1. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Modern Portfolio Concepts

2. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-2 Modern Portfolio Concepts Learning Goals 1.Understand portfolio objectives and the procedures used to calculate portfolio return and standard deviation. 2.Discuss the concepts of correlation and diversification, and the key aspects of international diversification. 3.Describe the components of risk and the use of beta to measure risk.

3. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-3 Modern Portfolio Concepts Learning Goals (cont’d) 4.Explain the capital asset pricing model (CAPM) – conceptually, mathematically, and graphically. 5.Review the traditional and modern approaches to portfolio management. 6.Describe portfolio betas, the risk-return tradeoff, and reconciliation of the two approaches to portfolio management.

4. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-4 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

5. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-5 The Ultimate Goal: An Efficient Portfolio Efficient portfolio –A portfolio that provides the highest return for a given level of risk, or –Has the lowest risk for a given level of return

6. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-6 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

7. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-7 Return on Portfolio

8. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-8 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

9. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-9 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

10. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-10 Figure 5.1 The Correlation Between Series M, N, and P

11. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-11 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

12. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-12 Figure 5.2 Combining Negatively Correlated Assets to Diversify Risk

13. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-13 Table 5.3 Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations

14. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-14 Figure 5.3 Range of Portfolio Return and Risk for Combinations of Assets A and B for Various Correlation Coefficients

15. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-15 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

16. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-16 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.

17. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-17 Methods of International Diversification Foreign company stocks listed on U.S. stock exchanges –Yankee Bonds –American Depository Shares (ADS’s) –Mutual funds investing in foreign stocks –U.S. multinational companies (typically not considered a true international investment for diversification purposes)

18. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-18 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

19. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-19 Components of Risk

20. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-20 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.

21. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-21 Figure 5.5 Graphical Derivation of Beta for Securities C and D*

22. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-22 Beta: A Popular Measure of Risk Table 5.4 Selected Betas and Associated Interpretations

23. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-23 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

24. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-24 Interpreting Beta

25. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-25 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

26. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-26 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

27. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-27 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

28. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-28 Figure 5.6 The Security Market Line (SML)

29. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-29 Two Approaches to Constructing Portfolios Traditional Approach versus Modern Portfolio Theory

30. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-30 Traditional Approach Emphasizes “balancing” the portfolio using a wide variety of stocks and/or bonds Uses a broad range of industries to diversify theportfolio Tends to focus on well-known companies –Perceived as less risky –Stocks are more liquid and available –Familiarity provides higher “comfort” levels for investors

31. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-31 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

32. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-32 Key Aspects of MPT: Efficient Frontier 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

33. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-33 Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier

34. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-34 Key Aspects of MPT: Portfolio Betas Portfolio Beta –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

35. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-35 Key Aspects of MPT: Portfolio Betas Table 5.6 Austin Fund’s Portfolios V and W

36. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-36 Figure 5.8 Portfolio Risk and Diversification

37. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-37 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.

38. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-38 Interpreting Portfolio Betas Table 5.7 Portfolio Betas and Associated Changes in Returns

39. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-39 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

40. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-40 Figure 5.9 The Portfolio Risk-Return Tradeoff

41. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-41 Chapter 5 Review Learning Goals 1.Understand portfolio objectives and the procedures used to calculate portfolio return and standard deviation. 2.Discuss the concepts of correlation and diversification, and the key aspects of international diversification. 3.Describe the components of risk and the use of beta to measure risk.

42. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-42 Chapter 5 Review (cont’d) Learning Goals (cont’d) 4.Explain the capital asset pricing model (CAPM) – conceptually, mathematically, and graphically. 5.Review the traditional and modern approaches to portfolio management. 6.Describe portfolio betas, the risk-return tradeoff, and reconciliation of the two approaches to portfolio management.

43. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 5 Additional Chapter Art

44. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-44 Table 5.1 Expected Return, Average Return, and Standard Deviation of Returns for Portfolio XY

45. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-45 Table 5.2 Expected Returns, Average Returns, and Standard Deviations for Assets X, Y, and Z and Portfolios XY and XZ

46. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-46 Figure 5.4 Risk and Return for All Combinations of Assets A and B for Various Correlation Coefficients

47. Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 5-47 Table 5.5 The Growth Fund of America, August 31, 2005