Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 1, Part 2 – Diversification and Asset Allocation – Sept 13
Chapter Two Outline
− Expected return and variances.
− Diversification and portfolio risk.
− Correlation and diversification.
− Markowitz efficient frontier.
− Asset allocation and security selection decisions of portfolio formation.
− In fact, diversification has a profound effect on portfolio return and portfolio risk.
Diversification and Asset Allocation
− Our goal in this chapter is to examine the role of diversification and asset allocation in
− In the early 1950s, Professor Harry Markowitz was the first to examine the role and
impact of diversification.
− Based on his work, we will see how diversification works, and we can be sure that we
have ‘efficiently diversified portfolios’.
o An efficiently diversified portfolio is one that has the highest expected return,
given its risk.
o You must be aware of the difference between historic return and expected return.
− Although it is important to be able to calculate historical returns, we really care about
expected returns, because we want to know how our portfolio will perform from today
− Expected return is the ‘weighted average’ return on a risky asset, from today to some
− To calculate an expected return, you must first:
o Decide on the number of possible economic scenarios that might occur.
o Estimate how well the security will perform in each scenario, and o Assign a probability to each scenario.
o (BTW, finance professors call these economic scenarios, ‘states’.)
− The next slide shows how the expected return formula is used when there are two states.
o Note that the ‘states’ are equally likely to occur in this example. BUT! They do
not have to be. They can have different probabilities of occurring.
Calculating the Variance of Expected Returns
− The variance of expected returns is calculated as the sum of the squared deviation of each
return from the expected return, multiplied by the probability of the state.
− The standard deviation is simply the square root of the variance.
− The following slide contains an example that shows how to use these formulas in a
− Portfolios are groups of assets, such as stocks and bonds that are held by an investor.
− One convenient way to describe a portfolio is by listing the proportion of the total value
of the portfolio that is invested into each asset.
− These proportions are called portfolio weights.
o Portfolio weights are sometimes expressed in percentages.
o However, in calculations, make sure you use proportions.
Variance of Portfolio Expected Returns
− Note: unlike returns, portf