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
portfolio
of 2 or more assets
•
As we did for individual assets, we will calculate
measures of both
return
and
risk
for 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% = R
A
–
Stock B has an expected return = 20% = R
B
–
Stock C has an expected return = 5% = R
C
•
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
W
A
= fraction in Stock A = $500k/$2M=0.25=
25%
W
B
= fraction in Stock B = $800k/$2M=0.40=
40%
W
C
= 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 return
of the portfolio is just the
portfolio-weighted average
of the individual
stocks’ returns
Expected Return
= W
A
*R
A
+ W
B
*R
B
+ W
C
*R
C
= 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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