How should the historical data affect decision making

The variance fo the portfolio will be less than the

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Unformatted text preview: The variance of a portfolio return depends on the weights of the parts of the portfolio AND the correlation among the parts: Correlation is how closely two things move together If you have two companies in a portfolio and one has variance of 10 the other of 5, and 50% in each, the variance is not necessarily 7.5% rate of return. It’s different because the two stocks are not perfectly correlated, so if one goes up the other may not necessarily move up as well. Variance would be less than 7.5%, unless they are perfectly correlated. that’s why you diversify, to take risk out of portfolio for free. Good to have stock in different sectors, to minimize correlation Security Portfolio Variance: Variance of portfolio with two stocks = w1^2*var1 + w2^2*var2 + 2w1w2stddev1stddev2corr1,2 As long as correlation is not perfectly 1, you will continue to reduce variance in your portfolio to a certain limit. The variance fo the portfolio will be less than the weighted average variances of the components if correlation is less than 1. Limit is about 30 diverse stocks You look at past histories of companies to come up with correlation Diversification: Therefore for situations where the correlation is less than 1, inc...
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