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PART II: IMPORTANT INVESTMENT CONCEPTS Chapter 7: Expected Return and Risk CHAPTER OVERVIEW Part II covers portfolio theory and capital market theory material along with efficient markets concepts. This allows students to be exposed to the important concepts of diversification, Markowitz portfolio theory, capital market theory, and efficient markets relatively early in the semester. They can then use these concepts throughout the remaining chapters. For example, it is very useful to know the implications of saying that stock A is very highly correlated with stock C, or with the market, and to be able to use the CAPM in some applications. Chapter 7 is the introduction to the portfolio management portion of the text which consists of four chapters. It is a standard treatment of basic portfolio theory, centering on the important building blocks of the Markowitz model. Students learn about such well known concepts as diversification, efficient portfolios, the risk of the portfolio, covariances, and so forth. The chapter also includes the Sharpe Single Index Model as a natural extension of the Markowitz model. The appendix discusses some additional details of the Sharpe model. It is important to note that Chapter 7 begins with a discussion of expected return and risk, whereas Chapter 6 focuses exclusively on realized return and risk. This organization allows the reader to focus on expected return and risk in Chapter 7 where portfolio theory, which is based on expected returns, is developed. The first part of the chapter discusses the estimation of individual security return and risk, which provides the basis for considering portfolio return and risk in the next section. It begins with a discussion of uncertainty, and develops the concept of a probability distribution. The important calculation of expected value, or, as used here, expected return, is presented, as is the equation for standard deviation. The next part of the chapter presents the Markowitz model along the standard dimensions of efficient portfolios, the inputs needed, and so forth. The discussion first examines expected portfolio return and risk. The portfolio risk discussion shows why portfolio risk is not a weighted average of individual
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security risks, which leads naturally into a discussion of analyzing portfolio risk. The concept of risk reduction is illustrated for the cases of independent returns (the insurance principle), random diversification, and Markowitz diversification. Correlation coefficients and covariances are explained in detail. This is a very standard discussion. The calculation of portfolio risk is explained in two stages, starting with the two-security case and progressing to the n- security case. Sufficient detail is provided in order for students to really understand the concept of calculating portfolio risk.
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