Chapter 7: Portfolio Theory

H
Based on calculation of the expected return or expected value
Two types of probability distribution
1. Discrete
i. ei!ht out the percenta!es
ii. "pecific nu#bers
$. Continuous
i.
Expected return on a portfolio
%eturn
o & portfolio cannot have an expected return over the expected return
nor below the expected return.
't has to be so#ewhere in between.
(easures of the relationship of %is)
o "tandard deviation:
To see the relationship or ris) of the share itself.
o Covariance
Describes the relationship between the shares
How do you co*vary between a friend+
't is an absolute measure
't is the third co#ponent of the avera!e
,ther cord: Correlation
-ou need the covariance. because you want to )now how the
shares react to each other when you have the# in the portfolio
o The variance of any asset with itself is the variance of an asset / 1.
o Correlation
Ta)es the covariance and divides it by the standard deviation of
each asset.
-ou0d want to select the share that has the lowest
correlation to reduce the ris)
o -ou0d prefer ne!ative correlation. but they are
hard to find
't is a relative measure
't will be in between *1 and 11
'f stoc) has a correlation of 11 / Perfect relationship.
o Their #ove#ent is in perfect ali!n#ent.
'f stoc) has a correlation of *1 / 'nverse %elationship
'f stoc) has a correlation of 2 / 3o relationship
Between 2*1:
o 4enerally #ove in the sa#e way
Between *1*2:
o 4enerally #oves in the opposite direction
'f you want to diversify your portfolio
5ower nu#bers are better.
Stock
Page 187-189
What would happen if we combine this stock with another
stocks?
o The stocks get the same return but the Stock ! and "
portfolio has less risk#
o $e% concept& returns of the portfolio is 'ust the a(erage
o )isk is where %ou ha(e to add the correlation
*arkowit+ Portfolio Theor%&
o ,ou need three things to calculate the risk&
1# Weights
-# .ariance or standard de(iation
/# "o(ariance or the correlation
)andom di(ersi0cation
o Picking random stocks
o 1t is risk reduction
2suall% incorporated in insurance industries
*arkowit+ 3i(ersi0cation
o !lso called e4cient di(ersi0cation
o !s we add stocks to our portfolio the risk of our portfolio
decreases
5ut we are left of with some kind of risk
"alled market risk non-di(ersi0able risk
o 6ood things and bad things will balance out the portfolio
o 2suall% between -7--77 to reduce minimal risk but the
highest bene0t
*ean .ariance 8ptimi+ation *odel
The same as *arkowit+ portfolio anal%sis
*ean (ariance 9 :;pected return
.ariance 9 S<uare root of s#d