Investment Theory

COMM 371 - Class 13

Portfolio Theory: Optimal Portfolio

“Whether you think you can or you think you can’t, you’re right.”
Henry Ford

Prof. Elena Pikulina

October 26, 2015
 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Last Class

I Diversification

I Mean-Variance Criterion and the Portfolio Frontier

I Complete Portfolio and Capital Allocation Line

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Today’s Class

I Tangent Portfolio

I Portfolio Frontier with Multiple Risky Assets

I Limits of Diversification

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Tangent Portfolio

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Example

Example: The investment opportunity set consists of two risky assets, one
stock fund and one bond fund. The expected returns, standard deviations, and
the correlation are given by

µs = E (Rs ) = 10%, µb = E (Rb ) = 6%,

σs = σ(Rs ) = 25%, σb = σ(Rb ) = 12%,
ρsb = ρ(Rs , Rb ) = 0.2

Consider forming complete portfolios using the risk-free asset (Rf = 5%) and
risky portfolios based on stocks and bonds.

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Example: Portfolio Frontier

Mean - Standard Deviation Frontier
0.12

0.11

0.1 Stock Portfolio

Portfolio Expected Return

0.09
CALB

0.08
CALA
Alternative Portfolio

0.07

Minimum Variance Portfolio

0.06 Bond Portfolio

0.05

Risk-free Asset

0.04
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Portfolio Standard Deviation

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Tangent Portfolio

I Question: Can we do better than portfolio B? That is, can we make the
CAL slope even higher?

I Remember: every risky portfolio should be located on the mean-variance

frontier

I The optimal risky portfolio choice is the tangent portfolio

I Tangent portfolio weights:

wsTP = 1 − wbTP

(E (Rb )−Rf )σs2 −(E (Rs )−Rf )ρsb σs σb

wbTP = (E (Rb )−Rf )σs2 +(E (Rs )−Rf )σb2 −(E (Rb )−Rf +E (Rs )−Rf )ρsb σs σb

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Combining Risky Assets with the Risk-free Asset

Example continued:
The portfolio weights for the optimal (tangent) portfolio are wsTP = 67.01% and
wbTP = 32.99%.

The expected return and standard deviation of the optimal portfolio, say O, are
E (RO ) = 8.68% and σ(RO ) = 17.97%.

The CAL that corresponds to the optimal portfolio O has a slope of

E (RO ) − Rf 8.68 − 5
SO = = = 0.20.
σ(RO ) 17.97
This slope is higher than the slope of any other feasible risky portfolio

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Capital Allocation Line of the Optimal Tangent Portfolio

Mean - Standard Deviation Frontier
0.12

0.11

0.1 Stock Portfolio

Portfolio Expected Return

0.09
Optimal Risky Portfolio

0.08

Optimal CAL
0.07

0.06
Bond Portfolio

0.05
Risk-free Asset

0.04
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Portfolio Standard Deviation

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Forming a Complete Portfolio

Suppose the investor puts 55% on portfolio O and 45% on the risk-free asset to
form the complete portfolio C.
The expected return and the standard deviation of the portfolio C are:

E (RC ) = Rf + wO (E (RO ) − Rf ) = 5 + 0.55 × (8.68 − 5) = 7.02%

σ(RO ) = wO σO = 0.55 × 17.97 = 9.88%

The overall asset allocation of the complete portfolio are

Complete Portfolio Weights

Weight in risk-free asset 1 − wO = 1 − 55% = 45.00%
Weight in stock portfolio wsTP wO = 67.01% × 55% = 36.86%
Weight in bond portfolio wbTP wO = 32.99% × 55% = 18.14%
Total 100%

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Complete Portfolio: Graphical Representation

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Complete Portfolio Decomposition

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolio Frontier with Multiple Risky Assets

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolios of Multiple Risky Assets: Expected Return

I Suppose there are N risky assets to be combined in a portfolio

I wi : fraction of funds invested in asset i, where i = 1, . . . , N

I The portfolio expected return is

E (Rp ) = w1 E (R1 ) + · · · + wN E (RN )

I That is, the expected return of the portfolio is the weighted average of
expected returns of individual assets in the portfolio

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolios of Multiple Risky Assets: Variance

In the case of two assets the variance of the portfolio return is the sum of the
following four boxes:

Variance components

Asset 1 Asset 2
Asset 1 w12 σ(R1 )2 w1 w2 Cov (R1 , R2 )
Asset 2 w2 w1 Cov (R2 , R1 ) w22 σ(R2 )2

Recall that Cov (R1 , R2 ) = Cov (R2 , R1 ).

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolios of Multiple Risky Assets: Variance

In the case of N risky assets the variance of the portfolio return is the sum of
the following N 2 boxes:

Variance components
Asset 1 Asset 2 ··· Asset N
Asset 1 w12 σ(R1 )2 w1 w2 Cov (R1 , R2 ) ··· w1 wN Cov (R1 , RN )
Asset 2 w2 w1 Cov (R2 , R1 ) w22 σ(R2 )2 ··· w2 wN Cov (R2 , RN )
. . . .. .
. . . . .
. . . .
Asset N wN w1 Cov (RN , R1 ) wN w2 Cov (RN , R2 ) ··· wN σ(RN )2
2

I The terms on the diagonal are variances and the terms off the diagonal are
covariances

I The portfolio return variance is

XN XN XN
σ(Rp )2 = wi2 σ(Ri )2 + 2 wi wj Cov (Ri , Rj )
i=1 i=1 j=i+1

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolio Frontier for Multiple Risky assets

I Optimal combinations of individual assets result in minimum level of risk

for a given level of expected returns

I So, for a given target value of E (Rp ), we solve for the weights wi ,
i = 1, . . . , N, to minimize the portfolio return variance

I The optimal expected return-risk trade-off is described as the

mean-variance frontier

I Efficient frontier is the set of portfolios with maximum expected return for
a given level of variance

I The efficient frontier is the upward-sloping part of the mean-variance

frontier

I Complete portfolios using the risk-free asset are formed as in the case of
two risky assets

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

The Portfolio Allocation Optimization Problem

I Among all portfolios that have a given expected return, denoted by µ,

which one is the portfolio with the minimum variance?

I Choose portfolio weights wi , i = 1, . . . , N, to minimize

N
X X
Var (Rp ) = wi2 Var (Ri ) + 2 wi wj Cov (Ri , Rj )
i=1 1≤i<j≤N

subject to the constraints

N
X
wi = 1
i=1

and
N
X
E (Rp ) = wi E (Ri ) = µ.
i=1

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Portfolio Frontier with Multiple Risky Assets

Mean-Variance
Mean-Variance Frontier
Frontier (risky
(risky assets)
assets)
E(rp) Efficient
frontier

Individual
Global assets
minimum
variance
portfolio Minimum
variance
frontier

σp
Modern Portfolio Theory (Review)
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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Limits of Diversification

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Limits of Diversification: Systematic vs. Idiosyncratic Risk

I Adding assets reduces the variance that can be achieved for a given
expected return.

I This is simply another way to say that diversification reduces risk.

I Question: How much can risk be reduced? Can it be reduced to zero, by

adding a very large number of assets?

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Theory . . .
Consider an equally weighted portfolio of N assets, and assume that: (1) all
assets have the same standard deviation (σ), (2) all assets are equally correlated
with each other (correlation ρ). The portfolio return variance is equal to
 
1 N −1
σp2 = σ 2 + ρ
N N
√ √ √
As N increases, we have σp /σ → ρ ( 0.1 = 0.316, 0.2 = 0.447)
σ(Portfolio Return)/σ(Individual Asset Return)

1
ρ= 0
0.9 ρ = 0.1
ρ = 0.2
0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
0 20 40 60 80 100 120 140 160 180 200
Number of Assets

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

. . . and some Evidence

Consider an equally weighted portfolio of randomly selected NYSE stocks.

Ratio of Portfolio
Number of Standard
Std. Dev. to Std.
Stocks in Deviation of
Dev. of a Single
Portfolio Portfolio
Stock
1 49.2% 1.00
2 37.4 0.76
4 29.7 0.60
8 25.0 0.51
20 21.7 0.44
50 20.2 0.41
200 19.4 0.39
500 19.2 0.39
1000 19.2 0.39
Source: Statman, Meir, 1987, How many stocks make a diversified portfolio?
Journal of Financial and Quantitative Analysis 22, 353-364.
This is consistent with the theory, assuming that the average correlation is
around 0.2.

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

The power of diversification

Most of the diversifiable risk eliminated at 25 or so stocks (from different

industries)

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Systematic vs. Idiosyncratic Risk

Consider a group of assets

I Systematic Risk: Risk which affects all assets

I If, for instance, the assets are US stocks, systematic risk corresponds to
events affecting the US economy

I Idiosyncratic Risk: Risk which affects only one asset

I For US stocks, idiosyncratic risk corresponds to events affecting only the
particular company or industry

I Diversification within the group of assets reduces, and eventually

eliminates, idiosyncratic risk

I However, it cannot reduce systematic risk

I Diversification outside the group of assets (if it is possible) is more

effective in reducing risk

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Limits of diversification

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 Tangent Portfolio
Portfolio Frontier with Multiple Risky Assets
Limits of Diversification

Summary, Suggested Problems and Next Class

I Tangent portfolio is an optimal risky portfolio for ALL investors

I Optimal complete portfolio depends on investor’s risk attitude
I Systematic vs. idiosyncratic risk

I PPS6 is on Connect
I Quiz 5 is due on Friday, Oct. 30, 5:59pm.

I Next class
I Passive Investment Strategies and Index Construction

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