Chapter 7

Why Diversification Is a Good Idea

Prof. Rushen Chahal

Prof. Rushen Chahal

The most important lesson learned is an old truth ratified.

- General Maxwell R. Thurman

Prof. Rushen Chahal

Outline
Introduction Carrying your eggs in more than one basket Role of uncorrelated securities Lessons from Evans and Archer Diversification and beta Capital asset pricing model Equity risk premium Using a scatter diagram to measure beta Arbitrage pricing theory
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Introduction
Diversification of a portfolio is logically a good idea Virtually all stock portfolios seek to diversify in one respect or another

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Carrying Your Eggs in More Than One Basket

Investments in your own ego The concept of risk aversion revisited Multiple investment objectives

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Investments in Your Own Ego

Never put a large percentage of investment funds into a single security
If the security appreciates, the ego is stroked and this may plant a speculative seed If the security never moves, the ego views this as neutral rather than an opportunity cost If the security declines, your ego has a very difficult time letting go

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The Concept of Risk Aversion Revisited

Diversification is logical
If you drop the basket, all eggs break

Diversification is mathematically sound

Most people are risk averse People take risks only if they believe they will be rewarded for taking them

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The Concept of Risk Aversion Revisited (cont d)

Diversification is more important now
Journal of Finance article shows that volatility of individual firms has increased
Investors need more stocks to adequately diversify

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Multiple Investment Objectives

Multiple objectives justify carrying your eggs in more than one basket
Some people find mutual funds unexciting Many investors hold their investment funds in more than one account so that they can play with part of the total
E.g., a retirement account and a separate brokerage account for trading individual securities

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Role of Uncorrelated Securities

Variance of a linear combination: the practical meaning Portfolio programming in a nutshell Concept of dominance Harry Markowitz: the founder of portfolio theory

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Variance of A Linear Combination

One measure of risk is the variance of return The variance of an n-security portfolio is:

2 W p ! xi x j VijW iW j i !1 j !1

where xi ! proportion of total investment in Security i Vij ! correlation coefficient between Security i and Security j
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Variance of A Linear Combination (cont d)

The variance of a two-security portfolio is:

W ! x W  x W  2 x A xB V ABW AW B
2 p 2 A 2 A 2 B 2 B

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Variance of A Linear Combination (cont d)

Return variance is a security s total risk
W
2 p

! xW
2 A

2 A

 xW
2 B

2 B

2 x A xB V ABW AW B
Interactive Risk

Total Risk

Risk from A

Risk from B

Most investors want portfolio variance to be as low as possible without having to give up any return

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Variance of A Linear Combination (cont d)

If two securities have low correlation, the interactive risk will be small If two securities are uncorrelated, the interactive risk drops out If two securities are negatively correlated, interactive risk would be negative and would reduce total risk

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Portfolio Programming in A Nutshell

Various portfolio combinations may result in a given return The investor wants to choose the portfolio combination that provides the least amount of variance

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Portfolio Programming in A Nutshell (cont d)

Example
Assume the following statistics for Stocks A, B, and C:

Stock A Expected return Standard deviation .20 .232

Stock B .14 .136

Stock C .10 .195

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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
The correlation coefficients between the three stocks are:

Stock A Stock A Stock B Stock C 1.000 0.286 0.132

Stock B 1.000 -0.605

Stock C

1.000
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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
An investor seeks a portfolio return of 12%. Which combinations of the three stocks accomplish this objective? Which of those combinations achieves the least amount of risk?

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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
Solution: Two combinations achieve a 12% return: 1) 2) 50% in B, 50% in C: (.5)(14%) + (.5)(10%) = 12% 20% in A, 80% in C: (.2)(20%) + (.8)(10%) = 12%

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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
Solution (cont d): Calculate the variance of the B/C combination:
2 2 2 2 W 2 ! xAW A  xBW B  2 xA xB V ABW AW B p

! (.50) 2 (.0185)  (.50) 2 (.0380)  2(.50)(.50)(.605)(.136)(.195) ! .0046  .0095  .0080 ! .0061

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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
Solution (cont d): Calculate the variance of the A/C combination:
2 2 2 2 W 2 ! x AW A  xBW B  2 x A xB V ABW AW B p

! (.20)2 (.0538)  (.80)2 (.0380)  2(.20)(.80)(.132)(.232)(.195) ! .0022  .0243  .0019 ! .0284

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Portfolio Programming in A Nutshell (cont d)

Example (cont d)
Solution (cont d): Investing 50% in Stock B and 50% in Stock C achieves an expected return of 12% with the lower portfolio variance. Thus, the investor will likely prefer this combination to the alternative of investing 20% in Stock A and 80% in Stock C.

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Concept of Dominance
Dominance is a situation in which investors universally prefer one alternative over another
All rational investors will clearly prefer one alternative

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Concept of Dominance (cont d)

A portfolio dominates all others if:
For its level of expected return, there is no other portfolio with less risk For its level of risk, there is no other portfolio with a higher expected return

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Concept of Dominance (cont d)

Example (cont d)
In the previous example, the B/C combination dominates the A/C combination:
0.14 0.12

Expected Return

0.1 0.08 0.06 0.04 0.02 0 0 0.005 0.01 0.015 0.02 0.025 0.03
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B/C combination dominates A/C

Risk
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Harry Markowitz: Founder of Portfolio Theory

Introduction Terminology Quadratic programming

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Introduction
Harry Markowitz s Portfolio Selection Journal of Finance article (1952) set the stage for modern portfolio theory
The first major publication indicating the important of security return correlation in the construction of stock portfolios Markowitz showed that for a given level of expected return and for a given security universe, knowledge of the covariance and correlation matrices are required

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Terminology
Security Universe Efficient frontier Capital market line and the market portfolio Security market line Expansion of the SML to four quadrants Corner portfolio

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Security Universe
The security universe is the collection of all possible investments
For some institutions, only certain investments may be eligible
E.g., the manager of a small cap stock mutual fund would not include large cap stocks

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Efficient Frontier
Construct a risk/return plot of all possible portfolios
Those portfolios that are not dominated constitute the efficient frontier

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Efficient Frontier (cont d)

Expected Return

No points plot above the line

100% investment in security with highest E(R)

All portfolios on the line are efficient

Points below the efficient frontier are dominated

100% investment in minimum variance portfolio

Standard Deviation

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Efficient Frontier (cont d)

The farther you move to the left on the efficient frontier, the greater the number of securities in the portfolio

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Efficient Frontier (cont d)

When a risk-free investment is available, the shape of the efficient frontier changes
The expected return and variance of a risk-free rate/stock return combination are simply a weighted average of the two expected returns and variance
The risk-free rate has a variance of zero

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Efficient Frontier (cont d)

Expected Return

C B

Rf

Standard Deviation
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Efficient Frontier (cont d)

The efficient frontier with a risk-free rate:
Extends from the risk-free rate to point B
The line is tangent to the risky securities efficient frontier

Follows the curve from point B to point C

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Capital Market Line and the Market Portfolio

The tangent line passing from the risk-free rate through point B is the capital market line (CML)
When the security universe includes all possible investments, point B is the market portfolio
It contains every risky assets in the proportion of its market value to the aggregate market value of all assets It is the only risky assets risk-averse investors will hold

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Capital Market Line and the Market Portfolio (cont d)

Implication for investors:
Regardless of the level of risk-aversion, all investors should hold only two securities:
The market portfolio The risk-free rate

Conservative investors will choose a point near the lower left of the CML Growth-oriented investors will stay near the market portfolio

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Capital Market Line and the Market Portfolio (cont d)

Any risky portfolio that is partially invested in the risk-free asset is a lending portfolio Investors can achieve portfolio returns greater than the market portfolio by constructing a borrowing portfolio

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Capital Market Line and the Market Portfolio (cont d)

Expected Return

C B

Rf

Standard Deviation
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Security Market Line

The graphical relationship between expected return and beta is the security market line (SML)
The slope of the SML is the market price of risk The slope of the SML changes periodically as the risk-free rate and the market s expected return change

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Security Market Line (cont d)

Expected Return

E(R) Market Portfolio Rf 1.0

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Beta

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Expansion of the SML to Four Quadrants

There are securities with negative betas and negative expected returns
A reason for purchasing these securities is their risk-reduction potential
E.g., buy car insurance without expecting an accident E.g., buy fire insurance without expecting a fire

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Security Market Line (cont d)

Expected Return

Securities with Negative Expected Returns

Beta

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Corner Portfolio
A corner portfolio occurs every time a new security enters an efficient portfolio or an old security leaves
Moving along the risky efficient frontier from right to left, securities are added and deleted until you arrive at the minimum variance portfolio

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Quadratic Programming
The Markowitz algorithm is an application of quadratic programming
The objective function involves portfolio variance Quadratic programming is very similar to linear programming

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Markowitz Quadratic Programming Problem

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Lessons from Evans and Archer

Introduction Methodology Results Implications Words of caution

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Introduction
Evans and Archer s 1968 Journal of Finance article
Very consequential research regarding portfolio construction Shows how nave diversification reduces the dispersion of returns in a stock portfolio
Nave diversification refers to the selection of portfolio components randomly

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Methodology
Used computer simulations:
Measured the average variance of portfolios of different sizes, up to portfolios with dozens of components Purpose was to investigate the effects of portfolio size on portfolio risk when securities are randomly selected

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Results
Definitions General results Strength in numbers Biggest benefits come first Superfluous diversification

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Definitions
Systematic risk is the risk that remains after no further diversification benefits can be achieved Unsystematic risk is the part of total risk that is unrelated to overall market movements and can be diversified
Research indicates up to 75 percent of total risk is diversifiable

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Definitions (cont d)
Investors are rewarded only for systematic risk
Rational investors should always diversify Explains why beta (a measure of systematic risk) is important
Securities are priced on the basis of their beta coefficients

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General Results
Portfolio Variance

Number of Securities

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Strength in Numbers
Portfolio variance (total risk) declines as the number of securities included in the portfolio increases
On average, a randomly selected ten-security portfolio will have less risk than a randomly selected three-security portfolio Risk-averse investors should always diversify to eliminate as much risk as possible

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Biggest Benefits Come First

Increasing the number of portfolio components provides diminishing benefits as the number of components increases
Adding a security to a one-security portfolio provides substantial risk reduction Adding a security to a twenty-security portfolio provides only modest additional benefits

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Superfluous Diversification
Superfluous diversification refers to the addition of unnecessary components to an already well-diversified portfolio
Deals with the diminishing marginal benefits of additional portfolio components The benefits of additional diversification in large portfolio may be outweighed by the transaction costs

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Implications
Very effective diversification occurs when the investor owns only a small fraction of the total number of available securities
Institutional investors may not be able to avoid superfluous diversification due to the dollar size of their portfolios
Mutual funds are prohibited from holding more than 5 percent of a firm s equity shares

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Implications (cont d)
Owning all possible securities would require high commission costs It is difficult to follow every stock

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Words of Caution
Selecting securities at random usually gives good diversification, but not always Industry effects may prevent proper diversification Although nave diversification reduces risk, it can also reduce return
Unlike Markowitz s efficient diversification

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Diversification and Beta

Beta measures systematic risk
Diversification does not mean to reduce beta Investors differ in the extent to which they will take risk, so they choose securities with different betas
E.g., an aggressive investor could choose a portfolio with a beta of 2.0 E.g., a conservative investor could choose a portfolio with a beta of 0.5

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Capital Asset Pricing Model

Introduction Systematic and unsystematic risk Fundamental risk/return relationship revisited

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Introduction
The Capital Asset Pricing Model (CAPM) is a theoretical description of the way in which the market prices investment assets
The CAPM is a positive theory

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Systematic and Unsystematic Risk

Unsystematic risk can be diversified and is irrelevant Systematic risk cannot be diversified and is relevant
Measured by beta
Beta determines the level of expected return on a security or portfolio (SML)

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Fundamental Risk/Return Relationship Revisited

CAPM SML and CAPM Market model versus CAPM Note on the CAPM assumptions Stationarity of beta

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CAPM
The more risk you carry, the greater the expected return:
  E ( Ri ) ! R f  F i E ( Rm )  R f  where E ( Ri ) ! expected return on security i R f ! risk-free rate of interest F i ! beta of Security i  E ( Rm ) ! expected return on the market
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CAPM (cont d)
The CAPM deals with expectations about the future Excess returns on a particular stock are directly related to:
The beta of the stock The expected excess return on the market

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CAPM (cont d)
CAPM assumptions:
Variance of return and mean return are all investors care about Investors are price takers
They cannot influence the market individually

All investors have equal and costless access to information There are no taxes or commission costs

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CAPM (cont d)
CAPM assumptions (cont d):
Investors look only one period ahead Everyone is equally adept at analyzing securities and interpreting the news

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SML and CAPM

If you show the security market line with excess returns on the vertical axis, the equation of the SML is the CAPM
The intercept is zero The slope of the line is beta

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Market Model Versus CAPM

The market model is an ex post model
It describes past price behavior

The CAPM is an ex ante model

It predicts what a value should be

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Market Model Versus CAPM (cont d)

The market model is:
Rit ! E i  F i ( Rmt )  eit where Rit ! return on Security i in period t E i ! intercept F i ! beta for Security i Rmt ! return on the market in period t eit ! error term on Security i in period t
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Note on the CAPM Assumptions

Several assumptions are unrealistic:
People pay taxes and commissions Many people look ahead more than one period Not all investors forecast the same distribution

Theory is useful to the extent that it helps us learn more about the way the world acts
Empirical testing shows that the CAPM works reasonably well

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Stationarity of Beta
Beta is not stationary
Evidence that weekly betas are less than monthly betas, especially for high-beta stocks Evidence that the stationarity of beta increases as the estimation period increases

The informed investment manager knows that betas change

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Equity Risk Premium

Equity risk premium refers to the difference in the average return between stocks and some measure of the risk-free rate
The equity risk premium in the CAPM is the excess expected return on the market Some researchers are proposing that the size of the equity risk premium is shrinking

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Using A Scatter Diagram to Measure Beta

Correlation of returns Linear regression and beta Importance of logarithms Statistical significance

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Correlation of Returns
Much of the daily news is of a general economic nature and affects all securities
Stock prices often move as a group Some stock routinely move more than the others regardless of whether the market advances or declines
Some stocks are more sensitive to changes in economic conditions

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Linear Regression and Beta

To obtain beta with a linear regression:
Plot a stock s return against the market return Use Excel to run a linear regression and obtain the coefficients
The coefficient for the market return is the beta statistic The intercept is the trend in the security price returns that is inexplicable by finance theory

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Importance of Logarithms
Taking the logarithm of returns reduces the impact of outliers
Outliers distort the general relationship Using logarithms will have more effect the more outliers there are

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Statistical Significance
Published betas are not always useful numbers
Individual securities have substantial unsystematic risk and will behave differently than beta predicts Portfolio betas are more useful since some unsystematic risk is diversified away

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Arbitrage Pricing Theory

APT background The APT model Comparison of the CAPM and the APT

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APT Background
Arbitrage pricing theory (APT) states that a number of distinct factors determine the market return
Roll and Ross state that a security s long-run return is a function of changes in:
Inflation Industrial production Risk premiums The slope of the term structure of interest rates

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APT Background (cont d)

Not all analysts are concerned with the same set of economic information
A single market measure such as beta does not capture all the information relevant to the price of a stock

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The APT Model

General representation of the APT model:
 RA ! E ( RA )  b1 A F1  b2 A F2  b3 A F3  b4 A F4 where RA ! actual return on Security A  E ( RA ) ! expected return on Security A biA ! sensitivity of Security A to factor i Fi ! unanticipated change in factor i
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Comparison of the CAPM and the APT

The CAPM s market portfolio is difficult to construct:
Theoretically all assets should be included (real estate, gold, etc.) Practically, a proxy like the S&P 500 index is used

APT requires specification of the relevant macroeconomic factors

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Comparison of the CAPM and the APT (cont d)

The CAPM and APT complement each other rather than compete
Both models predict that positive returns will result from factor sensitivities that move with the market and vice versa

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