Portfolio Choice Examples

Ritesh Pandey

September 13, 2023

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Expected return and standard deviation

A game of chance offers the following odds and payoffs. Each play
of the game costs |100, so the net profit per play is the payoff less
|100.

Probability Payoff Net profit (|)

.1 500 400
.5 100 0
.4 0 -100

What are the expected cash payoff and the expected rate of return?
Calculate the variance and standard deviation of this rate of return.

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Expected return and standard deviation

Probability Payoff Net profit (|) Return

.1 500 400 = 400/100 = 400%
.5 100 0 = 0/100 = 0%
.4 0 -100 = −100/100 = −100%

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Expected return and standard deviation

E (Payoff ) = .1(500) + .5(100) + .4(0)

= 100|

E (R) = .1(400) + .5(0) + .4(−100)

= 0%

var (R) = .1(400 − 0)2 + .5(0 − 0)2 + .4(−100 − 0)2

= 20, 000

p
σ(R) = 20, 000
= 141.41%

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Standard deviation of returns
The following table shows the nominal returns on Indian stocks and
the rate of inflation.

Year Nominal Return (%) Inflation (%)

2013 4.5 7.4
2014 10.5 6.0
2015 32.0 2.0
2016 -0.9 -2.5
2017 3.9 3.7

1 What was the standard deviation of the market returns?

2 Calculate the average real return.

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Real and nominal returns
If inflation rate if π in percentage terms, then

1 + r nominal = (1 + π)(1 + r real ) (1)

or equivalently,

1 + r nominal
1 + r real = (2)
1+π

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Real and nominal returns
If inflation rate if π << 1 , then we can ignore it in the denominator
and then,

r nominal ≈ r real + π (3)

or equivalently,

r real ≈ r nominal − π (4)

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Standard deviation of returns
Year Nominal Return (%) Inflation (%) Real return (%)

2013 4.5 7.4 1.045 − 1 = −2.7%

1.074
2014 10.5 6.0 1.105 − 1 = 4.25%
1.06
2015 32.0 2.0 1.32 − 1 = 29.41%
1.02
2016 -0.9 -2.5 .991 − 1 = 1.64%
.975
2017 3.9 3.7 1.039 − 1 = .19%
1.037

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Standard deviation of returns

E (rnom ) = [4.5 + 10.5 + 32.0 − .9 + 3.9]/5

= 10%

q
σ(rnom ) = [(4.5 − 10)2 + (10.5 − 10)2 + (32.0 − 10)2 + (−.9 − 10)2 + (3.9 − 10)2 ]/4
= 13.01%

E (rreal ) = [−2.7 + 4.25 + 29.41 + 1.64 + .19]/5

= 6.56%

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Portfolio risk
Suppose the standard deviation of the market return is 20%.
1 What is the standard deviation of returns on a well-diversified
portfolio with a beta of 1.3?
2 What is the standard deviation of returns on a well-diversified
portfolio with a beta of 0?
3 A well-diversified portfolio has a standard deviation of 15%.
What is its beta?
4 A poorly diversified portfolio has a standard deviation of 20%.
What can you say about its beta?

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Portfolio risk
A well diversified portfolio will have a correlation of 1 with the market
portfolio.

σp = β × σm
= 1.3 × 20%
= 26%

σp = β × σm
= 0 × 20%
= 0%

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Portfolio risk

σp
β=
σm
= 15%/20%
= .75

ρp,m × σp
β=
σm
= ρp,m × 20%/20%
<1

Since the portfolio is not fully diversified so some part of its risk will
be unique/specific risk and so its beta will be less than one.

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Portfolio Beta
A portfolio contains equal investments in 10 stocks. Five have beta
of 1.2; the remainder have a beta of 1.4 What is the portfolio beta?

1 1.3
2 Greater than 1.3 because the portfolio is not completely
diversified.
3 Less than 1.3 because diversification reduces beta.

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Portfolio Beta

βp = [5 × 1.2 + (10 − 5) × 1.4]/10

= 1.3

Beta is a measure of systematic risk which cannot be removed by

diversification.

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Beta
What is the beta of each of the stocks shown in the table below?

Stock r if rm is -10% r if rm is +10%

A 0 +20
B -20 +20
C -30 0
D +15 +15
E +10 -10

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Beta
Beta is measured as the slope of the line representing stock returns aa a linear function of market returns , i.e.,
∆r
β = ∆r i
m

∆r
Stock r if rm is -10% r if rm is +10% β = ∆r i
m

A 0 +20 β = (20 − 0)/(10 − (−10)) = 1

B -20 +20 β = (20 − (−20))/(10 − (−10)) = 2
C -30 0 β = (0 − (−30))/(10 − (−10)) = 1.5
D +15 +15 β = (15 − 15)/(10 − (−10)) = 0
E +10 -10 β = (−10 − 10)/(10 − (−10)) = −1

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Portfolio risk
1 How many variance terms and how many different covariance
terms do you need to calculate the risk of a 100 stock
portfolio?
2 Suppose all stocks had a standard deviation of 30% and a
correlation of .4 with each other. What is the standard
deviation of the returns on a portfolio that has equal holdings
in 50 stocks?
3 What is the standard deviation of a fully diversified portfolio of
such stocks?

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Portfolio risk
If we have N stocks then we will need to compute N variances and
1/2 × (N 2 − N) unique covariances. For N = 100, we have 100
variances and 4950 unique covariances.

Equal holdings in 50 stocks means a weight of 1/50 = .02 in each

stock. The std. dev. will be the square root of N(1/N)2 σ¯2 + (N 2 −
N)(1/N)2 Covar i.e., 50 × .022 × .32 + (502 − 50) × .022 × .4 × .3 × .3
that is 19.3%.

As we approach full diversification, σp approaches average covariance

= .3 × .3 × .4 = .036 so that σ = .19 = 19%

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Portfolio risk
Suppose that the standard deviation of returns from a typical share
is about 40% a year. The correlation between the returns from each
pair of shares is about .3
1 Calculate the variance and standard deviation of the returns on
a portfolio that has equal investments in 2 shares, 3 shares, 4
shares and so on, up to 10 shares.
2 Use your estimates to plot the portfolio std. dev. against the
no. of securities. How large is the underlying market variance
that cannot be diversified away?
3 Now repeat the problem, assuming that the correlation
between each pair of stocks is zero.

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Portfolio risk

The std. dev. will be the square root of N(1/N)2 (.4)2 + (N 2 −

N)(1/N)2 (.4 × .4 × .3)

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Portfolio risk

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Beta
There are few, if any, real companies with negative betas. But sup-
pose you found one with β = −.25.
a How would you expect this stock’s rate of return to change if
the overall market rose by an extra 5%? What if the market
fell by an extra 5%?
b You have |1 million invested in a well-diversified portfolio of
stocks. Now you receive an additional |200,000 bequest.
Which of the following actions will yield the safest overall
portfolio return?
1 Invest |20,000 in Treasury Bills (which have β = 0).
2 Invest |20,000 in stocks with β = 1.
3 Invest |20,000 in stocks with β = −.25.
Explain your answer.

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Beta

∆r = β × ∆rm
= −.25 × 5%
= −1.25%

∆r = β × ∆rm
= −.25 × −5%
= 1.25%

Since portfolio is well diversified, only systematic risk (measured by β)

remains i.e, portfolio beta is approximately one. Maximum reduction
in portfolio β will be achieved by investing the stock with β = −.25.

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Portfolio risk
You can form a portfolio of 2 assets A and B whose returns have the
following characteristics.

Stock Expected return Standard deviation Correlation

A 10% 20%
.5
B 15% 40%

If you demand an expected return of 12% what is the portfolio stan-

dard deviation?

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Portfolio risk
If weight in A be w , then E (rp ) = w × 10% + (1 − w ) ×
15% = p12% gives us, on solving for w, w = 60%. So,
σp = w 2 Var (RA ) + (1 − w )2 Var (RB ) + 2w .(1 − w )ρAB σ(RA )σ(RB )
which comes out to be 24.33%.

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Portfolio risk
Suppose that Treasury bills offer a return of about 6% and the ex-
pected market risk premium is 8.5%. The standard deviation of
market returns is 20%. Draw a graph showing how the returns of a
portfolio of T-bills and the market index changes with its standard
deviation.

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Portfolio risk
We know that σT −Bills = 0, the bills being risk-free. Also, therefore,
Cov (rT , rm ) = 0. So, E (rp ) = x × .06 + (1 − x) × (.06 + .085) and
σp = (1 − x) × .2

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Portfolio risk

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Efficient portfolios
Plot the following risky portfolios on a graph.

Portfolio Expected Return (%) Std. Dev. (%)

A 10 23
B 12.5 21
C 15 25
D 16 29
E 17 29
F 18 32
G 18 35
H 20 45

1 Five of these portfolios are efficient and three are not. Which are the inefficient ones?
2 Suppose that you can also borrow and lend at the interest rate of 12%. Which of the above portfolios has
the highest Sharpe ratio?
3 Suppose you are prepared to tolerate a standard deviation of 25%. What is the maximum expected return
that you can achieve if you cannot borrow or lend?
4 What is your optimal strategy if you can borrow or lend at 12% and are prepared to tolerate a standard
deviation of 25%? What is the maximum expected return that you can achieve with this risk?

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Efficient portfolios

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Efficient portfolios
Clearly, portfolios A, D and G are inefficient.

Portfolio Expected Return (%) Std. Dev. (%) (r − rf )/σ

A 10 23 (10 − 12)/23 = −8.7

B 12.5 21 (12.5 − 12)/21 = 2.4
C 15 25 (15 − 12)/25 = 12.0
D 16 29 (16 − 12)/29 = 13.8
E 17 29 (17 − 12)/29 = 17.2
F 18 32 (18 − 12)/32 = 18.8
G 18 35 (18 − 12)/35 = 17.2
H 20 45 (20 − 12)/45 = 17.8

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Efficient portfolios

Among portfolios with a maximum σ of 25%, the highest return is

offered by C, at 15%.

The highest Sharpe ratio is of portfolio F. We invest a fraction x in

F and 1-x in the risk-free security. We have x × 32% = 25% giving
x = 25/32. This will give us a return of 25/32 × 18% + 7/32 × 12%
i.e., 16.7%.

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