modern portfolio concepts ppt @ bec doms

Modern Portfolio Concepts

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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.

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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.

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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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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

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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

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Return on Portfolio

Returnon

portfolio

Proportion ofportfolio's total

dollar valuerepresented by

asset 1

Returnon asset

1

Proportion ofportfolio's total

dollar valuerepresented by

asset 2

Returnon asset

2

Proportion ofportfolio's total

dollar valuerepresented by

asset n

Return on assetn

j 1

n

Proportion ofportfolio's total

dollar valuerepresented by

asset j

Returnon assetj

rp w1 r1 w2 r2 wn rn w j rj

j1

n

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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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Figure 5.1 The Correlation Between Series M, N, and P

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Table 5.3 Correlation, Return, and Risk for Various Two-Asset Portfolio Combinations

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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

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.

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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)

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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

Nondiversifiable (Systematic) Risk Attributable to forces that affect all similar investments Cannot be eliminated through diversification Examples: war, inflation, political events

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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.

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Beta: A Popular Measure of Risk

Table 5.4 Selected Betas and Associated Interpretations

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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

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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

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Capital Asset Pricing Model (CAPM) (cont’d)

Uses beta, the risk-free rate and the market return to define the required return onan investment

Required returnon investment j

Risk-free rate Beta for

investment j

Marketreturn

Risk-free

rate

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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

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Figure 5.6 The Security Market Line (SML)

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Two Approaches to Constructing Portfolios

Traditional Approachversus

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 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

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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

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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

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Figure 5.7 The Feasible or Attainable Set and the Efficient Frontier

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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

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Key Aspects of MPT: Portfolio Betas

Table 5.6 Austin Fund’s Portfolios V and W

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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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Table 5.1 Expected Return, Average Return, and Standard Deviation of Returns for Portfolio XY

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Table 5.2 Expected Returns, Average Returns, and Standard Deviations for Assets X, Y, and Z and

Portfolios XY and XZ

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Table 5.5 The Growth Fund of America, August 31, 2005