Why Optimal Diversification Cannot Outperform Naive Diversification
14-Efficient Diversification II
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Transcript of 14-Efficient Diversification II
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14-Efficient Diversification II
BKM: Chapter 6
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Portfolio Allocation
What about the case of many risky assets? The efficient frontier has the same shape Intuition is the same
Exp
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Standard Deviation
Individual Assets
Tangency Portfolio
risk free rate Best possible CAL
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Multiple AssetsGiven time series of returns for n stock, you can find the portfolio with maximum Sharpe ratio as follows:
Pick arbitrary weights. For the last stock, specify weight as 1-sum of others
Find the portfolio return using these arbitrary weights for each date (point to cells with weights)
Estimate the expected return and standard deviation
Calculate the Sharpe ratio of the portfolio
Use solver: maximize Sharpe ratio of portfolio by changing cells containing weights. Change all weights except last, which equals 1-sum of others
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Diversification & Many Risky Assets
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Number of Assets in Portfolio
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Diversification
In any portfolio, what fluctuations are “cancelled out”?
Simple two-stock example:
BBAAp
p
DELL
MSFT
rwrwr
rrr
portfolioon return Dellon return Microsofton return
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Portfolio Variance
wMSFT
wDELL
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Components of MSFT
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Components of Dell
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Remaining Components
wMSFT
wDELL
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Portfolio Variance
wMSFT
wDELL
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Vanishing Components
wMSFT
wDELL
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Diversification
Portfolio Rule #5
The component of the stock return that is independent of the portfolio return is always “off-set” or “canceled out” in a portfolio.
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Diversification
tMSFTtpMSFTMSFTtMSFT erbar ,,,
Remaining Component Vanishing Component
tDELLtpDELLDELLtDELL erbar ,,,
Remaining Component Vanishing Component
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Market Portfolio
Assume the portfolio we hold is the market portfolio.
When we combine stocks into this portfolio, again there is a “remaining” and “vanishing” component to each stock.
We find this component for each stock by estimating the regression:
titMiMSFTti erbar ,,,
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Market portfolio When we estimate this regression using a stock return
as the “y” variable and the market return as the “x” variable, we call the slope coefficient beta ()
We call the variance of the remaining component “systematic risk”
We call the variance of the vanishing component “unsystematic” or idiosyncratic, or “firm specific” risk.
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Diversification and Many Risky Assets
R-square in this regression is
R-square in this regression is therefore the fraction of the total stock variance that “remains” or that is systematic.
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rVarrVarR
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Risk Systematic risk refers to fluctuations in asset prices
caused by macroeconomic factors that are common to all risky assets; hence systematic risk is often referred to as market risk. Examples of systematic risk factors include the business cycle, inflation, monetary policy and technological changes.
Firm-specific risk refers to fluctuations in asset prices caused by factors that are independent of the market, such as industry characteristics or firm characteristics. Examples of firm-specific risk factors include litigation, patents, management, and financial leverage.