Presentation on theme: "Modern Portfolio Concepts"— Presentation transcript:
1 Modern Portfolio Concepts Chapter 5Modern Portfolio Concepts
2 Required computations (10-12) Various return concepts (HPR, IRR, realized return, expected return)Compute the average return and standard deviation on a time series using excel.Compute the mean/expected return and standard deviation given scenarios with probabilities.Compute the mean return, beta of a portfolio of multiple assetsCompute the standard deviation of a two-asset portfolioApply CAPM to compute required rate of return, return sensitivity to market moves, and market risk premium.
3 What is a Portfolio?Portfolio is a collection of investments assembled to meet one or more investment goals.Efficient portfolioA portfolio that provides the highest return for a given level of riskRequires search for investment alternatives to get the best combinations of risk and return
4 Portfolio Return and Risk Measures The return on a portfolio is simply the weighted average of the individual assets’ returns in the portfolioThe standard deviation of a portfolio’s returns is more complicated, and is a function of the portfolio’s individual assets’ weights, standard deviations, and correlations with all other assets
6 Correlation: Why Diversification Works! Correlation is a statistical measure of the relationship between two series of numbers representing dataPositively Correlated items tend to move in the same directionNegatively Correlated items tend to move in opposite directionsCorrelation Coefficient is a measure of the degree of correlation between two series of numbers representing data
7 Correlation Coefficients Perfectly Positively Correlated describes two positively correlated series having a correlation coefficient of +1Perfectly Negatively Correlated describes two negatively correlated series having a correlation coefficient of -1Uncorrelated describes two series that lack any relationship and have a correlation coefficient of nearly zero
8 Figure 5.1 The Correlation Between Series M, N, and P
9 Correlation: Why Diversification Works! Assets that are less than perfectly positively correlated tend to offset each others movements, thus reducing the overall risk in a portfolioThe lower the correlation the more the overall risk in a portfolio is reducedAssets with +1 correlation eliminate no riskAssets with less than +1 correlation eliminate some riskAssets with less than 0 correlation eliminate more riskAssets with -1 correlation eliminate all risk
10 Figure 5.2 Combining Negatively Correlated Assets to Diversify Risk
12 Figure 5.4 Risk and Return for Combinations of Two Assets with Various Correlation Coefficients
13 Why Use International Diversification? Offers more diverse investment alternatives than U.S.-only based investingForeign economic cycles may move independently from U.S. economic cycleForeign markets may not be as “efficient” as U.S. markets, allowing true gains from superior research
14 International Diversification Advantages of International DiversificationBroader investment choicesPotentially greater returns than in U.S.Reduction of overall portfolio riskDisadvantages of International DiversificationCurrency exchange riskLess convenient to invest than U.S. stocksMore expensive to investRiskier than investing in U.S.
15 Methods of International Diversification Foreign company stocks listed on U.S. stock exchangesYankee BondsAmerican Depository Shares (ADS’s)Mutual funds investing in foreign stocksU.S. multinational companies (typically not considered a true international investment for diversification purposes)
16 Components of Risk Diversifiable (Unsystematic) Risk Results from uncontrollable or random events that are firm-specificCan be eliminated through diversificationExamples: labor strikes, lawsuitsNondiversifiable (Systematic) RiskAttributable to forces that affect all similar investmentsCannot be eliminated through diversificationExamples: war, inflation, political events
18 Beta: A Popular Measure of Risk A measure of undiversifiable riskIndicates how the price of a security responds to market forcesCompares historical return of an investment to the market return (the S&P 500 Index)The beta for the market is 1.0Stocks may have positive or negative betas. Nearly all are positive.Stocks with betas greater than 1.0 are more risky than the overall market.Stocks with betas less than 1.0 are less risky than the overall market.
19 Figure 5.5 Graphical Derivation of Beta for Securities C and D*
20 Beta as a Measure of Risk Table 5.4 Selected Betas and Associated Interpretations
21 Interpreting BetaHigher stock betas should result in higher expected returns due to greater riskIf 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 websites such as yahoo.com
23 Capital Asset Pricing Model (CAPM) Model that links the notions of risk and returnHelps investors define the required return on an investmentAs beta increases, the required return for a given investment increases
24 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
25 Capital Asset Pricing Model (CAPM) (cont’d) CAPM can also be shown as a graphSecurity Market Line (SML) is the “picture” of the CAPMFind the SML by calculating the required return for a number of betas, then plotting them on a graph
27 Two Approaches to Constructing Portfolios Traditional Approach versus Modern Portfolio Theory
28 Traditional ApproachEmphasizes “balancing” the portfolio using a wide variety of stocks and/or bondsUses a broad range of industries to diversify the portfolioTends to focus on well-known companiesPerceived as less riskyStocks are more liquid and availableFamiliarity provides higher “comfort” levels for investors
29 Modern Portfolio Theory (MPT) Emphasizes statistical measures to develop a portfolio planFocus is on:Expected returnsStandard deviation of returnsCorrelation between returnsCombines securities that have negative (or low-positive) correlations between each other’s rates of return
30 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 returnPortfolios that fall to the right of the efficient frontier are not desirable because their risk return tradeoffs are inferiorPortfolios that fall to the left of the efficient frontier are not available for investments
31 Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier
32 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 includesTo earn more return, one must bear more riskOnly nondiversifiable risk (relevant risk) provides a positive risk-return relationship
34 Key Aspects of MPT: Portfolio Betas Table 5.6 Austin Fund’s Portfolios V and W
35 Interpreting Portfolio Betas Portfolio betas are interpreted exactly the 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.
36 Interpreting Portfolio Betas Table 5.7 Portfolio Betas and Associated Changes in Returns
37 Reconciling the Traditional Approach and MPT Recommended portfolio management policy uses aspects of both approaches:Determine how much risk you are willing to bearSeek diversification between different types of securities and industry linesPay attention to correlation of return between securitiesUse beta to keep portfolio at acceptable level of riskEvaluate alternative portfolios to select highest return for the given level of acceptable risk