Modern Portfolio Concepts Chapter 5 Modern Portfolio Concepts

Modern Portfolio Concepts Learning Goals Understand portfolio management objectives and calculate the return and standard deviation of a portfolio. Discuss the concepts of correlation and diversification, and the effectiveness, methods, and benefits of international diversification. Describe the two components of risk, beta, and the capital asset pricing model (CAPM). Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Modern Portfolio Concepts Learning Goals (cont’d) Review traditional and modern approaches to portfolio management and reconcile them. Describe the role of investor characteristics and objectives and of portfolio objectives and policies in constructing an investment portfolio. Summarize why and how investors use an asset allocation scheme to construct an investment portfolio. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

The Ultimate Goal: An Efficient Portfolio A portfolio that provides the highest return for a given level of risk Given the choice between two equally risky investments, an investor will chose the one with the highest potential return. Given the choice between two investments offering the same return, an investor will choice the one that has the least risk. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Portfolio Return and Risk Measures Return on a Portfolio is the weighted average of returns on the individual assets in the portfolio. Standard Deviation of a portfolio’s returns is calculated using all of the individual assets in the portfolio. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Return on Portfolio Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.1 The Correlation Between Series M, N, and P Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.2 Combining Negatively Correlated Assets to Diversify Risk Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Table 5.3 Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.3 Range of Portfolio Return and Risk for Combinations of Assets A and B for Various Correlation Coefficients Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

International Diversification Advantages of International Diversification Broader investment choices Potentially greater returns than in U.S. Reduction of overall portfolio risk Disadvantages of International Diversification Currency exchange risk Less convenient to invest than U.S. stocks More expensive to invest Riskier than investing in U.S. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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) Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Nondiversifiable (Systematic) Risk Attributable to forces that affect all similar investments Cannot be eliminated through diversification Examples: war, inflation, political events Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Components of Risk Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Beta: A Popular Measure of Risk A measure of nondiversifiable risk Indicates how the price of a security responds to market forces Compares historical return of an investment to the market return (the S&P 500 Index) The beta for the market is 1.00 Stocks may have positive or negative betas. Nearly all are positive. Stocks with betas greater than 1.00 are more risky than the overall market. Stocks with betas less than 1.00 are less risky than the overall market. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.5 Graphical Derivation of Beta for Securities C and D Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Beta: A Popular Measure of Risk Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Interpreting Beta Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Capital Asset Pricing Model (CAPM) Model that links the notions of risk and return Helps investors define the required return on an investment As beta increases, the required return for a given investment increases Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Capital Asset Pricing Model (CAPM) (cont’d) Uses beta, the risk-free rate and the market return to define the required return on an investment Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Capital Asset Pricing Model (CAPM) (cont’d) 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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.5 The Security Market Line (SML) Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Two Approaches to Constructing Portfolios Traditional Approach versus Modern Portfolio Theory Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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 Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Modern Portfolio Theory (MPT) Emphasizes statistical measures to develop a portfolio plan Focus is on: Expected returns Standard deviation of returns Correlation between returns Combines securities that have negative (or low- positive) correlations between each other’s rates of return Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Key Aspects of MPT: Efficient Frontier The leftmost boundary of the feasible set of portfolios that include all efficient portfolios: those providing the best attainable tradeoff between risk and return Portfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferior Portfolios that fall to the left of the efficient frontier are not available for investments Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Key Aspects of MPT: Portfolio Betas The beta of a portfolio; calculated as the weighted average of the betas of the individual assets the portfolio includes To earn more return, one must bear more risk Only nondiversifiable risk (relevant risk) provides a positive risk-return relationship Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Key Aspects of MPT: Portfolio Betas Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.8 Portfolio Risk and Diversification Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Interpreting Portfolio Betas Portfolio betas are interpreted exactly same way as individual stock betas. Portfolio beta of 1.00 will experience a 10% increase when the market increase is 10% Portfolio beta of 0.75 will experience a 7.5% increase when the market increase is 10% Portfolio beta of 1.25 will experience a 12.5% increase when the market increase is 10% Low-beta portfolios are less responsive and less risky than high-beta portfolios. A portfolio containing low-beta assets will have a low beta, and vice versa. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Interpreting Portfolio Betas Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Reconciling the Traditional Approach and MPT Recommended portfolio management policy uses aspects of both approaches: Determine how much risk you are willing to bear Seek diversification between different types of securities and industry lines Pay attention to correlation of return between securities Use beta to keep portfolio at acceptable level of risk Evaluate alternative portfolios to select highest return for the given level of acceptable risk Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Figure 5.9 The Portfolio Risk-Return Tradeoff Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

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, don’t put all of your eggs in one basket, and choose your baskets carefully. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Constructing a Portfolio Using Asset Allocation (cont’d) Individual investor characteristics and objectives determine relative income needs and ability to bear risk Investor characteristics to consider: Level and stability of income, net worth Age and family factors Investment experience and ability to handle risk Tax considerations Investor objectives to consider: High level of current income Significant capital appreciation Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Portfolio Objectives and Policies Capital Preservation Objective Low-risk, conservative investment strategy Emphasis on current income and capital preservation Normally contains low-beta securities Capital Growth Objective Higher-risk investment strategy Emphasis on more speculative investments Normally contains higher-beta securities Tax Efficient Objective Emphasis on capital gains and longer holding periods to defer income taxes Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Approaches to Asset Allocation Fixed-Weightings Approach: asset allocation plan in which a fixed percentage of the portfolio is allocated to each asset category Flexible-Weightings Approach: asset allocation plan in which weights for each asset category are adjusted periodically based on market analysis Tactical Approach: asset allocation plan that uses stock-index futures and bond futures to change a portfolio’s asset allocation based on market behavior Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Alternative Asset Allocation Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Applying Asset Allocation Consider impact of economic and other factors on your investment objective. Design your asset allocation plan for the long haul (at least 7 to 10 years). Stress capital preservation. Provide for periodic reviews to maintain consistency with changing investments goals. Consider using mutual funds, especially for portfolios under $100,000. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Chapter 5 Review Learning Goals Understand portfolio management objectives and calculate the return and standard deviation of a portfolio. Discuss the concepts of correlation and diversification, and the effectiveness, methods, and benefits of international diversification. Describe the two components of risk, beta, and the capital asset pricing model (CAPM). Copyright © 2005 Pearson Addison-Wesley. All rights reserved.

Chapter 5 Review (cont’d) Learning Goals (cont’d) Review traditional and modern approaches to portfolio management and reconcile them. Describe the role of investor characteristics and objectives and of portfolio objectives and policies in constructing an investment portfolio. Summarize why and how investors use an asset allocation scheme to construct an investment portfolio. Copyright © 2005 Pearson Addison-Wesley. All rights reserved.