Investments An

Introduction 12th
Edition Mayo
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CHAPTER 5
RISK AND PORTFOLIO MANAGEMENT

Teaching Guides for Questions and Problems in the Text

QUESTIONS

5-1. Nondiversifiable risk (also referred to as systematic

risk) is the risk that is not reduced through the
construction of diversified portfolios. This risk is
associated with general movements in securities returns
(market risk), changes in interest rates (interest rate
risk), inflation (purchasing power risk), fluctuations in the
value of foreign currency (exchange rate risk), and
reinvestment rate risk. These sources of risk may be managed
by other techniques (e.g., duration to manage interest and
reinvestment rate risks associated with bonds), but they are
not affected through the construction of diversified
portfolios.

Diversifiable risk (also called unsystematic risk) is the

risk associated with the particular asset such as the
business and financial risk associated with investing in the
securities of a particular company. There may be no
systematic relationship between these sources of risk and the
return the individual earns on an investment in the stock and
the return achieved by the market as a whole.

5-2. A diversified portfolio consists of a variety of assets

(e.g., bonds, stocks, and real estate). A diversified
portfolio may also consist solely of stocks if the securities
are issued by a variety of firms in different industries.

A diversified portfolio reduces unsystematic risk. The

individual must decide how much nondiversifiable, systematic
risk to tolerate since this source of risk cannot be reduced
through diversification.

The number of assets (e.g., stocks) necessary to achieve

diversification may be as few as ten to fifteen different
stocks. However, for diversification to be achieved, the
returns on these stocks must not be highly correlated. The
lower the correlation among the returns, the greater is the
risk reduction achieved by combining the stocks in the same
portfolio.
5-3. The return from an investment can be either income,
price appreciation, or a combination of both. The expected
return is the return the investor anticipates when the
investment is made. The required return is the return
necessary to induce the investor to make the investment. The
expected return must be equal to or greater than the required
return in order to induce the investor to purchase the asset.
The realized return is the return the investor actually
earns. This realized return may differ considerably (in
either direction) from the expected return.

5-4. The investor will select the security that offers the
highest return for a given level of risk (or select the
security that offers the lowest level of risk for a given
return). If the expected return is the same for two stocks,
the investor will select the less risky of the two securities
(i.e., the one with the lower standard deviation around the
expected return).

5-5. To achieve diversification, the correlation among

investment returns should be low or even negative. If the
returns have high positive correlation, the returns move
together. Since the purpose of diversification is risk
reduction, acquiring two stocks whose returns are highly
correlated will not achieve the objective.

5-6. Risk may be measured by the dispersion around the

expected return (i.e., the standard deviation) or by beta.
(Betas are discussed in the next question.) Indifference
curves relating risk and return indicate the individual's
willingness to bear risk. The steeper the curves, the more
risk averse the individual (i.e., less willing to bear risk).

5-7. A beta coefficient is an index of systematic risk. It

is a measure of the volatility of a stock's return relative
to the market return. The larger the beta coefficient, the
more volatile is the stock's return relative to the return on
the market. A beta of 0.5 means that the return on the stock
is less volatile than the market return. A beta of 1.0
indicates that movement in the return on the market and the
return on the stock have been identical. A beta of 1.5 means
that a ten percent return on the market generated a 15
percent return on the individual stock. Stocks with beta
coefficients greater than 1.0 are considered aggressive while
low beta stocks are defensive and conservative (i.e., less
risky).
Beta coefficients are used to help select a portfolio that
mirrors the individual's willingness to bear systematic risk.
Since a diversified portfolio reduces unsystematic risk, the
important source of risk is systematic risk. The individual
then selects a diversified portfolio of securities with a
beta that is consistent with the individual's willingness to
bear risk. If the individual is willing to bear more risk,
that individual constructs a portfolio of stocks with higher
beta coefficients.

5-8. If the correlation coefficient between a stock and the

market is 0.0, then movements in the market have no impact on
the stock's return. While this may not apply to stocks, point
out that the return on many investments (e.g., savings
accounts and various money market instruments) may have no
correlation with the stock market's return.

5-9. In order to induce the investor to accept more risk,

the anticipated return must be higher. Thus, there is a
positive relationship between return and risk as measured by
either by total risk (i.e., the standard deviation) of
systematic risk (i.e., the beta coefficient). In both lines
the measure of return is the same, but they do differ with
regard to the measurement of risk. The capital market line
specifies the relationship between a portfolio's return and
uses the standard deviation as the measure of risk. The
security market line specifies the relationship between an
asset's return and uses the beta as the measure of risk.

5-10. The capital asset pricing model is a two variable

model in which return is dependent upon the riskiness of the
asset (or the portfolio). Arbitrage pricing theory expands
the number of variables that may affect an asset's return.

PROBLEMS

5-1. a. The expected return on an investment is the sum of

the dividend yield and the anticipated growth in the value of
the asset. In all three cases that sum is 14 percent.
b. If taxes on the returns and the costs of realizing the
returns are the same, there is no reason to prefer one source
to the other. Since taxes and commissions may differ, one
source may be preferred.
As of 2015, the short-term capital gains tax rate exceeded
the rates on dividend income and long-term capital gains.
Long-term capital gains and dividend income were taxed at the
same rate. Even if the tax rates are same, capital gains may
be preferred since capital gains taxes are deferred until the
gain is realized. This is especially true for investors who
do not need current income. Such individuals will prefer
stock C.

To realize the gains, the investor must sell the security and
pay commissions. Transaction costs argue for dividend paying
stocks since transaction costs are avoided. Investors who
need the flow of dividend income or who wish to reduce
transaction costs may prefer stock A.

The small cost associated with on-line trading has almost

erased the impact of brokerage commissions for many
investors. There remains, however, the question of the size
of the trade, since many small trades are not cost effective.

5-2. a. The expected return on a portfolio is the weighted

average of the assets included in the portfolio and their
expected returns. In this case the weighted average is

E(return) = .2(.16) + .1(.15) + .3(.12) + .4(.05) = 10.3%.

b. The substitution of real estate for AT&T stock in this

problem increases the expected return since the expected
return on the real estate is higher:

E(return) = .35(.16) + .1(.15) + .15(.12) + .4(.05) = 10.9%.

5-3. a. Expected return of the portfolio:

(.4)(10%) + (.6)(14%) = 12.4%

b. Standard deviation of the portfolio:

[(.4)2(3)2 + (.6)2(5)2 + 2(.4)(.6)(3)(5)(-.1)].5 = 3.118

c. Position Expected Return Standard Deviation

All A 10% 3.0
All B 14% 5.0
40%A-60%B 12.4% 3.118
The portfolio that combines A and B offers a higher return
than all in A for almost the same amount of risk. All in B
offers the highest expected return but is the riskiest of the
three alternatives. (Point out the reduction in risk caused
by the diversification.)

5-4. This problem repeats the previous problem but adds more
possible combinations.

a. Position Expected Return Standard Deviation

All A 12% 1.00
All B 20% 6.00
50%A/50%B 16% 3.14
25%A/75%B 18% 4.56
75%A/25%B 14% 1.81

Computations of the standard deviations:

50%A-50%B:

[(.5)2(1)2 + (.5)2(6)2 + 2(.5)(.5)(1)(6)(.2)].5 = 3.138

25%A-75%B:

[(.25)2(1)2 + (.75)2(6)2+ 2(.25)(.75)(1)(6)(.2)].5

= 4.557

75%A-25%B:

[(.75)2(1)2 + (.25)2(6)2 + 2(.75)(.25)(1)(6)(.2)].5

= 1.806

b. The substitution of stock A reduces both risk and expected

return.

c. Position Expected Return Standard Deviation

All A 12% 1.0
All B 20% 6.0
50%A/50%B 16% 2.73
25%A/75%B 18% 4.36
75%A/25%B 14% 1.21

Computations of the standard deviations:

 50%A-50%B:

[(.5)2(1)2 + (.5)2(6)2 + 2(.5)(.5)(1)(6)(-.6)].5 = 2.73

25%A-75%B:

[(.25)2(1)2 + (.75)2(6)2 + 2(.25)(.75)(1)(6)(-.6)].5

= 4.36

75%A-25%B:

[(.75)2(1)2 + (.25)2(6)2 + 2(.75)(.25)(1)(6)(-.6)].5

= 1.21

Again the substitution of stock A reduces both risk and

expected return, but the reduction in risk is greater in this
example because the correlation between the two returns is
more negative (i.e., the correlation coefficient is -0.6
instead of 0.2).

5-5. Total invested: $10 + 24 + 41 + 19 = $94

Weight of each stock in portfolio (assuming one share
of each stock):

A: $10/$94 = 11%
B: $24/$94 = 26%
C: $41/$94 = 44%
D: $19/$94 = 20%

Portfolio beta:
(.11)(1.4) + (.26)(0.8) + (.44)(1.3) + (.20)(1.8) = 1.29

This part of the problem changes the weights. If two shares

of B and C are purchased for every share of A and D, the
total invested and the weight of each stock in the portfolio
are as follows:

Total invested: $10 + 24(2) + 41(2) + 19 = $159

Weight of each stock in the portfolio:

A: $10/$159 = 6%
B: $48/$159 = 30%
C: $82/$159 = 52%
D: $19/$159 = 12%
 Portfolio beta:
(.06)(1.4) + (.30)(.8) + (.52)(1.3) + (.12)(1.8) = 1.22

The lower beta stocks constitute a larger proportion of the

portfolio, so the portfolio beta declines.

If equal dollar amounts were invested in each stock, the

portfolio beta is (1.4 + 0.8 + 1.3 + 1.8)/4 = 1.225.

5-6. The return according to the security market line is

rs = rf + (rm - rf)beta.

The return on the stock should be

rs = .06 + (.1 - .06)1.5 = 0.12 = 12%.

If the beta coefficient were 2.0, the return is
rs = .06 + (.1 - .06)2.0 = 0.14 = 14%.

The higher return (14% versus 12%) is consistent with the

portfolio theory covered in the chapter. Point out that this
formulation has two important uses. First, it explains return
and in this form is used to evaluate performance (e.g., the
portfolio managers of mutual funds). Second, it establishes
the required return used to value assets (e.g., the dividend-
growth valuation model covered in the next chapter).

5-7. Expected returns:

A: (-10)(.2) + (5)(.4) + 15(.3) + 25(.1) = 7.0%
B: (-5)(.2) + (5)(.4) + 7(.3) + 39(.1) = 7.0%
The expected returns are equal.

The standard deviations:

A: the weighted squared differences:

(-10 - 7)2(.2) = (-172).2 = 289(.2) = 57.8

(5 - 7)2(.2) = (-22).4 = 4(.4) = 1.6
(15 - 7)2(.2) = (-82).3 = 64(.3) = 19.2
(25 - 7)2(.2) = (-182).1 = 324(.1) = 32.4

the sum of the weighted squared difference

the variance): 57.8 + 1.6 + 19.2 + 32.4 = 111

the standard deviation: 111.5 = 10.536

B: the weighted squared differences:

(-5 - 7)2(.2) = (-122).2 = 144(.2) = 28.8

(5 - 7)2(.2) = (-22).4 = 4(.4) = 1.6
(7 - 7)2(.2) = (-02).3 = 0(.3) = 0.0
(39 - 7)2(.2) = (-322).1 = 1024(.1) = 102.4

the sum of the weighted squared difference

(the variance): 28.8 + 1.6 + 0 + 10.4 = 132.8

the standard deviation: 132.8.5 = 11.524

The expected returns are the same (7%). A is less risky

because it has the lower standard deviation (10.536 versus
11.524). The coefficients of variation are
A: 10.536/7 = 1.505
 B: 11.524/7 = 1.646.

The coefficient of variation permits a comparison of risk per

unit of return. (See problem #8.) Since the expected returns
were the same, the alternative with the lower standard
deviation must have a lower coefficient of variation.

5-8. The coefficient of variation facilitates comparisons of

standard deviations, by converting an absolute number into a
relative number. This is done by dividing the standard
deviation by the mean. In this problem, there are two sets of
stocks, and in both cases Stock B has the higher return. It
also has the higher standard deviation, which indicates more
variability of the returns and more risk. The question is the
additional return sufficient to justify bearing the risk.
Calculating the coefficient of variation will help answer
that question.

a. Stock A: average return 3.00%

standard deviation .395
coefficient of variation .132
Stock B: average return 9.00%
standard deviation 1.186
coefficient of variation .132

In this pairing, Stock B has a higher standard deviation but

the coefficients of variation are equal.

b. Stock A: average return 2.00%

standard deviation .237
coefficient of variation .119
Stock B: average return 8.00%
standard deviation .474
coefficient of variation .059

In this pairing, Stock B once again has a higher standard

deviation, but its coefficient of variation is smaller.

In the first pairing, the relative risks are the same. Both
the return and the risk associated with Stock B are three
times that of A.

In the second pairing, the relative risk is lower for Stock B

because its coefficient of variation is smaller. This would
suggest that the higher return from Stock B is more than
worth the additional risk associated with the stock.
5-9. Students may use any regression package such as Excel
and its regression program to obtain the beta coefficients.

a. The estimated equations are

Stock X: return stock X = 2.06 + 0.352market return
Stock Y: return stock Y = 1.727 + 1.185market return

The beta coefficients (i.e., the slopes of the lines) are

Stock X: 0.352
Stock Y: 1.185.
Stock X has the lower beta; it has less systematic risk.

b. In period 10 the return on the market was -5%. Using the

estimated equations the returns on each stock would be

Stock X = 2.06 + 0.352(-5) = 0.3 = .003%

Stock Y = 1.727 + 1.185(-5) = -4.198 = -.04198%.

Since the returns on stock X and Y were 8% and -14% during

the period 10, something other than the movement in the
market contributed to these stock's actual returns. (Point
out that this is the unsystematic risk associated with the
individual stocks.)

c. The R squared for the two equations are 0.41 and 0.82,
respectively. These indicate that for at least stock X
something other than the market primarily explains the
stock's return.

5-10. The following correlation coefficients were calculated

using Excel. I let my students use whatever method they
prefer to perform the calculations, since the purpose of the
problem is to demonstrate the change in the values of the
coefficients.

For the entire 20 year time period, the correlation

coefficient is 0.721. For the five years periods, the
coefficients are
1997-2001 0.527
2002-2006 0.106
2007-2011 0.969
2012-2016 0.999.
Combining these two stocks would have contributed to
diversification during 2002-2006. Since the correlation is
very high during 2012-2016, combining the two stocks in the
same portfolio would have had little impact on
diversification.

This problem also illustrates that correlations are not

static and do change. Combinations of assets that may have
contributed to diversification during one period may not
contribute during other periods.
Investment Assignment (Part 2)

a. The students add beta coefficients to the stocks they

selected in Part 1.

b. Next the student determines the beta of the portfolio.

Having the same amount invested in each stock reduces the
amount of calculations, if an equal dollar amount is invested
in each stock, an average of the individual stock’s beta will
give the portfolio beta. If an unequal amount is invested, a
weighted average should be used to determine the portfolio’s
beta. If the numerical value of the beta is greater than 1.0,
the portfolio has more systematic risk than the market.

c. Beta coefficients may differ depending on the source.

Part c tries to verify this reality and make students think
about the implication of any differences.

d through f. These questions ask students to compare the

changes (returns) on their portfolios with the movement in
the market. These questions should illustrate the tendency of
stocks to move with the market and that higher beta
portfolios tend to be more volatile.

g. Diversification is important because it reduces

unsystematic risk. To reduce unsystematic risk, the return on
the assets in the portfolio must not be highly, positively
correlated. If the prices of the stocks move together, they
do not contribute to diversification. As stated, the question
basically asks for visual inspection, but you may make the
question more analytical by having the students compute
correlation coefficients.
Teaching Guides for the Financial Advisor’s Case: Inferior
Investment Alternatives

This case essentially repeats the material on risk and

return, and helps determine is a particular combination of
risk and return is inefficient. The expected returns and
betas are

1. Position Expected Return Beta

All in T-bill 7% 0.0
All in A 9% 0.6
All in B 11% 1.3
All in C 14% 1.5

25% in each alternative: expected return =

(.25)(.07) + (.25)(.09) + (.25)(.11) + (.25)(.14)
= 10.25%

beta =
(.25)(.00) + (.25)(.6) + (.25)(1.3) + (.25)(1.5)
= 0.85%

50% in A & 50% in C: expected return =

(.5)(.09) + (.5)(.14) = 11.5%

beta = (.5)(.6) + (.5)(1.5) = 1.05

33 1/3% in each stock: expected return:

(.33)(.09) + (.33)(.11) + (.33)(.14) = 11.22%

beta = (.33)(.6) + (.33)(1.3) + (.33)(1.5) = 1.12

Summary of the portfolio returns and their betas:

return beta
All in T-bill 7% 0.00
All in A 9% 0.60
All in B 11% 1.30
All in C 14% 1.50
25% in each 10.25% 0.85
50% in A and C 11.5% 1.05
1/3 in each stock 11.22% 1.12
2. All that has to be shown is that a portfolio offers an
inferior return for a given amount of risk (or for a given
return requires more risk) to determine an inefficient
portfolio. For example, all in B produces a return of 11
percent with a beta of 1.3 while 50 percent in A and 50
percent in C produces a higher return (11 percent) and lower
risk (beta of 1.05). A portfolio invested entirely in B is
inefficient.
3. Combination of half the funds in A and half the funds in
C generates a return of 11.5% and has a beta of 1.05. What
combination of the Treasury bill and stock C offers a beta of
1.05? Answer:
(X%)(0) + (Y%)(1.5) = 1.05
(Y%)(1.5) = 1.05
Y% = 1.05/1.5 = 70%

A combination of 30 percent in the bill and 70 percent in

stock C generates a beta of 1.05.

That combination of the stock and the bill generates return

of
(.3)(7) + (.7)(14) = 11.9%

11.9 percent exceeds 11.5 percent, so that portfolio is

superior to 50 percent invested in A and C. (30 percent in
the bill and 70 percent in stock A produces a point that lies
above the point representing 50 percent in stock A and 50
percent in stock C, so that latter combination is
inefficient.)

4. To illustrate that a return of 12 percent and a beta of

1.4 is inefficient, all that is necessary is to find a
portfolio with either a higher return with a beta of 1.4 or a
lower beta with a higher return. For example, 89 percent in
stock C and 11 percent in stock A generates a beta of
(.89)(1.5) + (.11)(0.6) = 1.4
and a return of
(.89)(14%) + (.11)(9%) = 13.67%
which is superior and indicates the client's suggestion is an
inferior portfolio.

5. While investors may acquire one asset at a time, it is

important to see the acquisition in a portfolio context.
Since diversification is an important objective when
constructing a portfolio, the impact of the individual
security on the portfolio's risk as well as its return should
be considered before acquiring the asset. The obvious goal is
to acquire assets whose combinations of risk and return
produce the highest return for the amount of risk.
Teaching Guides for the Financial Advisor’s Case: Foreign
Country Funds and Diversification

The purpose of this case is to illustrate the potential for

diversification offered by investing in foreign securities.
The analysis is limited to investing in one foreign country,
Japan.

1. The first question asks for the portfolio's standard

deviation as the portfolio of the portfolio is shifted from
the domestic index fund to the foreign fund. The equation for
the standard deviation of a portfolio consisting of two
securities was given in Chapter 6 in equation 6.4. For
example, if 90 percent of the portfolio is invested in U.S.
securities and 10 percent in Japanese securities, the
standard deviations of their returns are 10 percent and 14,
and the correlation coefficient between the returns is 0.4,
the portfolio standard deviation is

SD = [(.9)2(.1)2 + (.1)2(.14)2 + 2(.9)(.1)(.1)(.14)(.4)].5

= .09649
= 9.649%

The portfolio standard deviations for the various

combinations of U.S. and Japanese securities are
Proportion Invested in Portfolio Standard
the U.S. Fund Deviation
100% 10.00%
90 9.65
80 9.47
70 9.49
60 9.71
50 10.10
40 10.65
30 11.34
20 12.37
10 13.04
0 14.00

(These answers were derived using the Investment Analysis

Calculator available through the publisher’s home page.)
2. This question illustrates the impact of a lower
correlation coefficient. If the coefficient is -0.2, the
portfolio standard deviations for the various combinations
are

Proportion Invested in Portfolio Standard

the U.S. Fund Deviation
100% 10.00%
90 8.82
80 8.20
70 8.26
60 8.99
50 10.25
40 11.87
30 13.72
20 15.72
10 17.83
0 20.00

In both 1 and 2, the substitution of the foreign securities

initially reduces risk as measured by the portfolio's
standard deviation. In both cases, risk is the least at a
combination of 80 percent U.S. securities and 20 percent
foreign securities.

3. This question reverses the first question.

Diversification also applies to foreign investors, so that
they may reduce their risk exposure by investing in the
securities of other nations. The above table argues that
Japanese investors could reduce risk by diversifying into
U.S. securities.

4. a. If investors anticipate that the value of the dollar

will rise, that argues against investing in foreign
securities denominated in the foreign currency. (Anything
such as the anticipation of inflation that would cause the
value of one currency to rise while the other to fall also
alters the willingness to invest in a specific country.)
b. One reason for investing in foreign securities is the
potential they offer for diversifying a domestic portfolio.
Increased globalization of financial markets may increase the
correlation among returns which reduces the potential for
using foreign securities to diversify a domestic portfolio.
(Increased globalization of business also increases
competition and reduces earnings and growth. This would also
argue against foreign investments, but that is not the thrust
of this question.)