Theory of Portfolio Allocation

Chapter 4 Part 1
Finance 327

Portfolios of U.S. Households

Big Question: What factors influence the way funds are distributed among different
assets? Depends on how much wealth you have in the first place, and characteristics
of the assets you have to choose from.
(1) Wealth elasticity
(2) After-tax return: Maximize expected return
(3) Risk: Minimize chance of losing money
(4) Costs of Acquiring Information
(5) Liquidity
Goal: Pick assets / portfolios that maximize your utility. Utility depends on return (more
return increases utility) and risk (more risk reduces utility.)

Risk and Return of Asset Classes

The table below illustrates the trade-off between risk and return.

Investors in stocks of small companies during these years experienced

the highest average returns but also accepted the most risk.
Investors in U.S. Treasury bills experienced the lowest average returns
but also the least risk.

Diversification, Risk, and Return

Background Assumptions
Investors want to maximize their expected returns for a given level of
risk, and minimize the risk for a given level of return.
Relationship between returns for assets in the portfolio is important.
A good portfolio is not simply a collection of individually good
investments.

Advantages of Diversification
Diversification is the allocation of savings among many different
assets.
Holding multiple assets:
Reduces risk
May raise return.

Types of Risk
Market Risk is common risk across assets and cant be eliminated by
diversifying
Idiosyncratic risk is unique to an asset and can be eliminated
Beta is a measure of systematic (market) risk

Reducing Risk Through Stock Portfolio Diversification

Relationship Between Risk and Return:

Capital Asset Pricing Model (CAPM)

Security Market line equation:

E (ri ) r f i ( E ( RM ) r f )
Where:

E(ri)
rf
Bi

= Expected return on asset i

= Risk-free rate
= Beta of asset i

E(rM) = Expected return on market portfolio

Note: the risk premium on the market portfolio is: (E(rM) - rf )

The CAPM equation tells you how much return investors require from an asset, in
order to be willing to hold the assets.

The CAPM Graphical Relationship Between Risk and Return

Rateof Return
Low
Risk

RFR

Average
Risk

High
Risk

Security
Market Line

The slope indicates the

required return per unit of risk
Risk
(business risk, etc., or systematic risk-beta)

Diversification and Risk in a portfolio setting

Financial risk = any uncertainty about future cash flows. Usually use standard deviation
= = square root of variance Assumes that assets returns are normally distributed
Portfolio return = Weighted average of individual investments returns

Portfolio Risk: Need to know the return and risk of each asset in the portfolio.
Measure risk with variance:

Variance ( )
i
n

(Probabilit y) (Possible Return - Expected Return)

i 1

Example: Probability Distributions of two different stocks -- tells you about

future riskiness
Stock A:

Stock B:

Return and risk of each stock:

Expected return best guess of the future return (weighted average of all future
possibilities)

p(s)[r (s) E(r)]

Risk = square root of variance =

where p(s) = probability of each possible outcome
r(s) = the return from state i

Going from a single asset to a portfolio Portfolio Standard Deviation

Formula
port

w i2 i2 w i w jCovij
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

Covij the covariance between th e rates of return for assets i and j,
where Covij rij i j