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(eD)
D D M

where is the correlation coefficient between RD and RM . Its square measures the ratio of ex-
plained variance to total variance, that is, the proportion of total variance that can be attributed
to market fluctuations. But if beta is negative, so is the correlation coefficient, an indication
that the explanatory and dependent variables are expected to move in opposite directions.
At the extreme, when the correlation coefficient is either 1.0 or 1.0, the security return is
fully explained by the market return, that is, there are no firm-specific effects. All the points
of the scatter diagram will lie exactly on the line. This is called perfect correlation (either pos-
itive or negative); the return on the security is perfectly predictable from the market return. A
large correlation coefficient (in absolute value terms) means systematic variance dominates
the total variance; that is, firm-specific variance is relatively unimportant. When the corre-
lation coefficient is small (in absolute value terms), the market factor plays a relatively un-
important part in explaining the variance of the asset, and firm-specific factors predominate.

5
Note that the average beta of all securities will be 1.0 only when we compute a weighted average of betas (using mar-
ket values as weights), since the stock market index is value weighted. We know from Chapter 5 that the distribution
of securities by market value is not symmetric: There are relatively few large corporations and many more smaller
ones. Thus, if you were to take a randomly selected sample of stocks, you should expect smaller companies to domi-
nate. As a result, the simple average of the betas of individual securities, when computed against a value-weighted
index such as the S&P 500, will be greater than 1.0, pushed up by the tendency for stocks of low-capitalization com-
panies to have betas greater than 1.0.
Bodieв€’Kaneв€’Marcus: II. Portfolio Theory 6. Efficient Diversification В© The McGrawв€’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

197
6 Efficient Diversification

<
6. Interpret the eight scatter diagrams of Figure 6.12 in terms of systematic risk,
Concept
diversifiable risk, and the intercept.
CHECK

R1 R3 R4
R2
*
*
**
* *
*
**
* *
* *
** **
*
*
*
* **
* RM * RM RM
RM
*
* * * * *
*

R5 R7 R8
R6
*
* *
*
*
*
* *
*
*
*
*
** *
*
RM RM RM
RM
* *
* * * *
*
* * *
* *
* *
*
*

F I G U R E 6.12
Various scatter diagrams

The direct way to calculate the slope and intercept of the characteristic lines for ABC and XYZ
is from the variances and covariances. Here, we use the Data Analysis menu of Excel to obtain
EXAMPLE 6.4
the covariance matrix in the following spreadsheet.
The slope coefficient for ABC is given by the formula Estimating
Cov(RABC, RMarket) the Index Model
773.31
1.156 Using Historical
ABC
Var(RMarket) 684.01
Data
The intercept for ABC is
Average(RABC) Average(RMarket)
ABC ABC

15.20 1.156 9.40 4.33
Therefore, the security characteristic line of ABC is given by
RABC 1.156 RMarket
4.33
This result also can be obtained by using the вЂњRegressionвЂќ command from ExcelвЂ™s Data
Analysis menu, as we show at the bottom of the spreadsheet. The minor differences between
the direct regression output and our calculations above are due to rounding error.
Bodieв€’Kaneв€’Marcus: II. Portfolio Theory 6. Efficient Diversification В© The McGrawв€’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

198 Part TWO Portfolio Theory

WEBMA STER

Risk Comparison
Go to www.morningstar.com and select the tab entitled Funds. In the dialog box for
selecting a particular fund, type Fidelity Select and hit the Go button. This will list all of
the Fidelity Select funds. Select the Fidelity Select Multimedia Fund. Find the fundвЂ™s top
25 individual holdings from the displayed information. The top holdings are found in
the Style section. Identify the top five holdings using the ticker symbol.
Once you have obtained this information, go to www.financialanalyses.com. From
the Site menu, select the Forecast and Analysis tab and then select the fundвЂ™s
Scorecard tab. You will find a dialog box that allows you to search for funds or
individual stocks. You can enter the name or ticker for each of the individual stocks and
the fund. Compare the risk ranking of the individual securities with the risk ranking of
the fund.
1. What factors are likely causing to the differences in the individual rankings and
the annual fund ranking?
Bodieв€’Kaneв€’Marcus: II. Portfolio Theory 6. Efficient Diversification В© The McGrawв€’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

199
6 Efficient Diversification

Diversification in a Single-Factor Security Market
Imagine a portfolio that is divided equally among securities whose returns are given by the
single-index model in Equation 6.6. What are the systematic and nonsystematic (firm-
specific) variances of this portfolio?
The beta of the portfolio is the simple average of the individual security betas, which we
denote . Hence, the systematic variance equals 2 2 . This is the level of market risk in Fig-
PM
ure 6.1B. The market variance ( 2 ) and the market sensitivity of the portfolio ( P) determine
M
the market risk of the portfolio.
The systematic component of each security return, i RM , is fully determined by the mar-
ket factor and therefore is perfectly correlated with the systematic part of any other securityвЂ™s
return. Hence, there are no diversification effects on systematic risk no matter how many se-
curities are involved. As far as market risk goes, a single-security portfolio with a small beta
will result in a low market-risk portfolio. The number of securities makes no difference.
It is quite different with firm-specific or unique risk. If you choose securities with small
residual variances for a portfolio, it, too, will have low unique risk. But you can do even better
simply by holding more securities, even if each has a large residual variance. Because the
firm-specific effects are independent of each other, their risk effects are offsetting. This is the
insurance principle applied to the firm-specific component of risk. The portfolio ends up with
a negligible level of nonsystematic risk.
In sum, when we control the systematic risk of the portfolio by manipulating the average
beta of the component securities, the number of securities is of no consequence. But in
the case of nonsystematic risk, the number of securities involved is more important than the
firm-specific variance of the securities. Sufficient diversification can virtually eliminate firm-
specific risk. Understanding this distinction is essential to understanding the role of diversifi-
cation in portfolio construction.
We have just seen that when forming highly diversified portfolios, firm-specific risk be-
comes irrelevant. Only systematic risk remains. We conclude that in measuring security risk
for diversified investors, we should focus our attention on the securityвЂ™s systematic risk. This
means that for diversified investors, the relevant risk measure for a security will be the secu-
rityвЂ™s beta, , since firms with higher have greater sensitivity to broad market disturbances.
As Equation 6.7 makes clear, systematic risk will be determined both by market volatility, 2 , M
and the firmвЂ™s sensitivity to the market, .

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7. a. What is the characteristic line of XYZ in Example 6.4? Concept
b. Does ABC or XYZ have greater systematic risk?
CHECK
c. What percent of the variance of XYZ is firm-specific risk?
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SUMMARY
вЂў The expected rate of return of a portfolio is the weighted average of the component asset
expected returns with the investment proportions as weights.
вЂў The variance of a portfolio is a sum of the contributions of the component-security
variances plus terms involving the correlation among assets.
вЂў Even if correlations are positive, the portfolio standard deviation will be less than the
weighted average of the component standard deviations, as long as the assets are not
perfectly positively correlated. Thus, portfolio diversification is of value as long as assets
are less than perfectly correlated.
Bodieв€’Kaneв€’Marcus: II. Portfolio Theory 6. Efficient Diversification В© The McGrawв€’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

200 Part TWO Portfolio Theory

вЂў The contribution of an asset to portfolio variance depends on its correlation with the other
assets in the portfolio, as well as on its own variance. An asset that is perfectly negatively
correlated with a portfolio can be used to reduce the portfolio variance to zero. Thus, it
can serve as a perfect hedge.
вЂў The efficient frontier of risky assets is the graphical representation of the set of portfolios
that maximizes portfolio expected return for a given level of portfolio standard deviation.
Rational investors will choose a portfolio on the efficient frontier.
вЂў A portfolio manager identifies the efficient frontier by first establishing estimates for the
expected returns and standard deviations and determining the correlations among them.
The input data are then fed into an optimization program that produces the investment
proportions, expected returns, and standard deviations of the portfolios on the efficient
frontier.
вЂў In general, portfolio managers will identify different efficient portfolios because of
differences in the methods and quality of security analysis. Managers compete on the
quality of their security analysis relative to their management fees.
вЂў If a risk-free asset is available and input data are identical, all investors will choose the
same portfolio on the efficient frontier, the one that is tangent to the CAL. All investors
with identical input data will hold the identical risky portfolio, differing only in how
much each allocates to this optimal portfolio and to the risk-free asset. This result is
characterized as the separation principle of portfolio selection.
вЂў The single-index representation of a single-factor security market expresses the excess rate
of return on a security as a function of the market excess return: Ri i RM ei .
i
This equation also can be interpreted as a regression of the security excess return on the
market-index excess return. The regression line has intercept i and slope i and is called
the security characteristic line.
вЂў In a single-index model, the variance of the rate of return on a security or portfolio can be
decomposed into systematic and firm-specific risk. The systematic component of variance
equals 2 times the variance of the market excess return. The firm-specific component is
the variance of the residual term in the index model equation.
вЂў The beta of a portfolio is the weighted average of the betas of the component securities.
A security with negative beta reduces the portfolio beta, thereby reducing exposure to
market volatility. The unique risk of a portfolio approaches zero as the portfolio
becomes more highly diversified.

KEY beta, 193 investment opportunity security characteristic
TERMS diversifiable risk, 171 set, 178 line, 195
efficient frontier, 189 market risk, 170 separation property, 192
excess return, 193 nondiversifiable risk, 170 systematic risk, 170
factor model, 192 nonsystematic risk, 171 unique risk, 171
firm-specific risk, 171 optimal risky
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