FIN 300 Fundamentals of Finance Risk and Return Pt. 2 Chapter 7 1 FIN 300 - Risk and Return Pt. 2

Portfolios •Previously, we considered the investment in a single investment, such as a stock •We will start off by considering the investment in a portfolioof 2 or more assets •As we did for individual assets, we will calculate measures of both returnand riskfor the portfolio, as well as the individual components of the portfolio–Expected return (or, often just “return”) –Variance and standard deviation to measure risk FIN 300 - Risk and Return Pt. 2 2

Portfolio Return Example •Given 3 assets: –Stock A has an expected return = 10% = RA–Stock B has an expected return = 20% = RB–Stock C has an expected return = 5% = RC•I am going to invest $2M in a portfolio containing a mix of the 3 stocks listed above •$500k of my money is invested in Stock A •$800k of my money is invested in Stock B •$700k of my money is invested in Stock C •What is the expected return of my portfolio? FIN 300 - Risk and Return Pt. 2 3

Portfolio Return Example •First, I must calculate the portfolio weights, the fraction of the total portfolio invested in each individual investment WA= fraction in Stock A = $500k/$2M=0.25= 25% WB= fraction in Stock B = $800k/$2M=0.40= 40% WC= fraction in Stock C = $700k/$2M=0.35= 35% (Note: The portfolio weights, of course, should sum to 100%) FIN 300 - Risk and Return Pt. 2 4

Portfolio Return Example •The expected returnof the portfolio is just the portfolio-weighted averageof the individual stocks’ returns Expected Return= WA*RA + WB*RB+ WC*RC = 0.25*10% + 0.40*20% + 0.35*5% = 2.5% + 8% + 1.75% = 12.25% FIN 300 - Risk and Return Pt. 2 5

Portfolio Risk •What do we do, when we measure the risk (calculate the variance and standard deviation) of a portfolio?•Well, first of all, it’s not as simple as calculating the weighted average of either the variances or standard deviations of the individual stocks –Because, the variances and standard deviations measure the degree to which the individual investments fluctuate over time –These measures don’t take into account to what extent individual investments (such as stocks) either move together (are correlated) or move in different directions (are uncorrelated or negatively correlated) over time FIN 300 - Risk and Return Pt. 2 6

Correlation and Portfolio Risk •Let’s consider a portfolio of two stocks that are uncorrelated –The two stocks’ returns don’t necessarily move up or down at the same time •The next slide contains a chart from the textbook –Returns for Southwest Airlines and Netflix are plotted over time –Note that sometimes, the 2 stocks’ returns go in opposite directions and sometimes they move together –Also, consider the plot for the equally weighted portfolio •When the 2 individual stocks move in opposite directions (are negatively correlated), the variation of the 50/50 portfolio is smoothed out •When the 2 stocks move up or down at the same time, you get much less smoothing of the variation FIN 300 - Risk and Return Pt. 2 7

Portfolio of 2 Uncorrelated Stocks FIN 300 - Risk and Return Pt. 2

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- Fall '08
- Olander
- Finance, Variance, Corporate Finance, Modern portfolio theory, systematic risk, Return Pt.