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INVESTMENT ANALYSIS AND
PORTFOLIO MANAGEMENT
CH-7: REILLY & BROWN
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
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Assumptions of
Markowitz Portfolio Theory
1. Investors consider each investment alternative as being presented by a probability
distribution of expected returns over some holding period
2. Investors minimize one-period expected utility, and their utility curves demonstrate
diminishing marginal utility of wealth
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 asset or portfolio of assets is considered to
be efficient if no other asset or portfolio of assets offers higher expected return with
the same (or lower) risk, or lower risk with the same (or higher) expected return.
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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 assets - weighted average of the expected rates of return for the
individual investments in the portfolio
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Computation of Expected Return for
an Individual Risky Investment
Computation of Expected Return for an Individual Risky Asset
Table 6.1
Possible Rate of Expected Return
Probability Return (Percent) (Percent)
0.25 0.08 0.0200
0.25 0.10 0.0250
0.25 0.12 0.0300
0.25 0.14 0.0350
E(R) = 0.1100
Computation of the Expected Return
for a Portfolio of Risky Assets
Table 6.2 Computation of the Expected Return for a Portfolio of Risky Assets
Weight (Wi ) Expected Security Expected Portfolio
(Percent of Portfolio) Return (Ri ) Return (Wi X Ri )
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(Rpor i ) = 0.1150
n
E(R por i )
i 1
W iR i
where :
W i the percent of the portfolio in asset i
E(R i ) the expected rate of return for asset i
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Variance (Standard Deviation) of
Returns for an Individual Investment
Standard deviation is the square root of the variance
Variance is a measure of the variation of possible rates of return Ri,
from the expected rate of return [E(Ri)]
Variance (Standard Deviation) of
Returns for an Individual Investment
n
Variance ( ) [R i - E(R i )] 2 Pi
2
i 1
where Pi is the probability of the possible rate of return, Ri
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Variance (Standard Deviation) of
Returns for an Individual Investment
Standard Deviation
n
( ) [Ri 1
i - E(R i )] 2 Pi
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Variance (Standard Deviation) of
Returns for an Individual Investment
Exhibit 7.3
Table 6.3 Computation of the Variance for an Individual of
Risky Asset
Possible Rate Expected
2 2
of Return (R i ) Return E(R i ) R i - E(Ri ) [Ri - E(Ri )] Pi [Ri - E(Ri )] Pi
0.08 0.11 0.03 0.0009 0.25 0.000225
0.10 0.11 0.01 0.0001 0.25 0.000025
0.12 0.11 0.01 0.0001 0.25 0.000025
Variance ( 2) = .0050
Standard Deviation ( ) = .02236
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Variance (Standard Deviation) of
Returns for a Portfolio Exhibit 7.4
Computation of Monthly Rates of Return
Closing Closing
Date Price Dividend Return (%) Price Dividend Return (%)
Dec.00 60.938 45.688
Jan.01 58.000 -4.82% 48.200 5.50%
Feb.01 53.030 -8.57% 42.500 -11.83%
Mar.01 45.160 0.18 -14.50% 43.100 0.04 1.51%
Apr.01 46.190 2.28% 47.100 9.28%
May.01 47.400 2.62% 49.290 4.65%
Jun.01 45.000 0.18 -4.68% 47.240 0.04 -4.08%
Jul.01 44.600 -0.89% 50.370 6.63%
Aug.01 48.670 9.13% 45.950 0.04 -8.70%
Sep.01 46.850 0.18 -3.37% 38.370 -16.50%
Oct.01 47.880 2.20% 38.230 -0.36%
Nov.01 46.960 0.18 -1.55% 46.650 0.05 22.16%
Dec.01 47.150 0.40% 51.010 9.35%
E(RCoca-Cola)= -1.81% E(Rhome Depot)== 1.47%
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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)]}
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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
r ij
i j
where :
r ij the correlatio n coefficien t of returns
i the standard deviation of R it
j the standard deviation of R jt
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Correlation Coefficient
■ It can vary only in the range +1 to -1. 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 correlation. This
means that the returns for two assets have the same percentage movement, but in
opposite directions
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Portfolio Standard Deviation Formula
n n n
port w i2 i2 w i w jCov ij
i 1 i 1 i 1
where :
port the standard deviation of the portfolio
Wi the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
i2 the variance of rates of return for asset i
Cov ij the covariance between the rates of return for assets i and j,
where Cov ij rij i j
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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
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Combining Stocks with Different Returns
and Risk
Asset E(R i ) Wi 2i i
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
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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
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Constant Correlation
with Changing Weights
Asset E(R i )
1 .10 rij = 0.00
2 .20
2
Case W1 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
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Constant Correlation
with Changing Weights
Case W1 W2 E(R i ) 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
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Portfolio Risk-Return Plots for
Different Weights
E(R)
0.20 2
0.18 With two perfectly
correlated assets, it is only
0.16
possible to create a two
0.14 asset portfolio with risk- Rij = +1.00
0.12 return along a line between
either single asset
0.10 1
0.08
0.06
0.04
0.02
-
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
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Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 2
g
0.18 With uncorrelated assets it
h
is possible to create a two
0.16 i
asset portfolio with lower
0.14 j
risk than either single asset Rij = +1.00
0.12
k
0.10 1
0.08 Rij = 0.00
0.06
0.04
0.02
-
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
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Portfolio Risk-Return Plots for
Different Weights
E(R) f
0.20 2
g
0.18 With correlated assets it is
h
possible to create a two
0.16 asset portfolio between the i
0.14 j
first two curves Rij = +1.00
0.12
k Rij = +0.50
0.10 1
0.08 Rij = 0.00
0.06
0.04
0.02
-
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
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Portfolio Risk-Return Plots for
Different Weights
E(R) With negatively Rij = -0.50 f
0.20 correlated assets it
is possible to create g 2
0.18 a two asset portfolio h
0.16 with much lower risk i
than either single j
0.14 asset
Rij = +1.00
0.12 k Rij = +0.50
0.10 1
Rij = 0.00
0.08
0.06
0.04
0.02
-
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07Standard
0.08 0.09 0.10 0.11
Deviation 0.12
of Return
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Portfolio Risk-Return Plots for
Different Weights Exhibit 7.13
E(R) Rij = -0.50 f
0.20 Rij = -1.00 2
g
0.18 h
0.16 i
0.14 j
Rij = +1.00
0.12
k Rij = +0.50
0.10 1
0.08 Rij = 0.00
0.06 With perfectly negatively correlated assets it is possible
0.04 to create a two asset portfolio with almost no risk
0.02
-
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
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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
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Efficient Frontier
for Alternative Portfolios Exhibit 7.15
Efficient Frontier
E(R) B
A C
Standard Deviation of Return
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The Efficient Frontier
and Investor Utility
■ 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
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Selecting an Optimal Risky Portfolio
Exhibit 7.16
E(R port ) U3’
U2’
U1’
U3 X
U2
U1
E( port )
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