Finance School of Management

Chapter 12: Choosing an

Investment Portfolio

Objective
• To understand the theory of personal
portfolio selection in theory
and in practice

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Finance School of Management

Chapter 12: Contents

 The process of personal portfolio selection

 The trade-off between expected return and risk
 Efficient diversification with many risky assets

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Finance School of Management

The Concept of ‘Portfolio’

 A person’s wealth portfolio includes

– Assets: stocks, bonds, shares in unincorporated
business, houses or apartments, pensions
benefits, insurance policies, etc.
– Liabilities: student loans, auto loans, home
mortgages, etc.

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Finance School of Management

Portfolio Selection
 A study of how people should invest their wealth
optimally
 A process of trading off risk and expected return
to find the best portfolio of assets and liabilities
 Narrow and broad definitions:
– How much to invest in stocks, bonds, and other securities
– Whether to buy or rent one’s house
– What types and amounts of insurance to purchase
– How to manage one’s liabilities
– How much to invest in one’s human capital

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Finance School of Management

Portfolio Selection

 Although there are some general rules for

portfolio selection that apply to virtually
everyone, there is no single portfolio or
portfolio strategy that is best for everyone.

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Finance School of Management

The Life Cycle

 In portfolio selection, the best strategy depends on
an individual’s personal circumstances (family
status, occupation, income, wealth).
 Illustrations
– Young couple: buy a house and take out a mortagage loan /
older couple: sell house and invest in assets provding a steady
stream of income.
– Investing in stock market: Chang (30, a security analyst) /
Obi (30, an English teacher).
– Buying insurance policies: Miriam (a parent with dependent
children) / Sanjiv (a single person with no dependents).

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Finance School of Management

Time Horizon
 In formulating a plan for portfolio selection, you
begin by determining your goals and time horizons.
– Planning horizon: the total length of time for which one
plans
– Decision horizon: the length of time between decisions to
revise the portfolio
– Trading horizon: the minimum time interval over which
investors can revise their portfolios / its determination and
impacts
– Investment strategy & trading horizon: portfolio insurance
or dynamic portfolio strategy.

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Finance School of Management

Risk Tolerance

 A major determinant of portfolio choices

 It is influenced by such characteristics as
– age, family status, job status, wealth, and
– other attributes that affect a person’s ability to maintain
his standard of living in the face of adverse movements
in the market value of his investment portfolio

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Finance School of Management

Professional Asset Managers

 Investment advisors & “finished products” from

a financial intermediary
 Specialization, information and cost advantages

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Finance School of Management

The Trade-off between Expected

Return and Risk
 The objective is to find the portfolio which
offers investors the highest expected rate of
return for the degree of risk they are willing to
tolerate.
 Two step process:
– find the optimal combination of risky assets.
– mix this optimal risk-asset with the riskless asset.

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Finance School of Management

Riskless Asset
 A security that offers a perfectly predictable rate
of return in terms of the unit of account selected
for the analysis and the length of the investor’s
decision horizon.
– For example, if the U.S dollars is taken as the unit of
account and the decision horizon is half a year, the
riskless rate is the interest rate on U.S Treasury bills
maturing after half a year.

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Finance School of Management

Rates of Return on Risky Assets

 Required return depends on the risk of the

investment.
– Greater the risk, greater the return
– Risk premium

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Finance School of Management

Security Prices

100000

Stock
10000 Bond
Stock_Mu
Value (Log)

Bond_Mu

1000

100

10
0 5 10 15 20 25 30 35 40
Years

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Finance School of Management

Security Prices

100000

Stock
10000 Bond
Stock_Mu
Value (Log)

Bond_Mu

1000

100

10
0 5 10 15 20 25 30 35 40
Years

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Finance School of Management

Probabilistic Stock Price Changes Over Time

0.020
0.018 Stock_Year_1
Stock_Year_2
0.016
Stock_Year_3
Probability Density

0.014 Stock_Year_4
0.012 Stock_Year_5
Stock_Year_6
0.010 Stock_Year_7
0.008 Stock_Year_8
Stock_Year_9
0.006
Stock_Year_10
0.004
0.002
0.000
0 200 400 600 800
Price

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Finance School of Management

Probabilistic Bond Price Changes over Time

0.045
Bond_Year_1
0.040
Bond_Year_2
0.035 Bond_Year_3
Bond_Year_4
Probability Density

0.030 Bond_Year_5
0.025 Bond_Year_6
Bond_Year_7
0.020 Bond_Year_8
Bond_Year_9
0.015
Bond_Year_10
0.010

0.005

0.000
0 100 200 300 400
Price
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Finance School of Management

Measuring Portfolio Return

 Portfolio of n risky assets

 I (1  r )
i i n
rp  i
 1   wi ri
I i 1

 wi  1
i

– Ii : the initial investment in asset i (if Ii <0, short selling)

– wi: the proportion of the portfolio investing in asset I
– ri : the rate of return on asset I
– rp: the rate of return on the portfolio

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Finance School of Management

Short Selling

If I k  0 , then  wi  1
i k

– Ik < 0 : short selling (borrowing) asset k

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Finance School of Management

Mean and Variance of Portfolio Return

n
rp  E(rp )   wi E(ri )   wi ri
i 1 i

 2p    wi w j  ij i  j
i j

– ri : the expected value of ri

–  i : the standard deviation of ri
–  ij : the correlation between ri and rj

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Finance School of Management

 Variance with 2 Securities

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

 Variance with 3 Securities

 p2  w12 12  w22 22  w32 32  2w1w2 1 2 1,2 

2w1w3 1 3 1,3  2w2 w3 2 3 2,3

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Finance School of Management

An Example: A Portfolio of BM and FM

 Suppose you invest $6000 in Bristol-Myers at an expected
return of 15%, and $4000 in Ford Motor at an expected
return of 21%.
 The standard deviation of the return on BM’s stock is 18.6%,
while the standard deviation of the return on FM is 28%.
 The correlation between the returns is 0.4.
rp  .60 .15  .40  .21  17.4%

 2p  .60 2  .186 2  .40 2  .28 2  2  .6  .4  .4  .186  .28  .0493

 p  .0493  22.4%

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Finance School of Management

Portfolios of BM and FM
Expected Return (%)
Ford Motor

40% F M
60% BM

Bristol-Myers

Standard Deviation (%)

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Finance School of Management

Portfolios of Two Correlated

Common Stock
 Two common stock with these statistics:
– mean return 1 = 0.15
– mean return 2 = 0.10
– standard deviation 1 = 0.20
– standard deviation 2 = 0.25
– correlation of returns = 0.90
– initial price 1 = $57.25
– initial price 2 = $72.625

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Finance School of Management

Share Prices

350

300
Value (adjusted for Splits)

250

200
ShareP_1
ShareP_2
150

100

50

0
0 1 2 3 4 5 6 7 8 9 10
Years
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Finance School of Management

Portfolio of Two Securities

0.25
Efficient Portfolio

0.20
Is one “better”?
Expected Return

Security 1 Sub-optimal Portfolio

0.15

Security 2
0.10
Minimum Variance Portfolio

0.05

0.00
0.15 0.17 0.19 0.21 0.23 0.25 0.27 0.29
Standard Deviation
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Finance School of Management

 Formula for Minimum Variance Portfolio

 2  1, 2 1 2
2

w1  2
*

 1  2 1, 2 1 2   22
 1  1, 2 1 2
2

w2  2
*

 1  2 1, 2 1 2   22
 1  w1*

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Finance School of Management

Portfolio Selection with n Risky Assets

minw  p2   wi w j ij i j  w w

i j
n
s.t. E (rp )   wi E (ri )  w r  
i 1
n

 w  w1  1
i 1
i

Harry Markowitz (1952): Portfolio Selection, Journal of Finance

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Finance School of Management

 Solution：
1
minw, , L  w w   (   w r)   (1  w 1)
2
 L
 w  w   r  1  0

 L
    w r  0
 
 L
 w  1  w 1  0


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Finance School of Management

where

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Finance School of Management

 Portfolio of many risky assets

Efficient frontier: the set of portfolios offering the highest
expected return for any given standard deviation.

Expected Return (%)

efficient frontier
minimum-variance
portfolio
Standard Deviation (%)

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Finance School of Management

Combining the Riskless Asset and a

Single Risky Asset: An illustration
 Let’s suppose that you have $100,000 to invest.
 You are choosing between a riskless asset with a interest
of 6% per year and a risky asset with an expected rate of
return of 14% per year and a standard deviation of 20%.
 How much of your $100,000 should you invest in the risky
asset?

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Finance School of Management

Mean and Standard Deviation

Proportion Proportion Expected

Standard
Portfolio Invested in the Invested in the Rate of
Deviation
Risky Asset Riskless Asset Return

F 0 100% 0.06 0.00

G 25% 75% 0.08 0.05
H 50% 50% 0.10 0.10
J 75% 25% 0.12 0.15
S 100% 0 0.14 0.20

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Finance School of Management

The Risk-Return Trade-off Line

0.16

0.14
S
0.12
Expected Return

J
0.1
H
0.08
G R inefficient
0.06
F
0.04

0.02

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Standard Deviation
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Finance School of Management

Combining the Riskless Asset and a

Single Risky Asset
 We know something special about the portfolio, namely
that security 2 is riskless, so σ2 = 0, and σp becomes

p  
w1 12  w2  0  2w1 w2 1  0
2
 12
 w1  1

rp  rf  (r1  r f )w1
where
If w1  0 rp  r f  [(r1  r f ) 1 ] p

else rp  r f  [(r f  r1 ) 1 ] p

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Finance School of Management

A Portfolio of a Risky and a Riskless Security

0.30

0.25

0.20

0.15

0.10
Return

0.05

0.00
0.00 0.10 0.20 0.30 0.40 0.50
-0.05

-0.10

-0.15

-0.20
Volatility

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Finance School of Management

Capital Market Line

0.30

100% Risky
0.25
Long risky and
0.20 short risk-free
Return

0.15
CML

0.10
Long both risky
and risk-free
0.05
100% Risk-less
0.00
0.00 0.05 0.10 0.15 0.20 0.25 0.30 0.35 0.40 0.45 0.50
Volatility
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Finance School of Management

Risk Premium
Sharpe
Ratio
r1  r f
rp  r f  p
1
 The slope (r1  r f )  1 measure the extra expected
return the market offers for each extra risk a
investor is willing to bear

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Finance School of Management

Achieving a Target Expected Return

 To find the portfolio corresponding to an expected
rate of return of 0.11 per year, we substitute 0.11 for
E(rp) and solve for w1.

0.11  0.06  0.08 w1

w1  0.375

 Thus, the portfolio mix is 62.5% risky asset and

37.5% riskless asset.

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Finance School of Management

Portfolios of the Riskless Security

and Two Risky Securities
 The riskless security and two risky securities with
the following statistics:
– riskless rate of return rf = 0.06
– mean return 1 = 0.14
– mean return 2 = 0.08
– standard deviation 1 = 0.20
– standard deviation 2 = 0.15
– correlation of returns = 0

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Finance School of Management

The Optimal Combination of the

Three Securities
0.16

0.14
S
0.12 ◆
Expected Return

T Tangent Portfolio
0.1

0.08 E R
0.06

0.04

0.02

0
0 0.05 0.1 0.15 0.2 0.25 0.3
Standard Deviation 40
Finance School of Management

 Formula for Tangent Portfolio

w1 
tan
r1  r f 
 2  r2  r f 1, 2 1 2
2

r1  r f  22  r2  r f  12  r1  r f  r2  r f 1,2 1 2

w2tan  1  w1
.08  .15 2  .02  0  .20  .15
w1tan 
.08  .15 2  .02  .20 2  0.08  0.02  0  .20  .15
w1tan  69 .23 % , w2tan  30 .77 %

E (rT )  0.12154  T  0.14595

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Finance School of Management

Efficient Trade-off Line

 New efficient trade-off line:

rT  r f
rp  r f   p  .06  .42165  p
T
 Compare the old trade-off line connecting points F and S.
rp  .06  .4 p

 Clearly the investor is better off.

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Finance School of Management

Achieving a Target Expected Return

 The investment criterion is to generate a 10% expected
rate of return.
0.10  0.06  (.12154  .06 ) wT
wT  .65
 p  .65  .14595  .09487

 Thus, the portfolio mix is 35% riskless asset and 65%

tangent portfolio, namely 45% risky security 1 and 20%
risky security 2.

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Finance School of Management

Selecting the Preferred Portfolio

 It is important to note that in finding the optimal
combination of risky assets, we do not need to know
anything about investor preferences.

 There is always a particular optimal portfolio of risky

assets that all risk-averse investors who share the same
forecasts of rates of return will combine with the
riskless asset to reach their most-preferred portfolio.

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Finance School of Management

The Rationale for Portfolio Selection

Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk

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Finance School of Management

 Portfolio of many risky assets and the

riskless asset

Expected Return (%)

Short sell

Efficient frontier

rf Tangent Portfolio

Standard Deviation (%)

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Finance School of Management

Efficient Frontier
 The jelly fish shape contains all possible combinations of risk and
return: The feasible set.
 The red line constitutes the efficient frontier of portfolios of risky
assets: Highest return for given risk.
 The tangent portfolio T is the optimal portfolio of risky assets
that all risk-averse investors will combine with the riskless asset.

Expected Return
T

Two-Fund Separation
Theorem (Tobin, 1958)

Standard Deviation
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Finance School of Management

Theory & Practice

 The static mean-variance model & elementary theory of
mutual fund financial intermediation.
 Dynamic versions integrating intertemporal optimization
of the life-cycle consumption-saving decisions with the
allocation of those savings among alternative
investments & a richer theory for the role of securities
and financial intermediation.
 Optimal combination of assets & optimal hedging
portfolio more tailored to the needs of different
clienteles.

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