Chapter 5 Modern Portfolio Concepts

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Chapter 5 Modern Portfolio Concepts
2
Principles of Portfolio Planning

• Portfolio Objectives (continued)
• The ultimate goal of an investor is to construct
  an efficient portfolio, which is one that
  provides the highest return for a given level of
  risk or that has the lowest level of risk for a
  given return.
• Portfolio Return and Standard Deviation (See
  Equation 5.1, 5.1a, and Table 5.1)
• Correlation and Diversification
• Correlation (See Figure 5.1)
• Diversification (See Figure 5.2 attached and
  Table 5.2)
• Impact on Risk and Return (See Table 5.3 and
  Figure 5.3 attached)

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Principles of Portfolio Planning

• Types of Portfolios
• Growth-oriented portfolios have as a primary
  objective long-term price appreciation.
• Income-oriented portfolios stress current
  dividend and interest income.
• Portfolio Objectives
• Setting portfolio objectives involves definite
  tradeoffs tradeoffs between risk and return, and
  capital gains and income.
• Most importantly, one must set objectives before
  beginning to invest.

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Figure 5.1 The Correlation Between Series M, N,
and P
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Figure 5.2 Combining Negatively Correlated
Assets to Diversify Risk
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Figure 5.3 Range of Portfolio Return and Risk
for Combinations of Assets A and B for Various
Correlation Coefficients
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Principles of Portfolio Planning

• International Diversification
• Effectiveness of International Diversification.
  Studies generally suggest investors can achieve
  superior risk-adjusted returns through
  international portfolio diversification.
• Methods of International Diversification
• The best way may be to invest in international
  mutual funds or in the securities of foreign
  securities listed on U.S. exchanges.
• One cannot generally achieve international
  diversification by investing in multinational
  corporations (MNCs).
• Benefits of International Diversification

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The Capital Asset Pricing Model (CAPM)

• Components of Risk (See Equation 5.2)
• Diversifiable (unsystematic or company-specific)
  Risk
• Nondiversifiable (systematic or market) Risk
• Beta A Popular Measure of (Market) Risk
• Deriving Beta (See Figure 5.4 on the following
  slide)
• Interpreting Beta (See Table 5.4)
• Applying Beta
• Beta measures the nondiversifiable (market) risk
  of a security
• The Beta for the market is 1.00
• Most stocks have positive betas
• The higher a stocks beta, the greater should be
  its expected level of return

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Figure 5.4 Graphical Derivation of Beta for
Securities C and D
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The Capital Asset Pricing Model (CAPM)

• The CAPM Using Beta to Estimate Return
• The Equation (See Equation 5.3 and 5.3a)
• The Graph (See Figure 5.5 on the following slide)

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Figure 5.5 The Security Market Line (SML)
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Traditional versus Modern Portfolio Management

• The Traditional Approach (See Table 5.5)
• Traditional portfolio management emphasizes
  balancing the portfolio by assembling a wide
  variety of stocks and/or bonds of companies from
  a broad range of industries.
• Those who invest in traditional portfolios
  generally invest in well-known companies. The do
  so because
• These are known as successful businesses,
  investing them is perceived as less risky than
  investing in lesser-known firms.
• The securities of large firms are more liquid and
  are available in large quantities.
• Institutional investors prefer successful
  well-known companies because it is easier to
  convince clients to invest in them.

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Traditional versus Modern Portfolio Management

• Modern Portfolio Theory
• Modern portfolio theory utilizes several basic
  statistical measures including expected return,
  standard deviation, and correlation to develop a
  portfolio plan.
• Statistical diversification is the deciding
  factor in choosing securities for an MPT
  portfolio.
• The Efficient Frontier (See Figure 5.6 on the
  following slide)
• Portfolio Betas
• Risk Diversification (See Figure 5.7 on the next
  slide)
• Calculating Portfolio Betas (See Equation 5.4,
  5.4a, and Table 5.6)
• Using Portfolio Betas
• Interpreting Portfolio Betas

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Figure 5.6 The Feasible or Attainable Set and
the Efficient Frontier
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Figure 5.7 Portfolio Risk and Diversification
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Traditional versus Modern Portfolio Management

• Modern Portfolio Theory (continued)
• The Risk-Return Tradeoff Some Closing Comments
• The risk-return tradeoff is the positive
  relationship between the risk associated with a
  given investment and its expected return.
• It is depicted as the upward sloping line as
  shown in Figure 5.8 on the following slide.
• Reconciling the Traditional Approach and MPT
• The average individual investor does not have the
  resources or ability to implement a total MPT
  portfolio strategy.
• But most individuals can use ideas from both the
  traditional and MPT approaches.
• The traditional approach discuses security
  selection (Ch 7 8)

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Traditional versus Modern Portfolio Management

• Reconciling the Traditional Approach and MPT
  (continued)
• It also emphasizes diversification across
  industries.
• MPT stresses negative correlations between rates
  of return for the securities within the portfolio
  to minimize diversifiable risk.
• Thus, diversification is common to both
  strategies and beta is a useful tool to help
  implement that strategy.
• The authors recommend
• Determine how much risk you are willing to bear.
• Seek diversification among a wide variety of
  securities, being attentive to how the return
  from one security is related to another.

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Figure 5.8 The Portfolio Risk-Return Tradeoff
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Constructing a Portfolio Using an Asset
Allocation Scheme

• Investor Characteristics and Objectives
• Financial and Family Situations
• Level of net worth and stability of income and
  employment
• Investor experience, age, and disposition toward
  risk
• What do I want from my portfolio?
• High current income versus future capital
  appreciation
• Portfolio Objectives and Policies
• Current income needs
• Capital preservation
• Capital growth
• Tax considerations
• Risk

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Constructing a Portfolio Using an Asset
Allocation Scheme

• Developing an Asset Allocation Scheme
• Asset Allocation involves dividing ones
  portfolio into various asset classes such as
  stocks, bonds, foreign securities, gold, and real
  estate.
• The objective of asset allocation is to preserve
  capital by protecting against negative
  developments while taking advantage of positive
  ones.
• Asset allocation is different from
  diversification in that it focuses on investments
  in various asset classes rather than on selecting
  specific securities to be held within an asset
  class.
• Asset allocation is based on the belief that the
  total return of a portfolio is influenced more by
  the division of investments into asset classes
  than by the actual investments.

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Constructing a Portfolio Using an Asset
Allocation Scheme

• Approaches to Asset Allocation
• Fixed Weightings
• Flexible Weightings
• Tactical Allocation
• Asset Allocation Alternatives (See Table 5.8)
• Applying Asset Allocation