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Portfolio Selection | A Matter of Course

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Theresultthatvarianceofthemarketportfolioisaweightedaverageofcovarianceoftheunderlying
stockswiththemarketisageneralresult.Thispostfillsinthemathematicalblanks.
Diversifiablevs.NondiversifiableRisk:TheMath
ConsiderthevarianceofaMarkowitzportfolio

containing

assets:

Nowifwelettheweightofeachassetintheportfoliotobethesame,i.e.
considertheaveragevarianceas:

,and

andaveragecovarianceas:

thentheaboveportfoliovariancesimplifiesto:

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Thenas

,theportfoliovariance

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convergesto:

That is, as the number of assets in the portfolio go up, the variance of individual assets become
unimportant,anditsthecovariancetermsthatdominate.Thisisjustourdiversification.Graphically
thiscanberepresentedas:

Diversification(Clickonthefiguretozoom;Source:BrealeyMyers,9thEd.)
Unique Risk (or alternatively, Diversifable Risk, or Unsystematic Risk, or Idiosyncratic Risk) is the
averagevarianceoftheindividualassets.
Asnumberofassetsintheportfolioincrease,thisaveragevariancetendstozero.Theonlyrisk,then,
thatmattersistheonethatremainsafterdiversificationhasdoneitswork.Andthisisjusttheaverage
covariancebetweenallassetsintheportfolio.ThisiscalledMarketRisk(oralternatively,Systematic
Risk,orUndiversifiableRisk).Andaccordingly,thecovarianceofanassetwiththemarketportfoliois
calleditsmarketrisk.
Thefactthatportfoliovarianceafterdiversificationisjusttheweightedaverageofcovariancebetween
assetscanbeseenbyfirstnotingthat:

Sincetheexpectationsaddup,wecantakeoutthesummationsignoutsidetheexpectation,andit
followsthat:

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Thatisthecovarianceofanyassetwiththemarketportfolioisnothingbuttheweightedaverageofits
covariancewithallotherassetsintheportfolio.
Next,notethatwecanwrite:

(Ifyouarelookingforthevarianceterms,notethechangeinthelimitsinthesummationoperator,and
recallthat
)
Thenifwesubstituteourresultthat

,weseethat:

Thatisthevarianceofthemarketportfolioisjusttheweightedaverageofthecovarianceofallassetsin
theportfoliowithitself.Again,thisresultisimportantenoughtowarrantaseparatebox:

Ifyounotice,whatwehavedoneisessentiallygivenaproofthatcovariancesaddup.
Toseethis,recallfromyourbasicprobabilitytheorythatforanythreerandomvariables,
:

and

.
Ifwelet

,andusethefactthat

,itimmediatelyfollowsthat

Ourproofaboveisjustageneralizationofthisresult.Combinethiswithourobservationthatinthe
limitindividualvariances(uniquerisks)disappearandwehaveoureconomicresultthat:
MoraloftheStory4:Theriskofanindividualassetisdeterminednotbyitsindividualvariance,but
byitscovariancewiththemarketportfolio,becausethediversifiable/unique/idiosyncraticriskcan
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bediversifiedaway.
WrittenbyVineet
September3,2015at9:19am
PostedinDiversification,FM,PortfolioSelection
TaggedwithDiversification,FM2,PortfolioTheory,Session9

leaveacomment
Enjoy!

WrittenbyVineet
August29,2015at6:09am
PostedinFM,PortfolioSelection,Stories
TaggedwithFM201516,History,Interview,Markowitz,Stories

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Atthisstage,havingintroducedthenewstraightlineecientset,weareallbuttheretoourfinal
destination.So,letsstepbackabitandtryandunderstandthelargerpicture.
In the beginning was the ecient frontier. Markowitz gave us that. Ecient frontier describes
themaximumpossibleexpectedreturnforanygivenamountofriskfromtheportfolioofavailableassets.Or
alternatively,theminimumamountofriskthatonemustlivewithforanygivenamountofexpectedreturn.
Asafirststep,wemovedfromindividualassetstoportfoliosthatlayontheecientfrontier.Whenwe
didthatimplicitlythexaxis(labeledasrisk/standarddeviation)thenbecametheriskoftheportfolio
(andnottheriskoftheindividualassets).Thereshouldbenocauseforthisconfusion,butnoharm
emphasizingitnonethelesstherightrisktoconsideristheriskoftheportfolioandnottheindividual
asset.
MoraloftheStory1:Whenweconsidertheecientfrontiertherelevantquantitiestoconsider
areportfolioriskandportfolioexpectedreturn.
Then,ofcourse,TobincamealongandintroducedariskfreeassetintheMarkowitzworld,andhesaid
wecouldignoreallotherpointsonthefrontierexceptthetangencyonebecauseeverybodywould
holdsomeproportionofonlythetangencyportfolio
(asallotherpointsevenontheenvelopeare
now inferior), and the line connecting the return from the risk free asset
and the tangency
portfoliooersthebestpossiblecombinationsofportfolioriskandexpectedreturn.Remember,the
operativewordhereisportfolio.
Thisgaveusourrevisedecientsetas:

(Clickonthefiguretozoom.)
Theequationofthenewecientsetimmediatelyfollows(itsalinearlinewithinterceptat
slope

and

)as:

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Whatisthetangencyportfolio

Havingsaidthatallinvestorsshouldholdthetangencyportfolio
,thenextthingtounderstandis
the meaningofthistangencyportfolio.Bysayingthatallinvestorsshouldhold
, what we are
andtheriskfree
essentiallysayingisthatinvestorswoulddemandonlycombinationsofportfolio
asset.(Holdinganyotherriskyportfoliootherthan
isinecient.)Thisisthedemandsideofthe
problem.Whatisthesupplyside?Thesupplysideisjustalltheassetsthatexistinthemarket.
Andbynowyouwouldknowenoughofmicroeconomicstounderstandthatequilibriumrequiresthat
demandbe same assupply.Thatis,assetsdemandedinthe portfolio
must exactly equal the
supplyofeachassetinthemarket.Andthesupplyofeachassetinthemarketisgivenbyitsmarket
capitalization.So,inequilibriumallassetsmustbeheldin
inexactlythesameproportionas
their market capitalization. That is, in percentage terms weight of assets in the total market
capitalizationandintheportfolio
mustbethesame.
ConsiderthecasewhereyourunyourMarkowitz optimizerandfindthatthatweightofaparticular
asset,say
is .Isthatpossible?Mathematically,ofcourse,yes.Butwhatabouteconomically?
Letstryandunderstandthis.
Sayingthattheweightofanasset
intheMarkowitzportfolio
is issayingthatnoinvestor
wantstoholdthe
asset.Ifnoinvestorwantstoholdthatasset,buttheassetexistsinthemarket
thenwehaveastateofdisequilibrium.Andwhathappensinastateofdisequilibrium?Pricesadjust.
So,ifnowantstoholdanasset,itspricewilldrop.Oncethepricestartstodropitsexpectedreturn:

willrise.Asthepricestartstofall,andexpectedreturnstartstorise,investorswouldstarttofindthis
asset more attractive. As its expected return
rises even more, then when you rerun your
Markowitzoptimizeragain,youllfindthatthisassethasanonzeroweightinthetangencyportfolio
.Thatis,allassetsthatexistinthemarketmustbeheld.Thisbringsustoanotherimportantlesson:
MoraloftheStory2:Thetangencyportfolio

isnothingbutthemarketitself!

AsanotherexampleconsiderasituationwheretheMarkowitzoptimizerprescribesaweightof
foranassetwhosemarketcapitalizationis
.Whathappensinthatcase?Well,nowyouknowhow
tothinkaboutsuchdisequilibriumsituations.Thisisthecasewheretheassethasmoredemandthan
supply.Whendemandismorethansupply,pricesrise.Aspricerises,theexpectedreturnwillfall.As
expected return falls, the Markowitz optimizer will prescribe a lower weight to this asset and in
equilibriumthe price andthe marketcapitalizationofthe assetwouldadjusttomake the demand
exactlyequalsupply.Thatis:
Whenoneimposesequilibrium,thelinepassingthroughthetangencyportfoliohasaspecificname
anditiscalledtheCapitalMarketLine.
Notethatatthisstage,whenweimposeeconomicequilibrium,wehavetonecessarilyassumethat
everybodyhasthe same information thingsdont quite workthe same wayotherwise.Andthis
bringsustothelastmoralofthestoryfortoday:

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MoraloftheStory3:AllecientportfolioslieontheCapitalMarketLine.
Again,asinthecaseoftheecientfrontier,therelevantquantitiesintheCapitalMarketLineare
theexpectedreturnandriskofecientportfolios.Allindividualstocksandotherinecientportfolios,
however,wouldbeanywherebelowtheecientfrontier,assayintheshadedportionofthegraph
below(fromyourbook;thinkof intheplotbelowastheequilibriummarketportfolio):

CMLwiththeEcientFrontier(Clicktozoom;Source:BrealeyMyers,9thEd.)
WrittenbyVineet
August28,2015at3:54pm
PostedinCapitalMarketLine,FM,PortfolioSelection
TaggedwithBank,CapitalMarketLine,Equilibrium,FM201516,Markowitz,Session8,Tangency
Portfolio,Tobin

withonecomment
Forallhisinsightsontheportfoliochoiceproblem,somehowMarkowitzdidntexplicitlyconsidera
bankinthesystem.Inprinciple,ofcourse,onecouldhavesolvetheproblembyjustaddingonemore
securityinhissetup.However,itturnsoutthathavingabankinthesystemisnotjustamatterof
addingonemoresecuritytotheworldthereisabitmoretoit.
LetsfirstconsiderhowaMarkowitzianwouldhandlethisproblem.AfanofMarkowitzwouldjust
rerunthefollowingoptimizationproblem,butinsteadwouldconsider
assetsinsteadof
,i.e.
nothingmuchreallychanges:

So,wewouldneedtorerunouroptimizationsoftwareandthiswillgiveusanewallocationofweights
toallthesecurities.Today,ofcourse,theproblemishardlydicult(youcanevendoitinExcel).Butis
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itthebestwaytointroduceariskfreeassetintheMarkowitz world?
JamesTobin,acolleague ofMarkowitzsatthe CowlesFoundationinthe50s(andanother Nobel
Laureate)arguedthatitsnot.Andbrilliantashisdevicewas,wecaneasilyseeitsimpactinatwo
stockworld.
Inourfamiliartwostockworld,letoneoftheassetsberiskfree,suchthatitsrateofreturnisknown
todayas
withvariance,ofcourse,zero.Then,sinceoftheassetsisnomorearandomvariable,
eventhecorrelationbetweenthetwo wouldalsobe0.So,ifinoursetofequations:

welet

weareleftwith:

Thatis,ourEcientFrontierinthiscaseissimplyastraightlineconnectingtherateofreturnfromthe
riskfreeasset
andtheexpectedreturnfromtheasset
,withslope
Ifone could
,thenwecouldeven
assumethatpeoplecouldbothborrowandlendatthesameriskfreerate,
considernegative weightsonthe riskfree asset,andextendthe EcientFrontiertothe right(the
bluedotsinthegraphbelow).So,ifaninvestorwouldextremelyrisklovinghe/shecouldborrow
moneyfromthebankandinvestitinthesecondriskyasset.

(Clickonthegraphtozoom.)
WiththisinsightTobinsaidthatwiththeriskfreeassetintheworldinthe
assetMarkowtizian
world,wecanjustconsidersuchstraightlinesemanatingfromtheinterceptontheordinate(return
fromtheriskfreeasset
)andconnectingwithallthepointsonEcientFrontier.Thatis,hesaid,
ratherthanrerunningtheMarkowitzoptimizer,letsonlyconsiderfollowingstraightlinesconnecting
theEcientFrontier:

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(Clickonthegraphtozoom.)
Thatis,insteadofconsideringjustsingleassets,Tobinarguedwecouldconsiderconnectingstraight
lines to ecient portfolios. And lines of the kind
,
and
all such
possibilities.BynowitshouldbeclearthatwehaveanewEcientFrontierwhichistheline
.
Sowhilepointslyingtotheleftofthebluedotsmeanthatsomeofthewealthisinvestedinthe
riskfreeassetandsomeintheportfolio
(calledthetangencyportfolio),andpointslyingonthe
bluedotsrepresentthepointswhereaninvestorhasputallofoneswealthinthetangencyportfolio
andthensome.
Thatis,asweseehavingariskfreeassetintheMarkowitzworldchangeseverything.Insteadofa
concaveenvelopesuperiortoallotherindividualassetsandinecientportfolios,havingabankinthe
worldmeansthatallinvestorsshouldparkalltheirweightonlyincombinationoftheriskfreeasset
andthetangencyportfolio.

Anotherwayofstatingthe same thingistosaythatthe line from


to
isthe steepest, or
alternativelyoersthemaximumrewardperunitofriskcomparedtoanyotherpointonthefrontier.
Thatis,theslopeoftheline
ismorethanslopeofbothlines
and
.
Financialmarketprofessionalshavekindamadethisideatheirownandturneditintoameasureof
performance to gauge the excess return per unit of risk from investment choices made by fund
managers.Theycallthe slope ofthe linesemanatingfrom
andjoiningpointsonthe ecient
frontier,like
,
and
,astheSharperatio.
isthehighest,soistheSharperatioofinvestmentinthemarket
Sincetheslopeoftheline
portfolio.Note that since Sharpe ratio isdefinedin termsof expectedreturns,exante (or before
thefact)Sharperatioofinvestmentinthemarketportfolioisthehighest.So,foragivenpoint,say, ,
ontheecientfrontiertheSharperatioisgivenas:

This brings us to the second separation theorem in finance, and it goes by multiple names
ofTobin/Twofund/MutualfundSeparation Theorem.Itsimportant enough towarrant a formal
statement:
Mutual Fund Separation Theorem: Each investor will have a utility maximising portfolio that is a
combinationoftheriskfreeassetandatangencyportfolio
.Allriskyportfoliosotherthantheportfolio
areinecient.
Note that all points to the top of
are unattainable. Our original Ecient
Frontierpresentedallpossibilitiesgivingmaximumreturnforanygivenlevelofrisk.Havingariskfree
assetimpliesthatthelineconnectingthereturnfromtheriskfreeassetandthetangencyportfolio
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dominatesallotherpossibilities.Thisisthenewecientfrontier.
Andnowwe cangetridofthe originalconcave envelope,andwe are leftwithjustthe
line.AndaquickGoogleImagesearchgivesusthisnicelittlepicturepresentingdierentpossibilities
combiningtheriskfreeassetandthetangencyportfolio:

[Clickonthefiguretozoom;Source:Wikipedia]

Postscript
Needlesstosay,bydefinition,Sharperatiocoincideswiththeslopeofthe
investmentmanagerchooses
asthepointonthefrontier,i.e.:

linewhenthe

HereisNobelLaureateWilliamSharpeontheratiothatbearshisname.
WrittenbyVineet
August28,2015at3:45pm
PostedinCapitalMarketLine,FM,PortfolioSelection
TaggedwithBank,CapitalMarketLine,FM201516,Markowitz,Session8,TangencyPortfolio,Tobin

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WithMarkowitzhavingshownusthatonlyexpectedreturnandvarianceofthegamblesmatter,we
neednotrestrictourselvestoconsidering12080kindofgambleswithonlytwopossiblestatesofthe
world.Theonlythingweneedisestimatesofexpectedreturnandvarianceofthegamblesandwe
canstudytheircombinationsmoregenerally.Letsdothatnow.

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Consider two stocks


and
with expected returns
, variances
and
correlation
between them. If we consider an investor with unit wealth, with amount
investedinstock
,and
investedinstock
thenthe portfolioexpectedreturn
andportfoliovariance
areeasilyobtainedusingsomebasicresultsfromprobabilitytheory
as:

Thatis,aslongas
,portfoliorisk(standarddeviation)isalwayslessthanthe risk(standard
deviation)ofthelinearcombinationofassetsintheportfolio.Thisiscalleddiversification.
It should be clear that the relationship between the portfolio weight in any asset and portfolio
expectedreturnislinear,andthatbetweenportfolioweightandvarianceisquadratic.Ourpurpose,
however,istolookatthetradeobetweenexpectedreturnandvarianceoftheportfolio.
Weareluckythattherelationshipbetweenexpectedreturnandweightinanyassetislinearsowecan
eliminatetheweightsandexpressexpectedreturnasaquadraticfunctionofvariance.Thealgebraic
expressionismessyandlacksintuition,butforanygivenlevelof ,itcanshown(andaswedidinthe
classusingExcel)thatshapeofthetradeoissomethinglikethis:

EcientFrontier:TwoAssets
Thatis,theopportunitiesavailabletoaninvestorisaconcaveenvelope.Andthisenvelopecaptures
thetradeobetweenexpectedreturnandriskavailablefromtheportfolio(geometricallyspeaking,itis
aconicsectionyoucandothemathandcheckwhichone!).
Itshouldbeclearthattoarationalinvestorallthepointsbelowtheminimumvariancepointshouldbe
inferiorasallthosepointsrepresentalowerexpectedreturnforanygivenlevelofrisk.Thatis,no
rationalinvestorwouldprefertochooseaportfoliothatliebelowtheminimumvariancepoint.
The envelope traced by the upper arm of the curve above the minimum variance point is called
theOpportunitySet(orEcientSetorEcientFrontier).Thisisthesetofopportunitiesavailableto
arationalinvestorgiventhesecuritiesavailableinthemarket.
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So,accordingtoMarkowitz allinvestorsshouldchooseoneoftheportfolioslyingontheEcient
Frontierdependingontheirdegree ofriskaversion.So,ifaninvestorisrisklovinghe/she should
choose one of the points on the top right end (high risk, high expected return), or if he/she is
riskaversechooseoneofthepointsonthebottomleftpartofthefrontier,butneverbelowtheFrontier.
InatwoassetworlditwaseasytovisuallyidentifytheEcientFrontierbutforan
assetworld,
theMarkowitzportfolioselectionboilstosolvingthefollowingQuadraticProgrammingproblem:

oralternatively,

AndhowdoestheEcientFrontierlookslikeforthecaseof
assets?Asexpected,allthesetof
opportunities available increase. But, importantly, luckily for us, Robert Merton showed that
theEcientFrontierretainsthesameconcaveshapewhateverbethenumberofsecuritiesinthe
market.Ingeneral,theshapelookssomethinglikethefollowing(fromyourbook):

EcientFrontier:MultipleAssets(Clickonthegraphtozoom;Source:BrealeyMyers,9thEd.)
Again,accordingtoMarkowitz,noinvestorshouldbeonanypointbelowthepinkline(Ecient
Frontier,tracedbyABCD),i.e.intheshadedregion,asallpointsonthecurveABCDoerahigher
expectedreturnforanygivenlevelofrisk/variance.
Giventhatexpectedutilityisalsoafunctionofexpectedreturnandvariance,byclubbingthe two
togetherMarkowitzhadsolvedthePortfolioSelectionproblemforarationalinvestor.So,ifaninvestor
wereriskaversehe/shewouldchooseaportfoliolikeCorD,andifonewererisklovingthenhe/she
wouldchooseaportfoliolikeBorA,butneveranythingbelowthecurveABCD.

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SpecialCases
Inthetwostockworldtwospecialcasesareinteresting.
Consider two stocks
and
with expected returns
, variances
and
correlation
betweenthem.Wehadthefollowingrelationshipsfortheportfoliovariancefromthe
twostocks:

1.Perfectpositivecorrelation:
Setting

doesntchangetheexpectedreturn

,butsimplifiestheportfoliovarianceto:

i.e.theportfoliostandarddeviationisjustaweightedaverageofthestandarddeviationofthetwo
assets.Thisisthe case ofzerodiversification. Thinkofitthisway.Ifthe twostocksare perfectly
positivelycorrelated,thatistheymoveinlockstepinthesamedirectionallthetime,itsasiftheyare
thetwosamestocks
2.Perfectnegativecorrelation:
Again,setting
to:

doesntchangetheexpectedreturn

,butsimplifiestheportfoliovariance

While eveninthiscase the portfoliostandarddeviationisjustaweightedaverage ofthe standard


deviationofthetwoassets,therearetwopossibilities(tworoots)giventhemagnitudeof
.
Whilemathematicallytherearetwopossibilities,asthegraphbelowshowsus,economicallythereis
onlyonepossibility.
Whatsmore interesting,however,isthatwhen
zero.Howisthat?Wehave:

,wecanreducetheportfoliovarianceto

Andsetting,

Thatis,whenthereisperfectnegativecorrelation(recallourearlier 12080example),byappropriately
allocatingourwealthinthetwostockswecanreduceourportfoliovarianceto0,i.e.removeallrisk.
Thisisthecaseofperfectdiversification.
Ingeneral,dependingonwhetherthe value ofthe correlationissuchthat
,theecientfrontierchangesasbelow:
13 of 17

or

,or

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EcientFrontier:TwoAssets(SpecialCases)
WrittenbyVineet
August27,2015at11:06am
PostedinFM,PortfolioSelection
TaggedwithFM201516,Markowitz,PortfolioTheory,Session7

withonecomment
InourjourneysofarfromgivingajustificationforNPVforvaluinginvestmentstovaluation of
commonstockswehavebeentalkingaboutriskallalong,butwehaventreallydonefulljusticetoit.
Fairenough,itsbeenatthebackofourmindinallourdiscussionsallalong,butwestilldontquite
haveawaytomeasureit.
Likeformostfundamentalideasinfinance,thefirstsystematictreatmentofriskcanalsobetraced
backtoearly/midtwentiethcentury,andthisbringsustothethirdprotagonistinourstory.
In the early 50s, a precocious graduate student at the University of Chicago named Harry
Markowitzwaslookingforasuitabletopicforhisdissertation.Anencounterwithatradersparked
his interest in financial markets, and his wouldbe adviser suggested he read John Burr Williams
TheoryofInvestmentValue,whoseDividendDiscountModelwelearntwhiletalkingaboutcommon
stockvaluation.
WhatstruckMarkowitzwasthatifJohnBurrWilliamstheoryiscorrect,thenpeopleshouldbuyjust
one stockthe one thatoeredthe maximumpossible expectedreturnandnothingelse.But,he
noticed, obviously its not what people did (or do). To quote Peter Bernstein in his rather
entertainingbiographyoffinance,Markowtiz
wasstuckwiththenotionthatpeopleshouldbeinterestedinriskaswellasreturn.
This, of course, is nothing new to us now. We learnt that while talking about the St. Petersburg
Paradox: that while valuing risky gambles we should not be looking at expected return from the
gamble,butexpectedutilityofreturnsfromthegamble.
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Weve already talked at length about the implications of concavity of utility curves. One of the
consequencesofthatwasforanyriskygamble
,expectedutility
isalwayslessthanthe
utility of the payo
(mathematically also known as the Jensens inequality for concave
functions),i.e.:

Markowitzfiguredthisouttoo,andhe exploitedthisideatocome upwithawaytoquantifythe


tradeobetweenriskandreturn.

Givenacertainstartingwealth
investmentsinriskygambles.

,Markowitz studiedthe change inexpectedutilitytomarginal

Thatis,heconsideredthequantity
startingwealth
.

foranysmallriskygamble

relativetothe

Asyoumayhavedoneinyourstatisticscourses,ausefulwaytothinkaboutariskygambleisasa
randomvariable(somethingthattakesadierentvaluedependingonthestateoftheworld).Since
wecantalkabout asarandomvariable,wecantalkaboutitsexpectedvalue,say ,andvariance,
say
.
With smallwecanevaluate
asaTaylorseries,andthentheexpectedutilityfrom
wealthincludingthegamblecanbewrittenas:

With

smallwecanignorethetheexponentsof

Givenacertain(sure)starting

greaterthan

,andthisgivesus:

,wecanwritetheaboveas:

thatis,thechangeinexpectedutility:

Giventhat issmall,itsexpectedvalue
ignorethehigherpowersof togive:

Since

where

15 of 17

isknown,soare

,beinganaverage,wouldbe smallerstillandwe can

,andwehave:

becauseconcavityof

implies

and

.The

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coecient
defines a measure of relative risk aversion. That is, higher the value of , more
riskaversetheperson,andloweritsvaluemorerisklovingtheperson.(Whatwouldbethevalueof
forariskneutralperson?Whataboutforarisklovingperson?)
Thatis,thechangeinexpectedutilityfromamarginalgambledependsonlyontheexpectedreturn
andvariance ofthe gamble.Andexpectedutilitygoesupasthe expectedreturnfromthe gamble
increasesandgoesdownasvarianceincreases.
Forsmallgambles,thenaccordingtoMarkowitz peopleshouldonlyconsiderasinglenumbertotalk
aboutrisk,i.e.itsvariance
,irrespectiveofthenumberofstatesoftheworld.Thisturnedouttobea
revolutionaryideainthehistoryoffinance,andisacornerstoneinthetheoryofportfoliochoiceand
assetpricing.ForhiseortsMarkowitzwasawardedtheNobelPrizeinEconomicsin1990.
Thisresult,thathowevercomplextheworldmaybe,forsmallgamblespeopleneedonlyconsiderthe
expectedreturn andvarianceofthegamble
willformthebasisforourfurtherdiscussions.

NotonlydidMarkowitznotice thatpeople care bothaboutriskandreturn,he alsoobservedthat


peopleheldnotonebutaportfolioofstocks.Justonitsown,thefactthatpeopleshouldcareabout
expectedreturnandvarianceofgamblesdoesntnecessarilyimplythatpeoplewouldholdmultiple
stocks.Iftheyknewtheirdegreeofriskaversion,theywouldjustwanttopickonethatoeredthe
righttradeoforthem.
Thefactthatpeoplecouldanddidholdaportfolioofstocksmadeampleeconomicsense.Considerthe
followingtworiskygambles:

Itshouldbeclearthatbyholdinghalfofeach
and
,aninvestorcouldmakehisendofperiod
payothesame(=100),irrespectiveoftheendofperiodstateoftheworld,i.e.theportfolioof
and
withequalpercentageinvestedineachiscompletelyriskless.
This,ofcourse,isanextremeexampleandingeneralsuchgambleswouldberarethatoeredperfectly
negativelycorrelatedpayos.However,Markowitzspointhadbeenmade.Aslongasendofperiod
payosarenotperfectlypositivelycorrelatedinvestorscouldreducethevarianceorriskassociated
withtheendofperiodpayosbyholdingmultiplestocks.Wellgeneralizethisideanext.
WrittenbyVineet
August27,2015at11:02am
PostedinFM,PortfolioSelection
TaggedwithFM201516,Markowitz,PortfolioTheory,Session7

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