Financial Economics and
Investments, Spring 25
Topic 5a
Efficient Diversification
Don’t Put All Your Eggs in One Basket
Portfolio Theory
The investment decision can be viewed as a top-down process:
1. capital allocation between the risky portfolio and risk-free
assets,
– Capital allocation determines the investor’s exposure to risk.
2. asset allocation within the risky portfolio across broad asset
classes (e.g., U.S. stocks, international stocks, and long-term
bonds), and
3. security selection of individual assets within each asset class.
Portfolio Theory
• In principle, asset allocation and security selection are technically identical
– Both aim at identifying the optimal risky portfolio, specifically, the combination
of risky assets that provides the best risk–return trade-off or, equivalently, the
highest Sharpe ratio.
– The higher the Sharpe ratio, the greater the expected return corresponding to
any level of volatility
– Steeper CALs provide greater rewards for bearing any level of risk
• In practice, asset allocation and security selection are typically separated
into two steps
– The broad outlines of the portfolio are established first (asset allocation), while
details concerning specific securities are filled in later (security selection)
Portfolio Theory
• The portfolios we discuss in this and the following chapters
presume a short-term horizon
– Even if the overall investment horizon is long, portfolio composition
can be rebalanced or updated almost continuously.
• For these short horizons, the assumption of normality is
sufficiently accurate to describe holding-period returns, and
we will be concerned only with portfolio means and variances.
Contents
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
– Minium-Variance Portfolio
– Portfolio Opportunity Set
Diversification and Portfolio Risk
Two broad sources of uncertainty:
1. Risk that comes from conditions in the general economy, such as
the business cycle, inflation, interest rates, and exchange rates.
– None of these macroeconomic factors can be predicted with certainty.
– Market risk, or systematic risk
2. Firm-specific influences, such as the firm’s success in research and
development and personnel changes.
– These factors affect the firm without noticeably affecting other firms in the
economy.
– firm-specific risk, or nonsystematic risk
Diversification and Portfolio Risk
Diversification should reduce portfolio risk
• If we diversify into many more securities, we continue to
spread out our exposure to firm-specific factors, and portfolio
volatility should continue to fall.
– The reason is that with all risk sources independent
• Even with a large number of stocks, we cannot avoid risk
altogether because virtually all securities are affected by the
common macroeconomic factors.
Diversification and Portfolio Risk
• Risk reduction by spreading exposure across many independent risk
sources is sometimes called the insurance principle: An insurance
company depends on such diversification when it writes many
policies insuring against many independent sources of risk, each
policy being a small part of the company’s overall portfolio.
• The risk that remains even after extensive diversification is called
nondiversifiable risk, market risk, or systematic risk,
• The risk that can be eliminated by diversification is called unique
risk, firm-specific risk, nonsystematic risk, or diversifiable risk.
Contents
1. Diversification and Portfolio Risk
2. Portfolios of Two Risky Assets
– Minium-Variance Portfolio
– Portfolio Opportunity Set
Portfolios of Two Risky Assets
Consider two mutual funds, a bond portfolio specializing in long-term debt
securities, denoted 𝐷, and a stock fund that specializes in equity securities, 𝐸.
• A proportion denoted by 𝑤𝐷 is invested in the bond fund, and the
remainder, denoted by 𝑤𝐸 and 𝑤𝐸 = 1 − 𝑤𝐷 , is invested in the stock fund.
• The expected return on the portfolio is
𝐸 𝑟𝑃 = 𝑤𝐷 ⋅ 𝐸 𝑟𝐷 + 𝑤𝐸 ⋅ 𝐸[𝑟𝐸 ]
• The variance of 𝑟𝑃 is
𝜎𝑝2 = 𝑤𝐷 2 𝜎𝐷2 + 𝑤𝐸 2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 ⋅ 𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸
𝜎𝑝2 = 𝑤𝐷 2 𝜎𝐷2 + 𝑤𝐸 2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝜎𝐷 𝜎𝐸 ⋅ 𝐶𝑜𝑟𝑟 𝑟𝐷 , 𝑟𝐸
Portfolios of Two Risky Assets
In words, the variance of the portfolio is a weighted sum of covariances, and each weight is the product of the
portfolio proportions of the pair of assets.
• in Panel B: Each covariance has been multiplied by the weights from the row and the column in the borders.
• This procedure works because the covariance matrix is symmetric around the diagonal, that is, 𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸 =
𝐶𝑜𝑣(𝑟𝐸 , 𝑟𝐷 )
Portfolios of Two Risky Assets
Portfolios of Two Risky Assets
𝜎𝑝2 = 𝑤𝐷 2 𝜎𝐷2 + 𝑤𝐸 2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 𝜎𝐷 𝜎𝐸 ⋅ 𝐶𝑜𝑟𝑟 𝑟𝐷 , 𝑟𝐸
• The expected return of a portfolio is not influenced by the correlation
between returns. However, the correlation does impact the portfolio's risk
(variance).
– Variance is reduced if the covariance term is negative.
• Potential benefits from diversification arise when correlation is less than
perfectly positive.
– The lower the correlation, the greater the potential benefit from diversification.
– Even if the covariance term is positive, the portfolio standard deviation is still less
than the weighted average of the individual security standard deviations, unless
the two securities are perfectly positively correlated.
Minium-Variance Portfolio
• A hedge asset has negative correlation with the other assets in
the portfolio.
• An asset that is perfectly negatively correlated with a portfolio
can serve as a perfect hedge. That perfect hedge asset can
reduce the portfolio variance to zero.
– When 𝐶𝑜𝑟𝑟 𝑟𝐷 , 𝑟𝐸 = −1, how can a perfectly hedged position be
achieved?
𝜎𝐸
• 𝑤𝐷 =
𝜎𝐷 +𝜎𝐸
Minium-Variance Portfolio
Consider two mutual funds, a bond portfolio specializing in long-term
debt securities, denoted 𝐷, and a stock fund that specializes in equity
securities, 𝐸.
1. If 𝐶𝑜𝑟𝑟 𝑟𝐷 , 𝑟𝐸 = −1, find the perfectly hedged position.
2. If 𝐶𝑜𝑟𝑟 𝑟𝐷 , 𝑟𝐸 = 0.3, find the minimum-variance portfolio.
• When 𝑤𝐸 < 0,
the equity fund
is sold short,
with proceeds of
the short sale
invested in the
debt fund.
• When 𝑤𝐷 < 0,
sell the bond
fund short and
𝑤𝐸 use the proceeds
to finance
additional
purchases of the
equity fund.
For 𝜌 = 0.30
• The graph illustrates that as the
portfolio weight in the equity
fund increases from -0.5 to 1.5,
the portfolio's standard deviation
initially decreases due to
diversification from bonds into
stocks. However, it rises again as
the portfolio becomes heavily
concentrated in stocks, resulting
in a lack of diversification.
• This pattern will generally hold
when 𝜌 is not too high.
– As long as 𝜌 < 𝜎𝐷 /𝜎𝐸 , volatility
will initially fall when we start with
all bonds and begin to move into
stocks.
For 𝜌 = 1
• There is no advantage from
diversification
– The portfolio standard
deviation is simply the
weighted average of the
component asset standard
deviations.
• For a pair of assets with a large
positive correlation of returns,
the portfolio standard
deviation will increase
monotonically from the low-
risk asset to the high-risk
asset.
Minium-Variance Portfolio
𝜎𝑝2 = 𝑤𝐷 2 𝜎𝐷2 + 𝑤𝐸 2 𝜎𝐸2 + 2𝑤𝐷 𝑤𝐸 ⋅ 𝐶𝑜𝑣 𝑟𝐷 , 𝑟𝐸
The minimum-variance portfolio
• The portfolio weight that yields the minimum level of portfolio risk
(standard deviation) is
𝜎𝐸2 − 𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
𝑤𝐷,𝑚𝑖𝑛 = 2
𝜎𝐷 + 𝜎𝐸2 − 2𝐶𝑜𝑣(𝑟𝐷 , 𝑟𝐸 )
• The minimum-variance portfolio has a standard deviation smaller than that
of either of the individual component assets. This illustrates the power of
diversification to limit risk.
The portfolio opportunity set
shows all combinations of
portfolio expected return and
standard deviation that can be
constructed from the two
available assets.
• 𝜌 = 1: no benefit from
diversification
• 𝜌 < 1: “pushed” to the
northwest
• 𝜌 = −1: the maximum
advantage from
diversification
Portfolio Opportunity Set
If an investor aims to choose the optimal portfolio from the
opportunity set, the best portfolio will depend on their risk
aversion.
• Portfolios to the northeast in Figure 7.5 provide higher rates of
return but impose greater risk. The best trade-off among these
choices is a matter of personal preference.
