Economics 122

F I N AN CIA L ECO N O MICS (O PTI M AL R I SKY PO RTFO LIO 2)

M . D E B UQ UE - GO N ZALES
1ST S E M ESTE R, 2 0 1 4 - 2 0 1 5

SOURCE: BODIE ET AL. (2009) 1

Markowitz Portfolio Selection
Model
We can generalize the construction problem to the
case of many risky securities and a risk-free asset.
The problem also has three parts:
1. Security selection
2. Finding the optimal CAL and ORP
3. Finding the OCP

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The Minimum-Variance Frontier
of Risky Assets

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Markowitz Portfolio Selection
Model
Step 1: Security Selection
Determining/identifying the risk-return
combinations available from the set of
risky assets.
All portfolios that lie on the minimum-
variance frontier from the global minimum-
variance portfolio and upward provide the
best risk-return combinations.

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Markowitz Portfolio Selection
Model
Step 2: Finding the optimal risky portfolio
(ORP)
We now search for the CAL with the
highest reward-to-variability ratio (the
steepest CAL).
This involves identifying the ORP weights.

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CALs with Various Portfolios
from the Efficient Set

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The Efficient Frontier of Risky
Assets with the Optimal CAL

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Markowitz Portfolio Selection
Model
Step 3: Finding the optimal complete
portfolio (OCP)
We now choose an appropriate complete
portfolio by mixing the risk-free asset with
the optimal risky portfolio.

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Markowitz Portfolio Selection
Model
Note: Again, everyone invests in the
(optimal) risky portfolio P regardless of their
degree of risk aversion.

More risk averse investors put more money

in the risk-free asset.

Less risk averse investors put more money

in P.

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Capital Allocation and the
Separation Property
After getting the efficient frontier, the
optimal risky portfolio is obtained by finding
that allocation that maximizes the reward-
to-volatility ratio.
At this point, the work of the portfolio
manager is done, and the optimal risky
portfolio for the manager's clients is
portfolio P.

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Capital Allocation and the
Separation Property
The most striking result: A portfolio manager will
offer the same risky portfolio P to all clients
regardless of their degree of risk aversion A
The degree of risk aversion of the client comes into
play only in the selection of the desired point along
the CAL.
The more risk averse will invest more in the risk-free
asset and less in the optimal risky portfolio than will
a less risk-averse client).
However, both will use portfolio P as their optimal
risky investment vehicle!

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Capital Allocation and the
Separation Property
The separation property tells us that the
portfolio choice problem may be separated
into two independent tasks.
Determination of the optimal risky portfolio
is purely technical.
Allocation of the complete portfolio to T-bills
versus the risky portfolio depends on
personal preference.

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Capital Allocation and the
Separation Property
Thus, the same (optimal) portfolio P is
offered by the manager to all clients.
Investor with varying degrees of A would be
satisfied with a universe of only two mutual funds: a
risk-free investment fund (e.g. a money market
fund) and a mutual fund that holds P on the
tangency point of the CAL and the efficient frontier.
This result makes professional fund management
more efficient and less costly (i.e. one firm can serve
any number of clients with relatively small
incremental administrative costs).
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Capital Allocation and the
Separation Property
In practice, though, different managers may input
different input lists, thus deriving different efficient
frontiers and offer different "optimal" portfolios to
their clients.
The source of disparity here lies in the security analysis.
If the quality of security analysis is poor, a passive
portfolio such as a market index fund will result in a
better CAL than an active portfolio that uses low-quality
security analysis to tilt portfolio weights toward
seemingly favourable (mispriced) securities.
Optimal risky portfolio for different clients may also vary
because of portfolio constraints such as dividend-yield
requirements, tax considerations, or other client
preferences.

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Capital Allocation and the
Separation Property
Nevertheless, the analysis above suggests that a
limited number of portfolios may be sufficient to
serve the demands of a wide range of investors,
giving the theoretical basis of the mutual fund
industry.
The (computerized) optimization technique is the easiest
part of the portfolio construction problem.
The real area of competition among portfolio managers
is in sophisticated security analysis.
This analysis, as well as its proper interpretation, is part
of the "art" of portfolio construction.

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The Input List
To undertake this risk-return analysis, the portfolio
needs as inputs a set of estimates for the expected
returns of each security 𝑖 and their covariance
matrix, which are needed to calculate the
expected return and covariance matrix of the risky
portfolio.
𝐸 𝑟 =∑ 𝑤 𝐸 𝑟
𝜎 =∑ ∑ 𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
These comprise the so-called  “input list”  fed into
the maximization program.
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Portfolio Selection Theory
Harry Markowitz in 1952 published a formal model of
portfolio selection embodying diversification
principles, specifically identifying the efficient set of
portfolios  or  the  “efficient  frontier  of  risky  assets”  
(step 1 above of portfolio management).
The principal idea behind the frontier set of risky
portfolios is that for any risk level, we are interested
only in that portfolio with the highest expected return.
Alternatively, the frontier is the set of portfolios that
minimizes the variance for any targeted expected
return.
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Portfolio Constraints
However, in getting the efficient frontier, added
constraints may be present. For example:
When institutions are prohibited from taking
short positions in any asset (i.e., if negative
positions via short-selling are effectively ruled
out).
Some clients may want to ensure a minimal
level of expected dividend yield from the optimal
portfolio (this will have to be put inside the input
list and the optimization program will now
include an additional constraint).
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Portfolio Constraints
Some investments may be ruled out—e.g., in
industries or countries considered ethically or
politically  undesirable  (referred  to  as  “socially
responsible investing”).
Any constraint carries a cost in the sense than
an efficient frontier constructed subject to extra
constraints will offer a reward-to-volatility ratio
inferior to that of an unconstrained or less
constrained one.

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Three-Asset Portfolio
𝐸 𝑟 =𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟 +𝑤 𝐸 𝑟

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
+2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟 + 2𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟

𝜎 = 𝑤 𝜎 + 𝑤 𝜎 + 𝑤 𝜎 + 2𝑤 𝑤 𝜎 ,
+2𝑤 𝑤 𝜎 , + 2𝑤 𝑤 𝜎 ,

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n-Asset Portfolio
Generalizing this to the n-asset case:
𝐸 𝑟 =∑ 𝑤 𝐸 𝑟
𝜎 =∑ ∑ 𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
=∑ ∑ 𝑤 𝑤 𝜎,

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The Power of Diversification
Portfolio variance:
𝜎 =∑ ∑ 𝑤 𝑤 𝐶𝑜𝑣 𝑟 , 𝑟
Consider now the naive diversification strategy in
which an equally-weighted portfolio is constructed
(i.e., 𝑤 = 1/𝑛 for each security).
We can rewrite the above equation as:
𝜎 = ∑ 𝜎 +∑ ∑ 𝐶𝑜𝑣 𝑟 , 𝑟

= ∑ 𝜎 + ∑ ∑ 𝐶𝑜𝑣 𝑟 , 𝑟

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The Power of Diversification
If we define the average variance and average
covariance of the securities as:
𝜎 = ∑ 𝜎
𝐶𝑜𝑣 = ∑ ∑ 𝐶𝑜𝑣 𝑟 , 𝑟

We can then express portfolio variance as:

𝜎 = 𝜎 + 𝐶𝑜𝑣

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The Power of Diversification
To see further the fundamental relationship
between systematic risk and security correlation,
suppose for simplicity that all securities have a
common standard deviation, 𝜎, and all security
pairs have a common correlation coefficient, 𝜌.
Therefore, the covariance between all pairs of
securities is 𝜌𝜎 .
The portfolio variance equation thus becomes:
𝜎 = 𝜎 + 𝜌𝜎

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Risk Reduction of Equally Weighted
Portfolios in Correlated and Uncorrelated
Universes

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