Lecture-3-Risk and Return

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Unformatted text preview: n, also known as not putting all of your eggs in one basket. Portfolio theory states that the risk for individual stock returns has two components: Systematic Risk ­ These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. Unsystematic Risk ­ Also known as "specific risk", this risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio 44 Systematic versus Unsystematic Risk An investment’s systematic risk is far more important than its unsystematic risk. If the risk of an investment comes mainly from unsystematic risk, the investment will tend to have a low correlation with the returns of most of the other stocks in the portfolio, and will make a minor contribution to the portfolio’s overall risk. 45 FIN3000, Liuren Wu Portfolio Return To find the expected return of a portfolio E(kp), or kp, we can apply what we have learned previously about the expected return being a weighted average of possible outcomes. However, when dealing with a portfolio of assets the expected return is calculated as the weighted average of the expected returns of all the individual assets making up the portfolio and this applies in all cases to portfolios of all sizes, not just two­asset portfolios. The individual asset weightings are simply the respective proportion of the portfolio invested in each asset and, as with our previous probability weightings, all the proportionate weightings will sum to 1.0 (or 100 per cent). 46 PortfolioReturn The expected return on a portfolio is represented mathematically as follows:. 47 PortfolioReturn For example, if you decided to invest £10,000 of your lottery winnings in a two­asset portfolio in the following proportions: 48 Checkpoint 8.1 Calculating a Portfolio’s Expected Rate of Return Penny Simpson has her first full­time job and is considering how to invest her savings. Her dad suggested she invest no more than 25% of her savings in the stock of her employer, Emerson Electric (EMR), so she is considering investing the remaining 75% in a combination of a risk­free investment in U.S. Treasury bills, currently paying 4%, and Starbucks (SBUX) common stock. Penny’s father has invested in the stock market for many years and suggested that Penny might expect to earn 9% on the Emerson shares and 12% from the Starbucks shares. Penny decides to put 25% in Emerson, 25% in Starbucks, and the remaining 50% in Treasury bills. Given Penny’s portfolio allocation, what rate of return should she expect to receive on her...
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This note was uploaded on 02/11/2014 for the course MANA 2028 taught by Professor Sisterennis during the Winter '12 term at Marquette.

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