Efficient

Diversification

6
SHOULD WE DIVERSIFY
Listen to Raymond Dalio, a billionaire investor,
hedge fund manager, and philanthropist, the
founder of investment firm Bridgewater Associates,
one of the world's largest hedge funds.

“Diversification and sample size, knowing how to

engineer your bet is even more important than
knowing what the good bet is.”

https://www.investopedia.com/investing/importance-
diversification/

2 Of course other successful investor will say

differently
OUTCOMES
CHECK IF YOU CAN DO/UNDERSTAND THE FOLLOWING AFTER
CLASS

• Understand systematic and nonsystematic risk

• Appreciate the benefit of diversification
• Allocate two risky assets
• Efficient diversification with many assets
• Index model

3
6.1 DIVERSIFICATION AND PORTFOLIO
RISK
 Can you eliminate all risks through diversification?

 Market/Systematic/Non diversifiable Risk

 Risk factors common to whole economy
 Example?

 Unique/Firm-Specific/Nonsystematic/ Diversifiable
Risk
 Risk that can be eliminated by diversification
 Example?

4
FIGURE 6.1 RISK AS FUNCTION OF NUMBER
OF STOCKS IN PORTFOLIO

5
FIGURE 6.2 RISK VERSUS
DIVERSIFICATION

How many stocks should be included in a portfolio to eliminate

diversifiable risks?
6
 6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Covariance and Correlation
 Portfolio risk depends on covariance between returns of
assets
 Expected return on two-security portfolio



E (rp )  W1r1  W2 r2

W1  Proportion of funds in security 1



W2  Proportion of funds in security 2
r1  Expected return on security 1
r 2  Expected return on security 2

7
Can I change r to sigma to get the expected risk of the portfolio?
6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Covariance Calculations
S
Cov( rS , rB )   p(i )[ rS (i )  E (rS )][ rB (i )  E (rB )]
i 1

 Excel example on the coming slides, spreadsheet 6.4

 Correlation Coefficient
Cov( rS , rB )
ρ SB 
σS  σB

Cov( rS , rB )  ρ SBσ S σ B
8

Note: subscript S and B stand for stock and bond

 SPREADSHEET 6.1 CAPITAL MARKET
EXPECTATIONS

Spreadsheet exercises Not required in the tests,

but please try to repeat the exercise at home if you have spare
time.

9
SPREADSHEET 6.2 VARIANCE OF
RETURNS

10
SPREADSHEET 6.3 PORTFOLIO
PERFORMANCE

0.4x-37%+-0.6x-9 = -20.2%

11
SPREADSHEET 6.4 RETURN COVARIANCE

12
 6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Portfolio risk and return depend on the means and
variances of the component securities (the two risky
assets in this case)
 How can we get the means and variances?

 Using Historical Data (a common approach)

 Variability/covariability change slowly over time, should be
more reliable when using realized returns to estimate
 However, using realized returns to estimate the averages of
past returns (the mean return) can be very noisy,
 Macroeconomic and security analysis are also used to
estimate the mean
13
6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Weighted average of returns on components, with
investment proportions as weights

 Weighted average of expected returns on

components, with portfolio proportions as weights

 Variance:

14
6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
 Risk-Return Trade-Off (graph to be shown)
 Should we look for lower risk? But it usually comes with
lower return?
 We can look at the Investment opportunity set
 Available portfolio risk-return combinations
 and use the mean-Variance Criterion

 Mean-Variance Criterion
 If E(rA) ≥ E(rB) and σA ≤ σB
 Portfolio A dominates portfolio B

15
SPREADSHEET 6.5 INVESTMENT
OPPORTUNITY SET

16
FIGURE 6.3 INVESTMENT
OPPORTUNITY SET

17
FIGURE 6.4 OPPORTUNITY SETS: VARIOUS
CORRELATION COEFFICIENTS

See port risk.xls as a

demonstration

18
 Near zero
SPREADSHEET 6.6 OPPORTUNITY SET -VARIOUS
CORRELATION COEFFICIENTS

19
6.3 THE OPTIMAL RISKY PORTFOLIO WITH A
RISK-FREE ASSET
 How to find the optimal risky portfolio?
 i.e. for a given level of risk, you get the highest expected return.
 Refer to Figure 6.3 Investment Opportunity Set

 Slope of CAL is Sharpe Ratio of Risky Portfolio



 Optimal Risky Portfolio

 Best combination of risky and safe assets to form
portfolio 20
6.3 THE OPTIMAL RISKY PORTFOLIO WITH A
RISK-FREE ASSET
 Calculating Optimal Risky Portfolio
 Two risky assets

[ E (rB )  rf ] S2  [ E (rs )  rf ] B S  BS
wB 
[ E (rB )  rf ] S2  [ E (rs )  rf ] B2  [ E (rB )  rf  E (rs )  rf ] B S  BS

wS  1  wB

Note: Formula will be given if required

21
FIGURE 6.5 TWO CAPITAL
ALLOCATION LINES

22
FIGURE 6.6 BOND, STOCK AND T-BILL
OPTIMAL ALLOCATION

23
FIGURE 6.7 THE COMPLETE PORTFOLIO
Once you have obtained the optimal risk
portfolio O, you may determine the complete
portfolio C based on your risk preference.

24
FIGURE 6.8 PORTFOLIO COMPOSITION: ASSET
ALLOCATION SOLUTION
An example may look like
this.
You can refer to the
text for the calculations

25
 6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Efficient Frontier of Risky Assets
 Graph representing set of portfolios that maximizes
expected return at each level of portfolio risk
 Maximize risk premium for any level standard deviation
 Minimize standard deviation for any level risk premium

 Maximize Sharpe ratio for any standard deviation or risk

premium

26
FIGURE 6.9 PORTFOLIOS CONSTRUCTED
WITH THREE STOCKS (A, B AND C)

27
E from AB and F from BC resulting curve EF, more northwest (i.e.
lower risk and higher return, a better feature)
FIGURE 6.10 EFFICIENT FRONTIER: RISKY
AND INDIVIDUAL ASSETS

28
 6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Choosing Optimal Risky Portfolio
 Optimal portfolio CAL tangent to efficient frontier
 Similar to process of choosing an optimal risky portfolio of

two risky assets

29
 6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
 Optimal Risky Portfolio: An Illustration
 Efficiently diversified global portfolio using stock market
indices of six countries
 Standard deviation and correlation estimated from
historical data
 Risk premium forecast generated from fundamental
analysis (not for historical averages)

30
FIGURE 6.11 EFFICIENT FRONTIERS/CAL: TABLE 6.1

0.09
Efficient Frontier
Capital Allocation Line
0.08 Eff Front - No Short
Min-Var with short sales
Min-Var no short sales
0.07 Optimum with short sales
Optimum no short sales
0.06 Individual countries
Risk Premium

0.05
0.04
0.03
0.02
0.01
0.00
0.00 0.05 0.10 0.15 0.20 0.25 0.30 31
Standard Deviation

Click the chart to access Excel data

6.5 A SINGLE-INDEX STOCK MARKET
 Index model
 Relates stock returns to returns on broad market index/firm-
specific factors
 Excess return
 Rate of return in excess of risk-free rate
 Beta
 Sensitivity of security’s returns to market factor
 Firm-specific or residual risk
 Component of return variance independent of market factor
 Alpha
 Stock’s expected return beyond that induced by market index
 Positive alpha means underpriced
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6.5 A SINGLE-INDEX STOCK MARKET
 Excess Return


Ri   i RM   i  ei
 RM : return from movements in overall market

 i : security's responsiveness to market
  i : expected return on stock beyond any return
induced by market index movements
ei : firm - specific risk

William Sharpe (1963) introduced single-index model

33
 6.5 A SINGLE-INDEX STOCK MARKET
 Statistical and Graphical Representation of Single-
Index Model
 Security Characteristic Line (SCL), next slide
 Plot of security’s predicted excess return from

excess return of market

 Algebraic representation of regression line


You can get Beta of the stock you want. How do we make
use of this in practice? 34
FIGURE 6.12 SCATTER DIAGRAM FOR
DELL

35
 6.5 A SINGLE-INDEX STOCK MARKET
 Statistical and Graphical Representation of Single-
Index Model
 Ratio of systematic variance to total variance, a measure on
the relative importance of systematic risk


Total variance = Systematic variance + Residual variance

= β2Dσ2M + σ2(eD)
36
Residual variance measures the dispersion of the scatter
of actual returns about the regression line
FIGURE 6.13 VARIOUS SCATTER
DIAGRAMS

37
 6.5 A SINGLE-INDEX STOCK MARKET
 What will be systematic and nonsystematic variances of a
portfolio if its securities’ returns follow single index model
 Diversification in Single-Index Security Market
 In portfolio of n securities with weights
 In securities with nonsystematic risk

 Nonsystematic portion of portfolio return

Note: Illustration only, proof

not required
 Portfolio nonsystematic variance

when num. of securities increase, w2i will get smaller, so the 38

nonsystematic components become less important

6.5 A SINGLE-INDEX STOCK MARKET

How about the systematic component?

Can it be diversify?

Each security is driven by the market

factor RM, so no diversification?

You may refer to the word file named “Portfolio risk_index

model” for details, proof will not be examined.

39
EXERCISES

Check the outcome

Q2, Q5, Q17, Q21

40