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6. Chapter 13

# 6. Chapter 13 - Chapter 13 Risk Return Diversification Key...

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Chapter 13: Risk, Return, & Diversification

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Key Concepts and Skills Know how to calculate expected returns Know how to calculate risk Understand the impact of diversification Understand the systematic risk principle
Expected Returns Expected returns are based on the probabilities of possible outcomes In this context, “expected” means average if the process is repeated many times The “expected” return does not even have to be a possible return = = n i i i R p R E 1 ) (

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Example: Expected Returns Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? State Probability C T Boom 0.3 0.15 0.25 Normal 0.5 0.10 0.20 Recession 0.2 0.02 0.01 • R C = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99% • R T = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%
Variance and Standard Deviation Variance and standard deviation still measure the volatility of returns Using unequal probabilities for the entire range of possibilities Weighted average of squared deviations = - = n i i i R E R p 1 2 2 )) ( ( σ

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Example: Variance and Standard Deviation Consider the previous example. What are the
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