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Risk Aversion
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Evidence That
Investors are Risk Averse
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Not all investors are risk averse
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Markowitz Portfolio Theory
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Markowitz Portfolio Theory
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Assumptions of
Markowitz Portfolio Theory
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Assumptions of
Markowitz Portfolio Theory
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Assumptions of
Markowitz Portfolio Theory
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Markowitz Portfolio Theory
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Alternative Measures of Risk
l Range of returns;
in this case, it is assumed that a larger range
of expected returns, from the lowest to the
highest return, means greater uncertainty
and risk regarding future expected return.
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Alternative Measures of Risk
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Alternative Measures of Risk
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Expected Rates of Return
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Computation of Expected Return for an
Individual Risky Investment
Table. 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
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Computation of the Expected Return
for a Portfolio of Risky Assets
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
n
Variance (s ) = å [R i - E(R i )] Pi
2 2
i =1
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Variance (Standard Deviation) of
Returns for an Individual Investment
Standard Deviation
n
(s ) = å [R
i =1
i
2
- E(R i )] Pi
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Variance (Standard Deviation) of
Returns for an Individual Investment
Table 3
Possible Rate Expected
2 2
of Return (Ri ) Return E(Ri ) R i - E(R i ) [Ri - E(Ri )] Pi [Ri - E(Ri )] Pi
Variance ( s 2) = .0050
Standard Deviation ( ) = .02236
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Variance (Standard Deviation) of
Returns for a Portfolio
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Variance (Standard Deviation) of
Returns for a Portfolio
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Covariance and Correlation
Correlation coefficient
varies from -1 to +1
Cov ij
rij =
s is j
where :
rij = the correlatio n coefficien t of returns
s i = the standard deviation of R it
37 s j = the standard deviation of R jt
Correlation Coefficient
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Portfolio Standard Deviation Formula
n n n
s port = åw
i =1
2
i s + å å w i w j Cov ij
i
2
i =1 i =1
where :
s 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
s i2 = the variance of rates of return for asset i
Cov ij = the covariance between th e rates of return for assets i and j,
39 where Cov ij = rijs is j
Portfolio Standard Deviation Formula
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Portfolio Standard Deviation Formula
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Portfolio Standard Deviation
Calculation
Asset E(R i ) Wi s 2i si
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
43 e -1.00 -.0070
Combining Stocks with Different
Returns and Risk
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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(R i )
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Portfolio Risk-Return Plots for
Different Weights
E(R)
0.20 2
With two perfectly
correlated assets, it
0.15
is only possible to
create a two asset Rij = +1.00
0.10
portfolio with risk-
return along a line 1
0.05
between either
single asset
-
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)
0.20 With g 2
uncorrelated
assets it is h f
0.15 Rij = +1.00
possible to i
create a two j
0.10 k1
asset portfolio
with lower risk Rij = 0.00
0.05
than either single
asset
-
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
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Portfolio Risk-Return Plots for
Different Weights
E(R) With Rij = -0.50 f
0.20 negatively g 2
correlated assets h
0.15 it is possible to i
create a two j Rij = +1.00
asset portfolio k Rij = +0.50
0.10
with much lower 1
risk than either Rij = 0.00
0.05
single asset
-
49 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
Portfolio Risk-Return Plots for
Different Weights
E(R) Rij = -0.50 f
0.20
g 2
Rij = -1.00
h
0.15 i
j Rij = +1.00
k Rij = +0.50
0.10 1
Rij = 0.00
With perfectly negatively correlated
0.05 assets it is possible to create a two asset
portfolio with almost no risk
-
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
50 Standard Deviation of Return
Estimation Issues
53
Estimation Issues
s is j
where s 2
m = the variance of returns for the
aggregate stock market
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The Efficient Frontier
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Efficient Frontier
for Alternative Portfolios
Efficient
E(R) B
Frontier
A C
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MODERN PORTFOLIO THEORY (MPT)
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Modern Portfolio Theory
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Modern Portfolio Theory
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l For a well-diversified portfolio, the risk - or
average deviation from the mean - of each
stock contributes little to portfolio risk.
Instead, it is the difference - or covariance -
between individual stocks' levels of risk that
determines overall portfolio risk. As a result,
investors benefit from holding diversified
portfolios instead of individual stocks.
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Number of Stocks in a Portfolio and
the Standard Deviation of Portfolio
Return
Unsystematic
Standard Deviation of
(diversifiable)
Risk
Return
Total
Risk Standard Deviation of
the Market Portfolio
(systematic risk)
Systematic Risk
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THE EFFICIENT FRONTIER
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l Any portfolio that lies on the upper part of the
curve is efficient: it gives the maximum
expected return for a given level of risk.
A rational investor will only hold a portfolio that
lies somewhere on the efficient frontier. The
maximum level of risk that the investor will
assume is determined by the position of the
portfolio on the line.
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l Modern portfolio theory takes this idea even further.
It suggests that combining a stock portfolio that sits
on the efficient frontier with a risk-free asset, the
purchase of which is funded by borrowing, can
actually increase returns beyond the efficient frontier.
In other words, if you were to borrow to acquire a
risk-free stock, then the remaining stock portfolio
could have a riskier profile and, therefore, a higher
return than you might otherwise choose.
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l What MPT Means for You
Modern portfolio theory has had a marked
impact on how investors perceive risk, return
and portfolio management.
l The theory demonstrates that portfolio
diversification can reduce investment risk. In
fact, modern money managers routinely
follow its precepts.
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Modern Portfolio Theory
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Modern Portfolio Theory
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Modern Portfolio Theory
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Modern Portfolio Theory
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CONCLUSION
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CONCLUSION
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CONCLUSION
l At the end of the day, a portfolio's success
rests on the investor's skills and the time he
or she devotes to it. Sometimes it is better to
pick a small number of out-of-favour
investments and wait for the market to turn in
your favour than to rely on market averages
alone.
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THANK YOU
FOR LISTENING
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