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Modern Portfolio
Concepts
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What is a Portfolio?
Portfolio is a collection of investment
vehicles assembled to meet one or more
investment goals.
Growth-Oriented Portfolio: primary
objective is long-term price appreciation
Income-Oriented Portfolio: primary
objective is current dividend and
interest income
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Return on Portfolio
Proportionof
Proportionof
portfolio'stotal
portfolio'stotal
Return
Return
Return
on
dollarvalue
onasset
dollarvalue
onasset L
portfolio
representedby
1
representedby
2
asset1
asset2
Proportionof
portfolio'stotal
Return
dollarvalue
onasset
n
representedby
assetn
j 1
Proportionof
portfolio'stotal
Return
dollarvalue
onasset
j
representedby
assetj
rp w1 r1 w2 r2 L wn rn
w
j 1
rj
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Correlation:
Why Diversification Works!
Correlation is a statistical measure of the relationship
between two series of numbers representing data.
Positively Correlated items move in the same direction.
Negatively Correlated items move in opposite directions.
Correlation Coefficient is a measure of the degree of
correlation between two series of numbers
representing data.
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Correlation Coefficients
Perfectly Positively Correlated describes two
positively correlated series having a correlation
coefficient of +1
Perfectly Negatively Correlated describes two
negatively correlated series having a correlation
coefficient of -1
Uncorrelated describes two series that lack any
relationship and have a correlation coefficient of
nearly zero
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Correlation:
Why Diversification Works!
To reduce overall risk in a portfolio, it is best to
combine assets that have a negative (or
low-positive) correlation.
Uncorrelated assets reduce risk somewhat, but
not as effectively as combining negatively
correlated assets.
Investing in different investments with high
positive correlation will not provide sufficient
diversification.
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Why Use
International Diversification?
Offers more diverse investment alternatives than U.S.-only
based investing
Foreign economic cycles may move independently from
U.S. economic cycle
Foreign markets may not be as efficient as U.S. markets,
allowing true gains from superior research
Study done between 1984 and 1994 suggests that portfolio
70% S&P 500 and 30% EAFE would reduce risk 5% and
increase return 7% over a 100% S&P 500 portfolio
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International Diversification
Advantages of International Diversification
Broader investment choices
Potentially greater returns than in U.S.
Reduction of overall portfolio risk
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Methods of
International Diversification
Foreign company stocks listed on U.S.
stock exchanges
Yankee Bonds
American Depository Receipts (ADRs)
Mutual funds investing in foreign stocks
U.S. multinational companies (typically not
considered a true international investment for
diversification purposes)
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Components of Risk
Diversifiable (Unsystematic) Risk
Results from uncontrollable or random events that are
firm-specific
Can be eliminated through diversification
Examples: labor strikes, lawsuits
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Components of Risk
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Interpreting Beta
Higher stock betas should result in higher expected
returns due to greater risk
If the market is expected to increase 10%, a stock
with a beta of 1.50 is expected to increase 15%
If the market went down 8%, then a stock with a
beta of 0.50 should only decrease by about 4%
Beta values for specific stocks can be obtained from
Value Line reports or online websites such
as yahoo.com
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Interpreting Beta
Stock
Amazon.com
Beta
1.60
Beta
1.10
0.60
1.25
Stock
Intl Bus
iness
Machines
Merrill Lynch & Co.
Microsoft
Anheuser Busch
Bank of America
Corp.
Dow Jones & Co.
Disney
eBay
ExxonMobil Corp.
Gap (The), Inc.
General Motors Corp.
Intel
1.00
1.25
1.55
0.80
1.35
1.20
1.35
Nike, Inc.
PepsiCo, Inc.
Qualcomm
Sempra Energy
Wal-Mart Stores
Xerox
Yahoo! Inc.
0.90
0.65
1.20
0.85
1.00
1.45
1.85
1.60
1.15
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Capital Asset
Pricing Model (CAPM) (contd)
Uses beta, the risk-free rate and the market
return to define the required return on
an investment
Requiredreturn
Betafor
Riskfree
Market
Riskfreerate
return
oninvestmentj
rate
investmentj
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Capital Asset
Pricing Model (CAPM) (contd)
CAPM can also be shown as a graph
Security Market Line (SML) is the
picture of the CAPM
Find the SML by calculating the required
return for a number of betas, then plotting
them on a graph
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Figure 5.5
The Security Market Line (SML)
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Two Approaches
to Constructing Portfolios
Traditional Approach
versus
Modern Portfolio Theory
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Traditional Approach
Emphasizes balancing the portfolio using a wide
variety of stocks and/or bonds
Uses a broad range of industries to diversify
the portfolio
Tends to focus on well-known companies
Perceived as less risky
Stocks are more more liquid and available
Familiarity provides higher comfort levels
for investors
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Combines securities that have negative (or lowpositive) correlations between each others rates
of return
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Figure 5.8
Portfolio Risk and Diversification
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Figure 5.9
The Portfolio Risk-Return Tradeoff
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Constructing a Portfolio
Using Asset Allocation
Asset Allocation is the process of dividing
an investment portfolio into various asset
classes to preserve capital by protecting
against negative developments while taking
advantage of positive ones.
In other words, dont put all of your
eggs in one basket, and choose your
baskets carefully.
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Constructing a Portfolio
Using Asset Allocation (contd)
Individual investor characteristics and objectives
determine relative income needs and ability to bear risk
Investor characteristics to consider:
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Chapter 5 Review
Learning Goals
1. Understand portfolio management objectives and
calculate the return and standard deviation of a
portfolio.
2. Discuss the concepts of correlation and diversification,
and the effectiveness, methods, and benefits of
international diversification.
3. Describe the two components of risk, beta, and the
capital asset pricing model (CAPM).
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