GO D

ST. PAUL’S UNIVERSITY

FACULTY OF BUSINESS AND INFORMATION TECHNOLOGY

Lesson 4: Portfolio selection

The objective of every rational investor is to maximize his returns and minimize risk.
Diversification is the method adopted for reducing risk. It essentially results in the construction
of portfolio.
The proper goal of portfolio construction would be to generate a portfolio that provides the
highest return and the lowest risk. Such a portfolio is known as optimal portfolio.

The process of finding the optimal portfolio is described as portfolio selection. The conceptual
framework and analytical tools for determining the optimal portfolio, provided by Harry
Markowitz in his Journal of finance.
Feasible set of portfolio
With a limited number of securities, an investor can create a very large number of portfolios by
combining these securities in different proportions.
This constitutes the feasible set of portfolio in which the investor can possibly invest. This is
known as the portfolio opportunity set.
Each portfolio in the opportunity set is characterized by an expected return and a measure of risk,
i.e. variance or standard deviation of returns.
Not every portfolio in the portfolio opportunity set is of interest to an investor.
In the opportunity set, others will obviously dominate some portfolio. A portfolio will dominate
another if it has either a lower standard deviation or the same standard deviation as the other
portfolios that are dominated by other portfolios are known as inefficient portfolios.
Portfolios that are dominated by other portfolio are known as inefficient portfolios.
An investor would not be interested in all the portfolios in the opportunity set instead; he would
be interested only in the efficient portfolios.
Efficient set of portfolios
The following illustration is used to help understand the concept of efficient portfolios. The risk
of these portfolios may be estimated by measuring the standard deviation of portfolio returns
below:
Portfolio No. Expected Return Standard
(Per Cent) Deviation
(Risk)
1 5.6 4.5
2 7.8 5.8
3 9.2 7.6
4 10.5 8.1
5 11.7 8.1
6 12.4 9.3
7 13.5 9.5
8 13.5 11.3
9 15.7 12.7
10 16.8 12.9

If portfolio number 4 and 5 are compared, they have the same standard deviation of 8.1 portfolio
no.5 gives a higher expected return of 11.7 making it more efficient than portfolio number 4.
Similarly, if portfolio number 7 and 8 are compared, here the same expected return of 13.5 per
cent. However, the standard deviation is lower for portfolio no.7, making it more efficient than
portfolio no.8.
Thus, the selection of portfolio by the investor will be guided by two criteria:
1. Given two portfolios with the same expected return, the investor would prefer the one
with the lower risk.
2. Given two portfolio with the same risk, the investor would prefer the one with the higher
expected return.

These criteria are based on the assumption that investors are rational and also risk-averse. A ...
investor would prefer more return to less return. A risk averse investor would prefer less risk to
more risk.
The concept of efficient set can be illustrated with the help of a graph be illustrated with the help
of a graph. The expected return and standard deviation of portfolios can be depicted on an XY
graph, measuring the expected return on the Y-axis and standard deviation on the X-axis.

The shaded area in the graph represents the set of all possible portfolios that can be constructed
from a given set of securities. This opportunity set of portfolio takes a concur shape because it
consists of portfolios containing securities that are less than perfectly correlated with each other.
Portfolio E and F have the same expected return but portfolio E has the less risk. Hence,
portfolio E would be preferred to portfolio F.
Similarly, consider portfolio C & E both have the same risk, but portfolio E offers more returns
for the same risk. Hence, portfolio E would be preferred to portfolio C. Thus, for any point in the
risk return space, an investor would like to more as far as possible in the direction of increasing
risk.
Effectively, he would be moving towards the left in search of decreasing risk and upward in
search of increasing returns.
Comparing portfolio A and C, portfolio C would be preferred to it, since E&A have the same
return but C has a lower risk.

In comparison of all portfolio; portfolio C in above diagram has the lowest risk. Hence, portfolio
C represents the global minimum variance portfolio.
Comparison of portfolio A and B, portfolio B is preferred the portfolio A because it offers higher
return of the same level of risk.
From the diagram, point B represents the portfolio with the highest expected return among all the
portfolios in the feasible set.
Thus, we find portfolio lying in the North West boundary of the shaded area is more efficient
than all the portfolio in the interior of the shaded area. This boundary of the shaded area is called
efficient frontier as it contains all the efficient portfolio in the opportunity set.
The set of portfolios lying between the global minimum variance portfolio and the maximum
return portfolio on the efficient frontier represents the efficient set of portfolios. This can be
shown is a diagram below:

The efficient frontier

Y B

C
0 X

The efficient frontier is a concave curve in the risk-return space that extended from the minimum
variance portfolio to the maximum return portfolio.
Selection of optimal portfolio
The portfolio selection problem is the process of delineating the efficient portfolio and then
selecting the best portfolio from the set.
Rational investors will prefer to invest in the efficient portfolios. The particular portfolio that an
individual investor will select from the efficient frontier will depend on that investor’s degree of
aversion to risk.
A highly risk averse investor will hold a portfolio on the lower left hand segment of the efficient
frontier. On the other hand, an investor who is not too risk averse will held one on the upper
portion of the efficient frontier.

The selection of the optimal portfolio thus depends on the investors risk aversion or his risk
tolerance. This can be graphically represented through a series of risk return utility curves or
indifference curves.
Each curve represents different combination of risk and return all of which are equally
satisfactory to the concerned investor.
The investor is indifferent between the successive points in the curve. Each successive curve
moving upwards to the left represents a higher level of satisfaction or utility.
The investor’s goal would be to maximize his utility by moving up to the higher utility curve.
The optimal portfolio for an investor would be tendency between the efficient frontier and his
risk-return utility or indifference curve.
Optimal portfolio
Graph
From the diagram, point a represents the optimal portfolio.
Markowitz used the technique of quadratic programming to identify the efficient portfolio.
Using the expected returns and risk of each security under consideration and the convenience
estimates for each pair of securities be calculated risk and returns for all possible portfolios.
Capital Asset Pricing Model
CAPM is a model that calculates expected return based on expected rate of return on the market,
the risk-free rate and the beta co-efficient of the stock.
E(R) = Rf + β (R market – Rf)
Example
Determine the expected return of new omo’s stock using the CAPM model. New omo beta is 1.2.
Assume the expected return on the market is 12% and the risk-free rate is 4%.
Answer
E(R) = 4% + 1.2 (12% - 4%) = 13.6%
The security market line (SML)
Expected return

SML

risk free rate

Risk beta
Beta = Co-variance of stock to the market
SML is derived from the CAPM, solving for expected return. However, the level of risk used is
the beta, the slope of the SML.
Beta is the measure of a stock’s sensitivity of returns to changes in the market. It is a measure of
systematic risk.
Given the expected return of a new one using CAPM, it is easy to determine if the stock is
underpriced or overpriced.
1) If the expected return using the CAPM is higher than the investor’s required return, the
security is undervalued and the investor should buy it.
2) If the expected return using CAPM is lower than the investor’s required return, the
security is overvalued and should be sold.

Simplifying the portfolio optimization process via single index model

The basic notion underlying the single index model is that movements in the stock market affect
all stocks.
Casual observation of share prices reveals that when the market moves up (as measured) by any
of the widely used stock market indices), prices of most shares tend to increase.
When the market goes down, the prices of most shares tend to decline. This suggests that one
reason why security returns might be correlated and there is co-movement between securities, is
because of a common response to market changes.
This co-movement of stocks with a market index may be studied with the help of a simple linear
regression analysis, taking the returns on the individual security as the independent variable (R)
and the return on the market index (Rm) as the independent variable.
The return of an individual security is assumed to depend on the return on the market index.
The return of an individual security may be expressed as
Ri = α i + β i Rm + е i
Where:
αi = Component of security is return that is independent of the market’s
performance. Rm = Rate of return on the market index.
Βi = constant that measures the expected change in Ri given a change in Rm.
ei = error term representing the random or residual return.
Single index model assumes that the co-movement between stocks is due to the single common
influence by market performance. Hence, the measure of this index can be found by relating the
stock return to the return on a stock market index.
The above equation i.e. ri = αi + βRm + еi breaks the return on a stock into two components:-
 a) Part one due to the market.
b) Independent of the market.

The beta parameter in the equation, βi measures how sensitive a stock’s return is to the return on
the market index. It indicates how extensively the return of a security will vary with changes in
the market return.
For instance, if βi of a security is 2, then the return of the security is expected in increase by 20%
when the market return increases by 10%.
A beta co-efficient greater than one would suggest greeter responsiveness on the part of the stock
in relation to the market and vice versa.
The alpha parameter αi indicates what the return of the security would be when the market return
is zero.
For example, a security with an alpha of +3 percent would earn 3 per cent return even when the
market return is zero and it would earn an additional 3% at all levels of market returns.
A positive alpha represents a sort of a bonus return, would be a highly desirable aspect of a
security whereas a negative alpha represents a penalty to the investor, and is an undesirable
aspect of a security.
еi is the unexpected return resulting from influences not identified by the model. It is referred to
as the random or residue return. It may take on any value, but over a large number of
observations, but it will average out to zero.
SECURITY MARKET INDEXES
An index number is a number that measures the relative change in price, quantity, value or some other
quantifiable attribute from one time period to another or one geographical region to another. A simple
index number is an index number that is used to measure the relative change in just one variable. It is the
ratio of the two values of the variables expressed as a percentage.

Measuring security return and risk under single model

The expected return, variance and co-variance can be estimated as follows when they are used to
represent the joint movement of stocks.
i. Mean return of stock, ri = αi + βirm
ii. Variance of stock returns, 𝜎2i = 𝛽2i𝜎2𝑚 + 𝜎2i
iii. Variance of stock returns, Co-variance of return between stock i and j
𝜎ij = 𝛽i 𝛽j 𝜎2m
Where 𝜎2m = market variance, and
 𝜎2i = unique risk factor.
The return of the security is a combination of two components
a) Specific returns component represented by alpha.
b) A market related return component represented by 𝛽i𝑅𝑚

The residual return disappears from the expression, since its average value is zero.
i.e. 𝑅̅ i = 𝖺 i + 𝛽i 𝑅̅ m
Correspondingly, the risk of a security 𝜎2i becomes the sum of a market related component
and a component that is specific to the security.
Thus, total risk = market related risk + specific risk
𝜎2i = 𝛽2i𝜎2m + 𝜎2ei
Where:
𝜎2i = variance of individual security.
𝜎2m = variance of market index return.
𝜎2ei = Variance of residual return and individual security.
𝛽i = Beat co-efficient of individual security.
The market related component of risk is referred to as systematic risk as it affects all
securities.
The specific risk component is the unique risk or unsystematic risk, which can be reduced
through diversification. It is also called diversification risk.
The estimates of 𝖺i, βi and 𝜎2ei of a security are often obtained from regression analysis of
historical data of returns of the security as well as returns of a market index.
Example
The estimated value of 𝖺i, βi and 𝜎2ei of a security are 2%, 1.5% and 300 respectively.
Assume the market index is expected to provide a return of 20% with variance of 120.
Required: Calculate the expected return and Risk of the security
Solutions
Expected return = 𝖺i + βi𝑅̅ m
= 2 + 1.5 (20)
= 32%
Risk of security = 𝜎2i = βi𝜎2m+ 𝜎2ei
= (1.5)2 + (120) + 300
= 570
Measuring portfolio return and risk under single index model
Portfolio analysis and selection requires as input the expected portfolio return and risk for all
possible portfolios that can be constructed with a given set of securities.
The return of portfolios can be calculated using the single index model.
The expected return of a portfolio may be taken as portfolio alpha plus (+) portfolio beta
times (x) expected market return.
Thus: 𝑅̅ p = 𝖺p + βp𝑅̅ m
The portfolio alpha is the weighted average of the specific returns (alpha) of the individual
securities.
Thus: 𝖺p = i=1 𝑤i 𝖺i
∑𝑢
Where:
wi = proportion of investment in an individual security.
𝖺i = specific return of an individual security.
Thus : 𝖺p =
∑𝑢 i=1 𝑤i 𝛽i

Where:
Wi = proportion of investment in an individual security.
𝛽i = Beta co − efficient of an individual security.
The expected return of the portfolio is the same as the weighted average of the specific
returns and the weighted average of the market related return of indivdul securities.
The risk of a portfolio is measured as the variance of the portfolio return. The risk of a
portfolio is simply a weighted average of the market related risks of individual securities plus
a weighted average of the specific risks of individual securities in the portfolio.
The portfolio risk may be expressed as:
𝜎
∑𝑢 = 𝛽 𝜎 +
2 2 2

𝑝 𝑝 𝑚 i=1
𝑤i2 𝜎𝑒i
2

𝛽2𝜎2 constitutes the variance of the market index multiplied by the square of
𝑝 𝑚

portfolio beta = systematic risk.

∑𝑢 𝑤2𝜎2 represents the weighted average of the variances of residual returns of
 i=1 i 𝑒i

individual securities and represents the specific risk of unsystematic risk the portfolio.

As more and more and more securities are added to the portfolio; the unsystematic risk of the
portfolio becomes smaller and is negligible for a moderately sized portfolio.
Thus for a large portfolio, the residual risk or unsystematic risk approaches zero and the portfolio
risk becomes equal to 𝛽2𝜎2 . Hence, the effective measure of portfolio risk is 𝛽𝑝.
𝑝 𝑚
Example
Security Weight Alpha Beta Residual variance
Wi 𝜎i 𝛽i 2
𝜎𝑒i
A 0.2 2.0 1.7 370
B 0.1 3.5 0.5 240
C 0.4 1.5 0.7 410
D 0.3 0.75 1.3 285
Portfolio value 1.0 1.575 1.06 108.45
The value of portfolio alpha, portfolio beta and portfolio residual variance can be calculated as
follows: -
𝑢
𝖺𝑝= ∑ 𝑤i 𝖺 i
i=1

= 0.2 (2) + 0.1 (5.5) + 0.4 (1.5) + 0.3 (0.75) = 1.575

Βp =
∑𝑢 i=1 𝑤i 𝛽i

= 0.2 (1.7) + 0.1 (0.5) + 0.4 (0.7) + 0.3 (1.3) = 1.06

Portfolio residual variance =
∑𝑢 𝑤2 𝜎2
i=1 i 𝑒i

= (0.2)2 (370) + (0.1)2 (240) + (0.4)2 (410) + (0.3)2 (285)

= 108.45
The expected portfolio return assuming a market return of 15% can be calculated as follows:
𝑅̅ p = 𝖺 𝑝 + 𝛽𝑝 𝑅̅ m
= 1.575 + 1.06(15)
= 17.475
Portfolio variance assuming a market return of 320
𝜎2 = 𝛽2𝜎2 + ∑𝑢 𝑤i 𝜎2
𝑝 𝑝 𝑚 i=1 𝑒i
= (1.06)2 (320) + 108.45
= 468.002