Chapter 8. Portfolio Selection. Learning Objectives. INVESTMENTS: Analysis and Management Second Canadian Edition

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1 INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones Chapter 8 Portfolio Selection Learning Objectives State three steps involved in building a portfolio. Apply the Markowitz efficient portfolio selection model. Describe the effect of risk-free borrowing and lending on the efficient frontier. Separate total risk into systematic and nonsystematic risk.

2 Portfolio Selection Diversification is key to optimal risk management Analysis required because of the infinite number of portfolios of risky assets How should investors select the best risky portfolio? How could riskless assets be used? Building a Portfolio Step 1: Use the Markowitz portfolio selection model to identify optimal combinations Step 2: Consider borrowing and lending possibilities Step 3: Choose the final portfolio based on your preferences for return relative to risk Portfolio Theory Optimal diversification takes into account all available information Assumptions in portfolio theory A single investment period (one year) Liquid position (no transaction costs) Preferences based only on a portfolio s expected return and risk

3 An Efficient Portfolio Smallest portfolio risk for a given level of expected return Largest expected return for a given level of portfolio risk From the set of all possible portfolios Only locate and analyze the subset known as the efficient set Lowest risk for given level of return An Efficient Portfolio All other portfolios in attainable set are dominated by efficient set Global minimum variance portfolio Smallest risk of the efficient set of portfolios Efficient set Segment of the minimum variance frontier above the global minimum variance portfolio Efficient Portfolios E(R) B x A y C Risk = σ Efficient frontier or Efficient set (curved line from A to B) Global minimum variance portfolio (represented by point A)

4 Selecting Optimal Asset Classes Another way to use the Markowitz model is with asset classes Allocation of portfolio assets to broad asset categories Asset class rather than individual security decisions most important for investors Different asset classes offers various returns and levels of risk Correlation coefficients may be quite low Optimal Risky Portfolios Investor Utility Function E (R) * Efficient Frontier σ Borrowing and Lending Possibilities Risk-free assets Certain-to-be-earned expected return, zero variance No correlation with risky assets Usually proxied by a Treasury Bill Amount to be received at maturity is free of default risk, known with certainty Adding a risk-free asset extends and changes the efficient frontier

5 Risk-Free Lending E(R) RF Z A X T L B Riskless assets can be combined with any portfolio in the efficient set AB Z implies lending Set of portfolios on line RF to T dominates all portfolios below it Risk Borrowing Possibilities Investor no longer restricted to own wealth Interest paid on borrowed money Higher returns sought to cover expense Assume borrowing at RF Risk will increase as the amount of borrowing increases Financial leverage The New Efficient Set Risk-free investing and borrowing creates a new set of expected return-risk possibilities Addition of risk-free asset results in A change in the efficient set from an arc to a straight line tangent to the feasible set without the riskless asset Chosen portfolio depends on investor s riskreturn preferences

6 Portfolio Choice The more conservative the investor, the more that is placed in risk-free lending and the less in borrowing The more aggressive the investor, the less that is placed in risk-free lending and the more in borrowing Most aggressive investors would use leverage to invest more in portfolio T Implications of Portfolio Selection Investors should focus on risk that cannot be managed by diversification Total risk = Systematic (non-diversifiable) risk + Non-systematic (diversifiable) risk Systematic risk Systematic risk Variability in a security s total returns directly associated with economy-wide events Common to virtually all securities

7 Non-Systematic Risk Non-Systematic Risk Variability of a security s total return not related to general market variability Diversification decreases this risk The relevant risk of an individual stock is its contribution to the riskiness of a welldiversified portfolio Portfolios rather than individual assets most important Portfolio Risk and Diversification σ p % Total risk Diversifiable Risk Systematic Risk Number of securities in portfolio Copyright Copyright 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.