Unit 2 Portfolio Theory (9 Hrs)

Risk & Return: Concept of Risk, Component; Measurement of risk, covariance and correlation,
Fundamental coefficient, Measurement of systematic Analysis: Economic, Industry, Company
Analysis, Portfolio risk and return, Beta as a measure of risk, calculation of beta, Selection of
Portfolio: Markowitz’s Theory, Single Index Model, Case Studies.

Portfolio Risk and Return

A portfolio is composed of two or more securities. Each portfolio has risk-return characteristics
of its own. A portfolio comprising securities that yield a maximum return for given level of risk
or minimum risk for given level of return is termed as ‘efficient portfolio’. In their Endeavour to
strike a golden mean between risk and return the traditional portfolio managers diversified funds
over securities of large number of companies of different industry groups.

However, this was done on intuitive basis with no knowledge of the magnitude of risk reduction
gained. Since the 1950s, however, a systematic body of knowledge has been built up which
quantifies the expected return and riskiness of the portfolio. These studies have collectively come
to be known as ‘portfolio theory’.

A portfolio theory provides a normative approach to investors to make decisions to invest their
wealth in assets or securities under risk. The theory is based on the assumption that investors are
risk averse. Portfolio theory originally developed by Harry Markowitz states that portfolio risk,
unlike portfolio return, is more than a simple aggregation of the risk, unlike portfolio return, is
more than a simple aggregation of the risks of individual assets.

This is dependent upon the interplay between the returns on assets comprising the portfolio.
Another assumption of the portfolio theory is that the returns of assets are normally distributed
which means that the mean (expected value) and variance analysis is the foundation of the
portfolio.

i. Portfolio Return:
The expected return of a portfolio represents weighted average of the expected returns on the
securities comprising that portfolio with weights being the proportion of total funds invested in
each security (the total of weights must be 100).

The following formula can be used to determine expected return of a portfolio:

Applying formula (5.5) to possible returns for two securities with funds equally invested in
a portfolio, we can find the expected return of the portfolio as below:

ii. Portfolio Risk:

Unlike the expected return on a portfolio which is simply the weighted average of the expected
returns on the individual assets in the portfolio, the portfolio risk, σp is not the simple, weighted
average of the standard deviations of the individual assets in the portfolios.

It is for this fact that consideration of a weighted average of individual security deviations
amounts to ignoring the relationship, or covariance that exists between the returns on securities.
In fact, the overall risk of the portfolio includes the interactive risk of asset in relation to the
others, measured by the covariance of returns. Covariance is a statistical measure of the degree to
which two variables (securities’ returns) move together. Thus, covariance depends on the
correlation between returns on the securities in the portfolio.

Covariance between two securities is calculated as below:

1. Find the expected returns on securities.

2. Find the deviation of possible returns from the expected return for each security

3. Find the sum of the product of each deviation of returns of two securities and respective
probability.

The formula for determining the covariance of returns of two securities is:

Let us explain the computation of covariance of returns on two securities with the help of
the following illustration:
So far as the nature of relationship between the returns of securities A and B is concerned, there
may be three possibilities, viz., positive covariance, negative covariance and zero covariance.
Positive covariance shows that on an average the two variables move together.

A’s and B’s returns could be above their average returns at the same time or they could be below
their average returns at the same time. This signifies that as the proportion of high return and
high risk assets is increased, higher returns on portfolio come with higher risk.

Negative covariance suggests that, on an average, the two variables move in opposite direction.
It means A’s returns could be above its average returns while B’s return could be below its
average returns and vice-versa. This implies that it is possible to combine the two securities A
and B in a manner that will eliminate all risk.

Zero covariance means that the two variables do not move together either in positive or negative
direction. In other words, returns on the two securities are not related at all. Such situation does
not exist in real world. Covariance may be non-zero due to randomness and negative and positive
terms may not cancel each other.

In the above example, covariance between returns on A and B is negative i.e., -38.6. This
suggests that the two returns are negatively related.

The above discussion leads us to conclude that the riskiness of a portfolio depends much more on
the paired security covariance than on the riskiness (standard deviations) of the separate security
holdings. This means that a combination of individually risky securities could still comprise a
moderate-to-low-risk portfolio as long as securities do not move in lock step with each other. In
brief, low covariance’s lead to low portfolio risk.

iii. Diversification:
Diversification is venerable rule of investment which suggests “Don’t put all your eggs in one
basket”, spreading risk across a number of securities.

Diversification may take the form of unit, industry, maturity, geography, type of security and
management. Through diversification of investments, an investor can reduce investment risks.
Investment of funds, say, Rs. 1 lakh evenly among as many as 20 different securities is more
diversified than if the same amount is deployed evenly across 7 securities. This sort of security
diversification is naive in the sense that it does not factor in the covariance between security
returns.

The portfolio comprising 20 securities could represent stocks of one industry only and have
returns which are positively correlated and high portfolio returns variability. On the other hand,
the 7-stock portfolio might represent a number of different industries where returns might show
low correlation and, hence, low portfolio returns variability.

Meaningful diversification is one which involves holding of stocks of more than one industry so
that risks of losses occurring in one industry are counterbalanced by gains from the other
industry. Investing in global financial markets can achieve greater diversification than investing
in securities from a single country. This is for the fact that the economic cycles of different
countries hardly synchronize and as such a weak economy in one country may be offset by a
strong economy in another.

Fig. 5.2 portrays meaningful diversification. It may be noted from the figure that the returns
overtime for Security X are cyclical in that they move in tandem with the economic fluctuations.
In case of Security Y returns are moderately counter cyclical. Thus, the returns for these two
securities are negatively correlated.

If equal amounts are invested in both securities, the dispersion of returns, up, on the portfolio of
investments will be less because some of each individual security’s variability is offsetting.
Thus, the gains of diversification of investment portfolio, in the form of risk minimization, can
be derived if the securities are not perfectly and positively correlated.

iv. Systematic and Unsystematic Risk:

Thus, the variance of returns on a portfolio moving in inverse direction can minimize portfolio
risk. However, it is not possible to reduce portfolio risk to zero by increasing the number of
securities in the portfolio. According to the research studies, when we begin with a single stock,
the risk of the portfolio is the standard deviation of that one stock.

As the number of securities selected randomly held in the portfolio increase, the total risk of the
portfolio is reduced, though at a decreasing rate. Thus, degree of portfolio risk can be reduced to
a large extent with a relatively moderate amount of diversification, say 15-20 randomly selected
securities in equal-rupee amounts.
Portfolio risk comprises systematic risk and unsystematic risk. Systematic risk is also known as
non- diversifiable risk which arises because of the forces that affect the overall market, such, as
changes in the nation’s economy, fiscal policy of the Government, monetary policy of the
Central bank, change in the world energy situation etc.

Such types of risks affect securities overall and hence, cannot be diversified away. Even if an
investor holds well diversified portfolio, he is exposed to this type of risk which is affecting the
overall market. This is why, non-diversifiable or unsystematic risk is also termed as market risk
which remains after diversification.

Another risk component is unsystematic risk. It is also known as diversifiable risk caused by
such random events as law suits, strikes, successful and unsuccessful marketing programmes,
winning or losing a major contract and other events that are unique to a particular firm.

Unsystematic risk can be eliminated through diversification because these events are random,
their effects on individual securities in a portfolio cancel out each other. Thus, not all of the risks
involved in holding a security are relevant because part of the risk can be diversified away. What
is relevant for investors is systematic risk which is unavoidable and they would like to be
compensated for bearing it. However, they should not expect the market to provide any extra
compensation for bearing the avoidable risk, as is contended in the Capital Asset Pricing Model.

Figure 5.3 displays two components of portfolio risk and their relationship to portfolio size.

Illustrative Problems:
1. An investor has two investment options before him. Portfolio A offers risk-free expected
return of 10%. Portfolio B offers an expected return of 20% and has standard deviation of 10%.
His risk aversion index is 5. Which investment portfolio the investor should choose?

Solution:
The following equation can be used to measure utility score of a portfolio:
 2. Companies X and Y have common stocks having the expected returns and standard deviations
given below:

The expected correlation coefficient between the two stocks is – 35.

You are required to calculate the risk and return for a portfolio comprising 60% invested in the
stock of Company X and 40% invested in the stock of Company Y.

Solution:
(i) Rp = (.60)(.10) + (.40)(.06) = 8.4%

Markowitz Theory of Portfolio Management

1. Introduction to Markowitz Theory

2. Assumptions of Markowitz Theory
3. Diversification of Markowitz Theory
4. Criteria of Dominance
5. Measurement of Risk

Introduction to Markowitz Theory

Harry M. Markowitz is credited with introducing new concepts of risk measurement and their
application to the selection of portfolios. He started with the idea of risk aversion of average
investors and their desire to maximize the expected return with the least risk.

Markowitz model is thus a theoretical framework for analysis of risk and return and their inter-
relationships. He used the statistical analysis for measurement of risk and mathematical
programming for selection of assets in a portfolio in an efficient manner. His framework led to
the concept of efficient portfolios. An efficient portfolio is expected to yield the highest return
for a given level of risk or lowest risk for a given level of return.

Markowitz generated a number of portfolios within a given amount of money or wealth and
given preferences of investors for risk and return. Individuals vary widely in their risk tolerance
and asset preferences. Their means, expenditures and investment requirements vary from
individual to individual. Given the preferences, the portfolio selection is not a simple choice of
any one security or securities, but a right combination of securities.

Markowitz emphasized that quality of a portfolio will be different from the quality of individual
assets within it. Thus, the combined risk of two assets taken separately is not the same risk of
two assets together. Thus, two securities of TISCO do not have the same risk as one security of
TISCO and one of Reliance.

Risk and Reward are two aspects of investment considered by investors. The expected return
may vary depending on the assumptions. Risk index is measured by the variance of the
distribution around the mean, its range etc., which are in statistical terms called variance and
covariance. The qualification of risk and the need for optimization of return with lowest risk are
the contributions of Markowitz. This led to what is called the Modern Portfolio Theory, which
emphasizes the tradeoff between risk and return. If the investor wants a higher return, he has to
take higher risk. But he prefers a high return but a low risk and hence the problem of a tradeoff.

A portfolio of assets involves the selection of securities. A combination of assets or securities is

called a portfolio. Each individual investor puts his wealth in a combination of assets depending
on his wealth, income and his preferences. The traditional theory of portfolio postulates that
selection of assets should be based on lowest risk, as measured by its standard deviation from the
mean of expected returns. The greater the variability of returns, the greater is the risk.

Thus, the investor chooses assets with the lowest variability of returns. Taking the return as the
appreciation in the share price, if TELCO shares price varies from Rs. 338 to Rs. 580 (with
variability of 72%) and Colgate from Rs. 218 to Rs. 315 (with a variability of 44%) during 1998,
the investor chooses the Colgate as a less risky share.

As against this Traditional Theory that standard deviation measures the variability of return and
risk is indicated by the variability, and that the choice depends on the securities with lower
variability, the modern Portfolio Theory emphasizes the need for maximization of returns
through a combination of securities, whose total variability is lower.

The risk of each security is different from that of others and by a proper combination of
securities, called diversification one can arrive at a combination wherein the risk of one is offset
partly or fully by that of the other. In other words, the variability of each security and covariance
for their returns reflected through their inter-relationships should be taken into account.

Thus, as per the Modern Portfolio Theory, expected returns, the variance of these returns and
covariance of the returns of the securities within the portfolio are to be considered for the choice
of a portfolio. A portfolio is said to be efficient, if it is expected to yield the highest return
possible for the lowest risk or a given level of risk.

A set of efficient portfolios can be generated by using the above process of combining various
securities whose combined risk is lowest for a given level of return for the same amount of
investment that the investor is capable of. The theory of Markowitz, as stated above is based on a
number of assumptions.
2. Assumptions of Markowitz Theory
The Portfolio Theory of Markowitz is based on the following assumptions:

(1) Investors are rational and behave in a manner as to maximize their utility with a given level
of income or money.
(2) Investors have free access to fair and correct information on the returns and risk.
(3) The markets are efficient and absorb the information quickly and perfectly.
(4) Investors are risk averse and try to minimize the risk and maximize return.
(5) Investors base decisions on expected returns and variance or standard deviation of these
returns from the mean.
(6) Investors choose higher returns to lower returns for a given level of risk.
A portfolio of assets under the above assumptions is considered efficient if no other asset or
portfolio of assets offers a higher expected return with the same or lower risk or lower risk with
the same or higher expected return. Diversification of securities is one method by which the
above objectives can be secured. The unsystematic and company related risk can be reduced by
diversification into various securities and assets whose variability is different and offsetting or
put in different words which are negatively correlated or not correlated at all.

Diversification of Markowitz Theory:

Markowitz postulated that diversification should not only aim at reducing the risk of a security
by reducing its variability or standard deviation, but by reducing the covariance or interactive
risk of two or more securities in a portfolio. As by combination of different securities, it is
theoretically possible to have a range of risk varying from zero to infinity.

Markowitz theory of portfolio diversification attaches importance to standard deviation, to

reduce it to zero, if possible, covariance to have as much as possible negative interactive effect
among the securities within the portfolio and coefficient of correlation to have – 1 (negative) so
that the overall risk of the portfolio as a whole is nil or negligible.

Then the securities have to be combined in a manner that standard deviation is zero, as
shown in the example below:
Possible combinations of securities (1) and (2):
In the example, if 2/3rds are invested in security (1) and 1/3rd in security (2), the coefficient of
variation, namely = S.D./mean is the lowest.
The standard deviation of the portfolio determines the deviation of the returns and correlation
coefficient of the proportion of securities in the portfolio, invested. The equation is-

σ2p = Portfolio variance

σp = Standard deviation of portfolio
xi = Proportion of portfolio invested in security i
xj = Proportion of portfolio invested in security J
rij = Coefficient of correlation between i and J
σi standard deviation of i
σj standard deviation of J
N = number of securities

Problem:
Given the following example, find out the expected risk of the portfolio.
Parameters of Markowitz Diversification:
Based on his research, Markowitz has set out guidelines for diversification on the basis of the
attitude of investors towards risk and return and on a proper quantification of risk. The
investments have different types of risk characteristics, some called systematic and market
related risks and the other called unsystematic or company related risks. Markowitz
diversification involves a proper number of securities, not too few or not too many which have
no correlation or negative correlation. The proper choice of companies, securities, or assets
whose return is not correlated and whose risks are mutually offsetting to reduce the overall risk.

For building up the efficient set of portfolio, as laid down by Markowitz, we need to look
into these important parameters:
(1) Expected return.

(2) Variability of returns as measured by standard deviation from the mean.

(3) Covariance or variance of one asset return to other asset returns.

In general the higher the expected return, the lower is the standard deviation or variance and
lower is the correlation the better will be the security for investor choice. Whatever is the risk of
the individual securities in isolation, the total risk of the portfolio of all securities may be lower,
if the covariance of their returns is negative or negligible.

Criteria of Dominance:
Dominance refers to the superiority of one portfolio over the other. A set can dominate over the
other, if with the same return, the risk is lower or with the same risk, the return is higher.
Dominance principle involves the tradeoff between risk and return.

For two security portfolio, minimize the portfolio risk by the equation-

σp = Wa σa2 + Wb σb2 + 2 (WaWbσaσb σab)

E (Rp) = WaE (Ra) + Wb E (Rb)

R refers to returns and E (Rp) is the expected returns, σp is the standard deviation, W refers to
the proportion invested in each security σaσb are the standard deviation of a and b securities and
σab is the covariance or interrelations of the security returns.
The above concepts are used in the calculation of expected returns, mean standard deviation as a
measure of risk and covariance as a measure of inter-relations of one security return with
another.

Measurement of Risk:
Risk is discussed here in terms of a portfolio of assets. Any investment risk is the variability of
return on a stock, assets or a portfolio. It is measured by standard deviation of the return over the
Mean for a number of observations.

Example:
Standard deviation to be calculated: Average in Mean Observations: 10% – 5% 20% 35% – 10%
= 10% will be their Mean.

Portfolio Risk:
When two or more securities or assets are combined in a portfolio, their covariance or interactive
risk is to be considered. Thus, if the returns on two assets move together, their covariance is
positive and the risk is more on such portfolios. If on the other hand, the returns move
independently or in opposite directions, the covariance is negative and the risk in total will be
lower.

Mathematically, the covariance is defined as-

Where Rx is return on security x, Ry return security Y, and R̅ x and R̅ y are expected returns on
them respectively and N is the number of observations.

The coefficient of correlation is another measure designed to indicate the similarity or

dissimilarity in the behaviour of two variables. We define the coefficient of correlation of x and
y as-

Cov x y is the covariance between x and y and σ x is the standard deviation of x and σy is the
standard deviation of y.

Where, N = 2

The covariance equation is as follows:

The coefficient of correlation can be set out as follows:

If the coefficient of correlation between two securities is – 1.0, it is perfect negative correlation.
If it is + 1.0 it is perfect positive correlation. If the coefficient is ‘0’ then the returns are said to be
independent. To sum up, correlation between two securities depend- (a) on covariance between
them, and (b) the standard deviation of each.

In Markowitz Model, we need to have the inputs of expected returns, risk measured by standard
deviation of returns and the covariance between the returns on assets considered.

Single Index Model Explained

The single index model (SIM) was developed by William F. Sharpe in 1963, which’s most
notable for his development of the capital asset pricing model (CAPM), for which he won
the Nobel Prize in Economics in 1990. Sharpe found that instead of finding the relationship
between every pair of stock returns to find their covariance (how two variables differ) or
correlation (how two variables are related) as proposed in the Markowitz model, this relationship
can more simply be found through a market index (e.g., the S&P 500 Index), thereby reducing
the number of required calculations in a portfolio analysis exercise.

To further elaborate, the SIM proposes that a firm's returns are due to a single factor, being the
market factor. In other words, the SIM states that the returns of a stock can be found through its
relationship to some market index. This makes the SIM useful in basic event studies, where
investors are seeking to gain the ability to predict a firm's returns on any given day. However,
this differentiates it from multifactor models, which assert that the firm's returns are due to more
than one factor.

There are two ways the SIM can be expressed, either in "raw returns" (aka ordinary returns) or
in "excess returns."

The SIM formula expressed in raw returns is shown below:

Ri = α i + β i Rm + ε i

where:

 Rit = total return of a stock or portfolio i

 βi = investment beta.
 Rm = market portfolio return
 αit = time regression investment's alpha
 εit = time regression residuals

This formula is saying that the returns of the firm are equal to the alpha plus its beta multiplied
by the returns in the market index plus the residual. When this formula is adjusted for the risk-
free rate, you'll get excess returns.

The SIM formula expressed in excess returns is shown below:

Ri - Rf = αi + βi(Rm - Rf) + εi

where:

 Rit = total return of a stock or portfolio i

 βi = investment beta.
 Rm = market portfolio return
 Rf = risk-free rate of return
 αit = time regression investment's alpha
 εit = time regression residuals

This formula is saying that the excess returns on the firm are equal to its alpha plus the beta
multiplied by the excess return on the market plus the residual.
Regardless of which formula you use, you're going to get very similar outputs. The alpha output
may differ slightly, but the beta is generally always going to be relatively the same. This is
primarily because the risk-free rate typically does not change frequently and/or by any
significant margin. Therefore, including the risk-free rate will likely not have much of an impact
on the beta you ultimately end up getting. For this reason, there's nothing wrong with investors
using the ordinary returns formula instead.

Both formula approaches have the market portfolio return and the risk-free rate of return as
formula inputs. These are described more in-detail below:

 Market portfolio return (Rm): Market portfolio return is typically represented by the
S&P 500 Index, but can also be represented by any other index for portfolio analysis, so
long as it's not price-weighted (e.g., the DJIA). Otherwise, this can cause misleading
appearances of alpha. If you're using the S&P 500, then on a historical basis, this returns
about 8-10% annually.
 Risk-free rate of return (Rf): This is the rate an investor can expect to earn an
investment with "zero risk." Clearly, nothing of the sorts exists, so the standard approach
is to use the rate on the 10-year Treasury note or the 3-month T-bill rates from the U.S.
Department of the Treasury as a proxy to represent a risk-free investment. You only need
to worry about the risk-free rate if you're using the excess return SIM formula.

Now, when you estimate the SIM regression, you're going to get outputs for alpha and beta,
which will enable you to calculate the residual. Beta, alpha, and the residual are important to
understand and interpret the SIM and are described below.

Beta

Beta (β) represents the sensitivity and responsiveness of the firm's returns to the returns on the
market index. More technically, beta is defined as the "slope coefficient that relates the returns
for security i to the returns for the aggregate stock market." Therefore, beta measures systematic
risk, which means macroeconomic risk (e.g., inflation, interest rates, market news) that affects
all securities in the market.

If an investment's beta is equal to 1, then when the market goes up 1%, your firm (on average)
will also be expected to go up 1%. Because this is an average prediction, beta will not tell you
precisely what will happen on any given day. Rather, it will tell you what is expected to happen
on average.

A higher beta coefficient means more risk in the portfolio or security. On the other hand, a lower
beta coefficient means less risk in the portfolio or security, which can be more beneficial for an
efficient portfolio.

Alpha

Alpha (α), over any given time period, tells you to what extent the security or portfolio has
outperformed or underperformed the market index, adjusted for beta. Alpha can also be thought
of the security's expected excess return when the market excess return is zero. Alpha therefore
represents the expected return on a security (in excess of the risk-free rate) beyond any returns
due to movements in the market.

To elaborate, any expected excess return on any individual security is due to firm-specific (aka
nonsystematic or unsystematic risk) factors, denoted by the alpha coefficient, which refers to
firm-specific events that would affect its market returns (e.g., poor financial performance,
management turnover, credit rating downgrades). As the name suggests, these firm-specific
factors would only affect the firm and have a negligible effect on the economy. Unsystematic
risk can also be reduced to zero through portfolio diversification.

The alpha output you get in your SIM regression is only as good as your inputs. If your model
inputs are misspecified, then you'll get a misleading alpha. For example, this could be the case if
you believe more than one factor is driving the firm's returns, as the SIM only considers one risk
factor. Regardless, investors should seek investments with a positive alpha, given that they're
looking to invest in a security or fund to beat the selected index.

Residual

Residuals (ε) explain how much of your security or fund's returns are being driven by random
miscellaneous movements in the market that cannot be explained by the asset-pricing model, also
known as "idiosyncratic volatility". The residual represents the facts that are not being driven
by the market returns of the alpha on any given day, but rather random firm-specific movements
on any given day.

Greater residual values (positive or negative) translates to wider scatter returns and greater
residual risk. Therefore, if the residual value is relatively high in your SIM output, then the risk-
reward relationship for any individual security could be based slightly more on the impacts on
firm-specific risk, and not so much on systematic risk. This can be useful to interpret and analyze
in portfolio management scenarios, where you may want to examine the riskiness of an
individual firm and perhaps construct a portfolio based upon these residuals.

Security Characteristic Line

Now that you understand the SIM, another item worth discussing is that the relationship between
the security's excess returns and the market's excess returns can be plotted on a scatter diagram.
A line can then be constructed using linear regression to best-fit these plotted data points. What
results from this regression line is called the "security characteristic line" (SCL), as shown
below:
As you can see from the image above, the intercept of this regression line represents alpha and
the slope represents its beta. This regression line is therefore a representation of both the
systematic and unsystematic risk of a security. Investors can analyze this regression line to
understand, on average, how much a security's stock price rises for every additional percentage
return in the market index.

How to Calculate and Interpret the Single Index Model on Excel

To fully understand and interpret the Single Index Model (SIM), its best to run a regression
analysis on Excel. For our example, I'll be looking at ordinary returns, not excess returns,
because it's simpler and doesn't make much of a qualitative difference to the outputs you
ultimately end up getting from the regression.

I will provide a step-by-step instruction below for the Home Depot (HD) Company. To assist in
this instruction, I've provided a completed Excel sheet model below:

Home Depot (HD) SIM Calculation - StableBreadDownload

Step #1: Setup, Download, and Organize the Data

The first step in calculating the SIM on Excel is to setup, download, and organize the data to
perform our calculation and analysis. These steps are provided below:

1. To perform any type of regression analysis, you must install the "Data Analysis" Excel
ToolPak add-in program. Follow these steps to install the add-in on Excel: Open Excel --
> File --> Options --> Add-ins --> Go --> Analysis ToolPak --> OK. Restart your Excel
if the "Data Analysis" button/text doesn't initially show up under the "Data" tab on the
Excel ribbon.
2. Navigate to Yahoo Finance or some other data aggregator website for historical stock
market financial data.
 3. Download the monthly, weekly, or daily adjusted close price data for your selected
company. I typically use a 1-year period for the SIM and prefer using daily adjusted close
price data.
4. Sort your adjusted close price data by ascending order (meaning oldest dates come first).
At this point, you should have a date column and a closing price data column.
5. Calculate the monthly, weekly, or daily return percentage for your selected company in a
separate column. This formula is simply: [(new date's adjusted close price / previous
date's adjusted close price) - 1]. Drag/copy this percentage return calculation to the
bottom of your data set.

By this point, you should have five columns on your spreadsheet: A column for date, stock price,
stock percentage return, S&P 500 price (or another index of your choice), and S&P 500
percentage return. If you were using the SIM excess return formula, you would also have a
column for the risk-free rate and a column for the excess return calculation (Rm - Rf).

Step #2: Run a Regression Analysis

After you run a regression, you will be able to analyze the relationship between the returns on the
stock and the returns on the index. To run a regression on Excel, follow the steps below:

1. Assuming you have the "Data Analysis" Excel ToolPak installed, navigate to Data -->
Data Analysis --> Regression --> OK.
2. "Input Y Range" is the dependent variable. This will be the percentage return on your
selected stock, given that we believe it will be influenced by the independent variable.
3. "Input X Range" is the independent variable, also called the "regressor." This is going to
be the percentage return on the index, which we believe will influence returns on our
selected stock.
4. Select "Labels" if your column selection has labels in them and select "Regression" if you
want to calculate idiosyncratic volatility. Choose an output location for your regression
and click on the "OK" button. Don't select the checkbox that says "Constant is Zero," as
this will effectively set the alpha to be equal to zero.

Once this step is completed, you should get a "Summary Output" and "Residual Output" table.

Step #3: Assess Idiosyncratic Volatility

The residuals output describes the random performance occurring on any given day. This is the
difference between the predicted value and the actual value that is observed. If you wanted to
evaluate "idiosyncratic volatility," which is really just the volatility of the residuals, you can
accomplish this through this residual output. These steps are shown below:

1. Calculate the variance of the residuals using the =VAR.P Excel formula. Reference the
entire residuals column when doing so.
2. Standard deviation is just equal the square root of the variance. Use the =SQRT function
on the variance number you just calculated. With our example, we get a standard
 deviation of 1.34%, which appears to be relatively small. However, we should keep in
mind that the average residual value should be zero, which the next step validates.
3. Use the =AVERAGE function in Excel on the residuals column. Again, this should be
equal to zero. Given that the average value for all of your residuals is practically zero,
your residuals are outputted in an appropriate manner.

The idiosyncratic volatility itself is not necessarily what we're interested in. If you have a
diversified portfolio, then the idiosyncratic volatility values will generally cancel one another
out, leaving you exposed to only systematic risk from market movements. However, if your goal
is to construct a portfolio based on low volatility effects, then evaluating the standard deviation
value itself can be useful.

For most investors, what's more important here is to evaluate idiosyncratic volatility (based on
the standard deviation output). You should look at how this number compares to other firms over
the same exact date range, and rank the company's value accordingly.

Step #4: Interpret the Regression Output

After a regression is completed, a summary output similar to the one shown below should result
(without the formatting):

Home Depot (HD): Single Index Model Regression Summary Output | StableBread

To interpret the SIM regression output, what's most important to analyze is the R Square, the p-
values, the alpha and market beta coefficients, and the standard error discussed in step #3.

The "R Square" and "Adjusted R Square" value show how much of the change in our
dependent y-variable is explained by the change in the independent x-variable. Here, it's 39%,
which means that 39% of the changes/variations in Home Depot's stock return is explained by
the market return over the last year. In other words, this means that the other 61% is not
explained by the market and is due to firm-specific (unsystematic) risk.
As you'll see in the attached file, the alpha and market beta can also be represented in formula
form through the security characteristic line (SCL). In our case, this formula would be "y =
0.8497x + 0.0002."

In terms of our regression table at the bottom, what's important to assess first is the p-value. A p-
value greater than 5% is not considered to be statistically significant (given the null hypothesis is
rejected). Therefore, our alpha is not statistically significant but our market beta is significant,
given that the p-value is near-zero. Again, beta represents the sensitivity and responsiveness of
the firm's returns to the returns on the market. Here it's 85%, which means that if the market goes
up 1%, the market will (on average) go up 85%.

The Bottom Line

The Single Index Model (SIM) was proposed by William F. Sharpe in 1963, and states that the
returns on a security are largely driven by its sensitivity and relationship to the returns on the
market index. In formula form, the SIM states that the returns on a stock are a linear combination
of its alpha plus the beta multiplied by the returns on the market index, plus a residual on any
given day that represents the random movements on the firm on that day.

Prior to the SIM, investors were relying on Harry Markowitz's approach of finding covariance
through calculating the relationship between every pair of stock returns in a portfolio. With
Sharpe's SIM, covariance could simply be calculated through estimating the betas of the
individual securities and the market variance, which significantly reduced the number of
computations in portfolio analysis.

Following this article, investors should look into the "capital asset pricing model" (CAPM),
given that it was also developed by Sharpe in the early 1960's alongside the SIM. The CAPM
attempts to explain the relationship between stock market returns and market risk, by stating that
returns on an individual security depends only on its non-diversifiable risk. Unlike the SIM, the
CAPM assumes the market is perfectly efficient and no assumption is made that a security's
return is linearly dependent on the market return.

Lastly, if you want to look at other factors, you can look into the Fama and French and Carhart
multifactor models, which introduce additional factors to explain stock market returns. Although
these models are more complex, they are proven to do a better job at explaining stock market
returns and are worth exploring.