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Investment Theory

1) Investment theory examines how to allocate wealth across different securities while considering risk and return. The goal is to optimize the portfolio. 2) Individual stock returns may not be normally distributed but a portfolio of many stocks will tend toward a normal distribution. This allows using only the mean and variance to describe the portfolio return distribution. 3) Diversification reduces risk because less than perfectly correlated assets provide better risk-return opportunities than holding individual assets alone. Adding unrelated assets reduces total portfolio variance.

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62 views

Investment Theory

1) Investment theory examines how to allocate wealth across different securities while considering risk and return. The goal is to optimize the portfolio. 2) Individual stock returns may not be normally distributed but a portfolio of many stocks will tend toward a normal distribution. This allows using only the mean and variance to describe the portfolio return distribution. 3) Diversification reduces risk because less than perfectly correlated assets provide better risk-return opportunities than holding individual assets alone. Adding unrelated assets reduces total portfolio variance.

Uploaded by

pgdm23samamal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Investment Theory

Risk and Return


Portfolio Optimisation
Investment theory - Asset
allocation problem
• Why investors invest in risky assets?
• How much of your wealth should you invest in
each security?
Properties of returns distributions
• Normal model provides a useful approximation
(Fama 1976)
• Implications of the portfolio model for relationships
between expected returns on securities and their
risks.
Jointly normally distributed?

Individual stock return may not be normally-distributed, but a portfolio


consists of more and more stocks would have a return increasingly close to
being normally-distributed.
NOTE: (N = No. of stocks in the portfolio)
Jointly normally-distributed?
1st moment: Mean = Expected return of portfolio
2nd moment: Variance = Variance of the return of portfolio (RISKNESS)
Mean and Var as sole choice variables => Distribution of return can be
adequately described by mean and variance only
That means, distribution has to be normally-distributed.

Mean-variance criteria
1) As the table shows, portfolios consisting of large number of risky assets
tend to have returns that are very close to normally-distributed.
2) The fact that investors re-balance their own portfolios frequently will act
so as to make higher moments (3rd, 4th, etc) unimportant (Samuelson
1970).
3) Cost-effective consideration: data required to compute 3rd and 4th
moments are very demanding. Both computational and cost inefficient.
Estimation of Expected Return &
Risk
Expected Return – Arithmetic
Average
• Suppose that the price of a common stock is 100.
There is an equal chance that at the end of the year
the stock will be worth 90, 110, or 130.

• Expected return
• To the board!
~
( Pj − P0 )
Rj = ,
P0
~
R ~ N (E,σ 2 )

Probability End of period Price Return


0.1 20 - 20%
0.2 22.50 -10%
P0= 25
0.4 25 0
0.2 30 20%
0.1 40 60%
Measures of Location & Dispersion

~
Mean: E ( X ) = Σpi X i
~
~ E ( Pj ) − P0
E(R j ) = ,
P0
~
E ( R ) = 6%
~ ~
Porperty 1 : E ( X + a ) = E ( X ) + a
~ ~
Porperty 2 : E ( aX ) = aE ( X )

Dispersion: Is the expected return of 6% risky?


~ ~
Var ( X ) = E[( X i − E ( X )) 2 ]
n
~ ~
Var ( X ) = ∑
i =1
p i ( X i − E ( X )) 2

1 ~ ~ ~
Var ( R j ) = 2 Var ( P ) σ (R) = Var ( R )
P0
~
Var ( R ) = 4.64
~
σ ( R ) = 2.154%

~ ~
Porperty 1 : Var ( X + a ) = Var ( X )
~ ~
Porperty 2 : Var ( aX ) = a 2Var ( X )
Portfolio mean variance
Two asset Portfolio

• How do we measure the mean and variance of a


portfolio with a% of wealth invested in asset X and
b%=(1-a%) invested in Y ?
• Long position => a, b >0
• Short position => a<0 or b<0
• Assumption: Allocate all wealth between two
assets X and Y.
Covariance of Returns
• A measure of the degree to which two variables
“move together” relative to their individual mean
values over time
• For two assets, i and j, the covariance of rates of
return is defined as:

Covij = E[(Ri - E(Ri))(Rj - E(Rj))]

13
Covariance and Correlation

Correlation coefficient varies from -1 to +1


Cov ij
rij =
σ iσ j
where :
rij = the correlatio n coefficien t of returns
σ i = the standard deviation of R it
σ j = the standard deviation of R jt
14
Portfolio risk with N assets

N N
σ = ∑∑ wi w jσ ij
2
P
i =1 j =1
Diversification
Proposition: portfolio of less than perfectly correlated
assets always offer an equal or better risk-return
opportunities than the individual component assets on
their own.
Proof:
If ρxy = 1 (perfectly positively correlated)
then, σp = a σx + b σy
=> portfolio risk is merely the weighted avg. s.d.

If < 1 (less than perfectly correlated)


then, σp < a σx + b σy
=> portfolio risk is less than the weighted avg. s.d.
Naïve diversification

N σ 2j ( N − 1) N N σ jk
σ P2 = (1 / N )∑ + ∑∑
j =1 N N j =1 k =1 N ( N − 1)
k≠ j
Diversification reduces risk
Portfolio Diversification

Prob.

Large

0 15 Return

σ1 ≈ 35% ; σLarge ≈ 20%.


Construction of Investment
Opportunity set
Prob State of Nature X Y
.2 I 18 0
.2 II 5 -3
.2 III 12 15
.2 IV 4 12
.2 V 6 1

% in X 125 100 75 50 25 0 -25

% in Y -25 0 25 50 75 100 125

Q: Plot the opportunity set.


• E(R_p) = aE(x)+(1-a)E(y)
• Var(R_p) = a var( x) + 2a(1 − a)Cov( x, y) + (1 − a)
2 2
var( y )

% in X % in Y E(R_p) Sd (R_p)
125 -25 10 6.905
100 0 9 5.292
75 25 8 4.298
50 50 7 4.370
25 75 6 5.466
0 100 5 7.127
-25 125 4 9.048
Opportunity Set
11

10

0
4.00 5.20 6.40 7.60 8.80 10.00
Diversification Vs Hedging
• To the board!
Minimum Variance Portfolio

Var ( R p ) = a 2σ x2 + (1 − a ) 2 σ y2 + 2a (1 − a )rx , yσ xσ y
(σ y2 − rxyσ xσ y )
dVar ( R p ) / da = 0 ⇒ a * =
(σ + σ − 2rxyσ xσ y )
2
x
2
y

E σ y2 − Cov( x, y )
a* =
σ y2 + σ x2 − 2Cov( x, y )

a*

σ
Feasible Portfolios
• You can trace out the feasible portfolios as
combination of risk and return given the correlation
between stocks.
• “portfolio locus”
Class problems - Excel

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