55
.50
.30

Expected Return
[rf + (rm rf)]
15.4
12.6
10.2
8.4
8.3
7.0
4.7
4.2
3.8
2.4
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SML Equilibrium
In equilibrium no stock can lie below the security market
line. For example, instead of buying stock A, investors
would prefer to lend part of their money and put the
balance in the market portfolio. And instead of buying
stock B, they would prefer to borrow and invest in the
market portfolio. (lend=save, borrow is leveraging.) risk
free assets and the market portfolio can span the whole
Security market line)

Higher risk
lower return

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Testing the CAPM

Beta vs. Average Risk Premium: low beta
portfolio fared better than high beta
Average Risk
portfolio 1931-2008
20

SML

Investors
12

Market
Portfolio

0
1.0

Portfolio
Beta
30

Testing the CAPM

Beta vs. Average Risk Premium
Average Risk
12
8

Investors

SML

Market
Portfolio

0
1.0

Portfolio
Beta

31

Dollars
(log scale)

Cumulated difference of Small minus big firm stocks

Cumulated difference of High minus low book-to-market firm stocks

2008

Small minus big

http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
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