Portfolio

A portfolio is a bundle or a combination of individual assets or

securities.
Objectives of a Portfolio
◦ To minimize the risk for a given level of expected return
◦ To maximize the return for a given level of risk

Don’t put all your eggs in one basket

DIVERSIFY
Investors can eliminate unsystematic risk through diversification:
Create a portfolio

Total Risk (σ)

Market or
Unique (Non-systematic) Risk
systematic risk
is risk that
cannot be
eliminated
from the
portfolio by
Market (Systematic) Risk investing into
more and
different
securities.

Number of Securities
Portfolio Return
Weighted average of the individual security returns
◦ Each portfolio asset has a weight, w, which represents the percent of the total portfolio value

𝑅𝑝 = ෍ 𝑤𝑖 𝑅𝑖
𝑖=1
◦ Rp is portfolio return
◦ Ri is return on individual security i
◦ wi is the proportion of investment in security I
◦ n is the number of securities
Calculate the portfolio return
No.of Rate of
Security shares Price Return %

Jazz Ltd 100 40 17

Classical Ltd 400 20 13
Rock Ltd 200 20 23

Find the return on the three stock portfolio

No.of Weight in Rate of Weighted

Security shares Price Cost portfolio Return Return

Jazz Ltd 100 40 4000 0.25 0.17 0.0425

Classical Ltd 400 20 8000 0.5 0.13 0.065
Rock Ltd 200 20 4000 0.25 0.23 0.0575
16000 1 0.165
16.5%
Portfolio Expected Return
Weighted average of the individual security expected returns
◦ Each portfolio asset has a weight, w, which represents the percent of the total portfolio value

n
E(Rp )   w iE(Ri )
i1
Portfolio Risk
Encompasses three factors
◦ Variance or Standard Deviation of each security
◦ Portfolio weights for each security
◦ Covariance between each pair of securities
Standard Deviation of a Portfolio

n n n
p   w i  i    w i w jCovij
2 2
i1 i1 j1
i j
where :
 p  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   ij i j
Another way to denote the SD of the portfolio is:
 Covariance of Returns

A measure of the degree to which two variables “move together”

relative to their individual mean values over time
For two stocks, 1 and 2, the covariance (historical) of rates of
return is defined as:

n is the number of periods

Expected Covariance
A positive covariance means that the returns of the two securities
move in the same direction

A negative covariance implies that the returns of the two securities

move in opposite direction.

Zero covariance: returns are unrelated

Correlation
If x & y are the two variables of discussion, then the correlation coefficient can
be calculated using the formula

n = Number of values or elements

Computing correlation from covariance

Where:
ρ(X,Y) – the correlation between the variables X and Y
Cov(X,Y) – the covariance between the variables X and Y
σX – the standard deviation of the X-variable
σY – the standard deviation of the Y-variable
Correlation can have a value:
1 is a perfect positive correlation
0 is no correlation (the values don't seem linked at all)
-1 is a perfect negative correlation
Covariance vs. Correlation
Covariance and correlation both primarily assess the relationship between variables.
Covariance measures the total variation of two random variables from their expected values.
Using covariance, we can only gauge the direction of the relationship (whether the variables
tend to move in tandem or show an inverse relationship). However, it does not indicate the
strength of the relationship, nor the dependency between the variables.
On the other hand, correlation measures the strength of the relationship between variables.
Correlation is the scaled measure of covariance. It is dimensionless. In other words, the
correlation coefficient is always a pure value and not measured in any units.
The value of correlation lies between -1 and +1.
Risk of a two asset portfolio

 p  w12 12  w22 22  212w1w2 1 2

 p  w12 12  w22 22  2 cov12 w1w2

𝜎𝑝 = Standard Deviation of portfolio 𝑤1 = weight of stock 1

𝜎1 = Standard Deviation of stock 1 𝑤2 = weight of stock 2
𝜎2 = Standard Deviation of stock 2 𝑐𝑜𝑣12 = covariance of returns of stock 1 and 2
𝜌12 = correlation of returns of stock 1 and 2
Find the SD of the portfolio with two stocks, A and B.
A B

Weight 0.9 0.1

Covariance -0.016
Std Deviation 20% 40%

Find the Standard Deviation or risk of the Portfolio

  p  w12 12  w22 22  2 cov12 w1w2

Variance of portfolio =
= (0.92)(0.2)2 + (0.1)2(0.4)2 + 2(-0.016)(0.9)(0.1)
= .0324 + .0016 - .00288 = .03112

SD of portfolio = Square root of (0.03112)

= 17.64%
Find the SD of the portfolio with two stocks, A and B.
A B

Weight 0.9 0.1

Correlation -0.2
Coefficient
Std Deviation 20% 40%

Find the Standard Deviation or risk of the Portfolio

  p  w12 12  w22 22  212w1w2 1 2

Variance of portfolio =
(0.9)2(0.2)2 + (0.1)2(0.4)2 + 2(-0.2)(0.9)(0.1)(0.2)(0.4)
= .0324 + .0016 - .00288 = .03112

SD of portfolio = Square root of (0.03112)

= 17.64%
Find the SD of the portfolio with two stocks, A and B if the correlation
coefficient is -1
A B

Weight 0.9 0.1

Correlation -1
Coefficient
Std Deviation 20% 40%

Variance of portfolio = .0324 + .0016 - .0144 = .0196

SD of portfolio = √. 0196

= 14%
Can the SD be driven down to ZERO theoretically?
When correlation coefficient is -1, use the following formula:
Wt 1 = .4/(.2+.4) = .666667
Wt 2 = 1- .666667 = .333333

Using these weights what is the SD of the portfolio?

Weights as calculated earlier
A B

Weight 0.666667 0.333333

Correlation -1
Coefficient
Std Deviation 20% 40%

Variance of portfolio = . 017777777+ .01777777 - .3555555 = 0

SD of portfolio = 0
Risk will change due to changing weights and correlations
Risk will change due to changing weights and correlations

Correlation Weights SD

1 0.9 and 0.1 22.00%

0.5 0.9 and 0.1 20.30%
0 0.9 and 0.1 18.44%
-0.2 0.9 and 0.1 17.64%
-1 0.9 and 0.1 14%
-1 0.6777 and 0.3333 0
Minimum Variance Portfolio
(for 2 security case, A and B)
when correlation is not -1
wA is the optimum proportion of investment in security A that
minimizes portfolio variance.
Investment in B: wB = 1 – wA.

or
Minimum Variance Portfolio
Example
Assume the following statistics for Stock A and Stock B:

Stock A Stock B
Expected return .015 .020
Standard deviation .224 .245
Weight ? ?
Correlation coefficient .50
Minimum Variance Portfolio (cont’d)
The weights of the minimum variance portfolios in the this case are:
wA =
[(0.2452) – (0.224*0.245*0.5)]
[(0.2242)+(0.2452)-(2* 0.224*0.245*0.5)]

=0.032585/0.055321 = 0.5890168 = 58.90168%

wB = 1- 58.902% = 41.098%

◦SD of the portfolio = 20.2%

With SD of 22.4% and 24.5% and correlation of 0.5
Wt A Wt B SD of portfolio

90.00% 10.00% 21.49%

70.00% 30.00% 20.37%
58.90% 41.10% 20.21%
40.00% 60.00% 20.69%
20.00% 80.00% 22.18%
10.00% 90.00% 23.25%
SD for 3 stock portfolio
 p  w12 12  w22 22  w32 32  2 12 w1w2 1 2  2 13 w1w3 1 3  2  23 w2 w3 2 3
Assume a 3 stock portfolio, with proportions of 1,2 and 3 being 0.3, 0.5 and 0.2
respectively.
SD1 = 6%, SD2=9%, SD3 =10%
Correl12 = 0.4, correl13=0.6, correl23=0.7
Find the risk (SD) of the portfolio.

Variance = .00324 + .002025 + .0004 + .000648 + .000432 + .00126 = .005089

SD = .0713
 Portfolio Risk Depends on
Correlation between Assets

Investing wealth in more than one security reduces

portfolio risk.

This is attributed to diversification effect.

Diversification always reduces risk provided the correlation

coefficient is less than 1.
Correlation and Portfolio Risk

Correlation between
assets in the portfolio

Portfolio risk
 Portfolio Risk Depends on Correlation between Assets

◦ Covariance calculations grow quickly

◦ n(n-1) for n securities
◦ For 2 securities, covariance terms are: 2*(2-1)=2
◦ For 3 securities, covariance terms are: 3*(3-1)=6
◦ For 4 securities, covariance terms are: 4*(4-1)=12

◦ As the number of securities increases:

◦ The importance of covariance relationships increases
◦ The importance of each individual security’s risk decreases