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Diversification
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SHOULD WE DIVERSIFY
Listen to Raymond Dalio, a billionaire investor,
hedge fund manager, and philanthropist, the
founder of investment firm Bridgewater Associates,
one of the world's largest hedge funds.
https://www.investopedia.com/investing/importance-
diversification/
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6.1 DIVERSIFICATION AND PORTFOLIO
RISK
Can you eliminate all risks through diversification?
Unique/Firm-Specific/Nonsystematic/ Diversifiable
Risk
Risk that can be eliminated by diversification
Example?
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FIGURE 6.1 RISK AS FUNCTION OF NUMBER
OF STOCKS IN PORTFOLIO
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FIGURE 6.2 RISK VERSUS
DIVERSIFICATION
E (rp ) W1r1 W2 r2
W1 Proportion of funds in security 1
W2 Proportion of funds in security 2
r1 Expected return on security 1
r 2 Expected return on security 2
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Can I change r to sigma to get the expected risk of the portfolio?
6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
Covariance Calculations
S
Cov( rS , rB ) p(i )[ rS (i ) E (rS )][ rB (i ) E (rB )]
i 1
Cov( rS , rB ) ρ SBσ S σ B
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SPREADSHEET 6.2 VARIANCE OF
RETURNS
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SPREADSHEET 6.3 PORTFOLIO
PERFORMANCE
0.4x-37%+-0.6x-9 = -20.2%
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SPREADSHEET 6.4 RETURN COVARIANCE
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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
Portfolio risk and return depend on the means and
variances of the component securities (the two risky
assets in this case)
How can we get the means and variances?
Variance:
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6.2 ASSET ALLOCATION WITH TWO
RISKY ASSETS
Risk-Return Trade-Off (graph to be shown)
Should we look for lower risk? But it usually comes with
lower return?
We can look at the Investment opportunity set
Available portfolio risk-return combinations
and use the mean-Variance Criterion
Mean-Variance Criterion
If E(rA) ≥ E(rB) and σA ≤ σB
Portfolio A dominates portfolio B
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SPREADSHEET 6.5 INVESTMENT
OPPORTUNITY SET
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FIGURE 6.3 INVESTMENT
OPPORTUNITY SET
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FIGURE 6.4 OPPORTUNITY SETS: VARIOUS
CORRELATION COEFFICIENTS
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Near zero
SPREADSHEET 6.6 OPPORTUNITY SET -VARIOUS
CORRELATION COEFFICIENTS
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6.3 THE OPTIMAL RISKY PORTFOLIO WITH A
RISK-FREE ASSET
How to find the optimal risky portfolio?
i.e. for a given level of risk, you get the highest expected return.
Refer to Figure 6.3 Investment Opportunity Set
[ E (rB ) rf ] S2 [ E (rs ) rf ] B S BS
wB
[ E (rB ) rf ] S2 [ E (rs ) rf ] B2 [ E (rB ) rf E (rs ) rf ] B S BS
wS 1 wB
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FIGURE 6.6 BOND, STOCK AND T-BILL
OPTIMAL ALLOCATION
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FIGURE 6.7 THE COMPLETE PORTFOLIO
Once you have obtained the optimal risk
portfolio O, you may determine the complete
portfolio C based on your risk preference.
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FIGURE 6.8 PORTFOLIO COMPOSITION: ASSET
ALLOCATION SOLUTION
An example may look like
this.
You can refer to the
text for the calculations
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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
Efficient Frontier of Risky Assets
Graph representing set of portfolios that maximizes
expected return at each level of portfolio risk
Maximize risk premium for any level standard deviation
Minimize standard deviation for any level risk premium
premium
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FIGURE 6.9 PORTFOLIOS CONSTRUCTED
WITH THREE STOCKS (A, B AND C)
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E from AB and F from BC resulting curve EF, more northwest (i.e.
lower risk and higher return, a better feature)
FIGURE 6.10 EFFICIENT FRONTIER: RISKY
AND INDIVIDUAL ASSETS
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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
Choosing Optimal Risky Portfolio
Optimal portfolio CAL tangent to efficient frontier
Similar to process of choosing an optimal risky portfolio of
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6.4 EFFICIENT DIVERSIFICATION WITH
MANY RISKY ASSETS
Optimal Risky Portfolio: An Illustration
Efficiently diversified global portfolio using stock market
indices of six countries
Standard deviation and correlation estimated from
historical data
Risk premium forecast generated from fundamental
analysis (not for historical averages)
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FIGURE 6.11 EFFICIENT FRONTIERS/CAL: TABLE 6.1
0.09
Efficient Frontier
Capital Allocation Line
0.08 Eff Front - No Short
Min-Var with short sales
Min-Var no short sales
0.07 Optimum with short sales
Optimum no short sales
0.06 Individual countries
Risk Premium
0.05
0.04
0.03
0.02
0.01
0.00
0.00 0.05 0.10 0.15 0.20 0.25 0.30 31
Standard Deviation
You can get Beta of the stock you want. How do we make
use of this in practice? 34
FIGURE 6.12 SCATTER DIAGRAM FOR
DELL
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6.5 A SINGLE-INDEX STOCK MARKET
Statistical and Graphical Representation of Single-
Index Model
Ratio of systematic variance to total variance, a measure on
the relative importance of systematic risk
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6.5 A SINGLE-INDEX STOCK MARKET
What will be systematic and nonsystematic variances of a
portfolio if its securities’ returns follow single index model
Diversification in Single-Index Security Market
In portfolio of n securities with weights
In securities with nonsystematic risk
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EXERCISES
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