Portfolio Risk and Return

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock's risk can be eliminated, i.e., diversified away. This principle is presented on the Diversification page. First, the computation of the expected return, variance, and standard deviation of a portfolio must be illustrated. Once again, we will be using the probability distribution for the returns on stocks A and B.
Return on Return on State Probability Stock A Stock B 1 2 3 3 20% 30% 30% 20% 5% 10% 15% 20% 50% 30% 10% -10%

From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is 12.5%, the expected return on Stock B is 20%, the variance on Stock A is .00263, the variance on Stock B is .04200, the standard deviation on Stock S is 5.12%, and the standard deviation on Stock B is 20.49%. Portfolio Expected Return The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can be expressed as follows:

where

E[Rp] = the expected return on the portfolio, N = the number of stocks in the portfolio, wi = the proportion of the portfolio invested in stock i, and

E[Ri] = the expected return on stock i.

For a portfolio consisting of two assets, the above equation can be expressed as

Expected Return on a Portfolio of Stocks A and B Note: E[RA] = 12.5% and E[RB] = 20% Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Portfolio Variance and Standard Deviation The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient. The Covariance between the returns on two stocks can be calculated using the following equation:

where

12 = the covariance between the returns on stocks 1 and 2, N = the number of states, pi = the probability of state i, R1i = the return on stock 1 in state i, E[R1] = the expected return on stock 1, R2i = the return on stock 2 in state i, and E[R2] = the expected return on stock 2.

The Correlation Coefficient between the returns on two stocks can be calculated using the following equation:

where

12 = the correlation coefficient between the returns on stocks 1 and 2, 12 = the covariance between the returns on stocks 1 and 2, 1 = the standard deviation on stock 1, and 2 = the standard deviation on stock 2.
Covariance and Correlation Coefficent between the Returns on Stocks A and B Note: E[RA] = 12.5%, E[RB] = 20%, A = 5.12%, and B = 20.49%.

Using either the correlation coefficient or the covariance, the Variance on a TwoAsset Portfolio can be calculated as follows:

The standard deviation on the porfolio equals the positive square root of the the variance.
Variance and Standard Deviation on a Portfolio of Stocks A and B Note: E[RA] = 12.5%, E[RB] = 20%, A = 5.12%, B = 20.49%, and AB = -1. Portfolio consisting of 50% Stock A and 50% Stock B

Portfolio consisting of 75% Stock A and 25% Stock B

Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock B has a lower variance and standard deviation than either Stocks A or B and the portfolio has a higher expected return than Stock A. This is the essence of Diversification, by forming portfolios some of the risk inherent in the individual stocks can be eliminated.

Measures of Risk - Variance and Standard Deviation

Risk reflects the chance that the actual return on an investment may be very different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns. Consider the probability distribution for the returns on stocks A and B provided below.
Return on Return on State Probability Stock A Stock B 1 2 3 3 20% 30% 30% 20% 5% 10% 15% 20% 50% 30% 10% -10%

The expected returns on stocks A and B were calculated on the Expected Return page. The expected return on Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%. Given an asset's expected return, its variance can be calculated using the following equation:

where

N = the number of states, pi = the probability of state i, Ri = the return on the stock in state i, and E[R] = the expected return on the stock.

The standard deviation is calculated as the positive square root of the variance.

Variance and Standard Deviation on Stocks A and B

Note: E[RA] = 12.5% and E[RB] = 20% Stock A

Stock B

Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater thanStock A's. This, however, is only part of the picture because most investors choose to hold securities as part of a diversified portfolio.

Portfolio Analysis
A portfolio is a collection of securities owned by an investor. The calculation of expected return of portfolio is straightforward, but calculation of variance and standard deviation involves covariance and correlation, statistical measures that quantify the relationship between the returns of two different securities. Expected Return of Portfolio Since each securitys future return may be considered as a random variable, the return of a portfolio also can be thought as a random variable dependant on expected returns of the individual securities that make up the portfolio. The expected return of portfolio is a weighted sum of the expected returns of the individual securities: Portfolio Expected Return = A*r(a) + B*r(b) + C*P(c) +... , where A, B, C, ... are relative weights of securities a, b, c, ... in portfolio and r(a), r(b), r(c) , ... are corresponding expected returns of securities. Relative weight of each security in portfolio is a fraction of this securitys present value in the total present value of the portfolio: Weight of Security(x) = val(x) /(Total Value of Portfolio), where "val" means present value. Lets consider numeric example. First we compute relative weights of securities in portfolio:
Security: Present Value: Relative Weight: a $400 $400/$2500 = 0.16 b $900 $900/$2500 = 0.36 c $700 $700/$2500 = 0.28 d $500 $500/$2500 = 0.20 --------------------------------------------------------Total: $2500 1.0

Now we can calculate expected return of portfolio R:

Security: Weight: Expected Ret: a 0.16 5% 0.16 * 5% = 0.80% b 0.36 3% 0.36 * 3% = 1.08% c 0.28 7% 0.28 * 7% = 1.96% d 0.20 11% 0.20 * 11% = 2.20% -----------------------------------------------------------Portfolio Expected Return = 6.04%

Covariance and Correlation The portfolio variance and standard deviation are used as a measures to quantify the portfolio risk. For their calculation we need to compute covariance and correlation between securities of portfolio. Covariance is a statistical quantity which measures the relationship between two

random variables. In case of returns of financial securities covariance measures relationship between returns of two securities: Covariance(a,b) = Expected Value of [( A-r(a) )*( B-r(b) )], where A and B are returns and r(a) and r(b) are expected values of a and b securities. If random variables A and B are discrete (i.e. their values can be listed), the above formula will take the form:
Covariance(a,b) = [x-r(a)]*[y-r(b)]*P(x,y) + [y-r(a)]*[zr(b)]*P(y,z) + + [x-r(a)]*[z-r(b)]*P(x,z) + ...

where x, y, z, ... are particular returns for securities a and b, P(x,y) is the joint probability of x and y, etc. A large positive covariance implies that the returns move together, i.e. if one securitys return is high then other securitys return is likely to be high. Large negative covariance signifies the opposite trend in movements of returns of two securities, i.e. if one securitys return is high, the other securitys return is likely to be low. Finally, if covariance is close to zero then two securities have very weak relationship, or in other words, movements of returns of two securities are not related to each other. But what does large mean, what is the comparison criteria? Given the computed value of covariance, its difficult to say whether it is large or small. This is where the correlation is useful. The correlation is computed by dividing the covariance by the standard deviations of the two securities: Correlation(a,b) = Covariance(a,b) / ( St.Dev.(a)* St.Dev.(b) ) Since standard deviations are positive values, the correlation always has the same sign as covariance. The division of covariance by standard deviations forces values of correlation to be between -1 and 1. -1 means perfect negative relationship between securities, 1 means perfect positive relationship, and values close to zero means weak relationship between movements of returns of two securities. Variance and Standard Deviation of Portfolio Now we can compute variance and standard deviation of portfolio: Variance of Portfolio = A*B*cv(a,b)+B*C*cv(b,c)+A*C*cv(a,c)+A*D* cv(a,d) + ... , where A, B, C, D, ... are corresponding relative weights of a,b,c,d, ... securities in portfolio and "cv()" symbol means covariance. Standard deviation of portfolio is a square root from variance value: Standard Deviation of Portfolio = sqrt( Variance of Portfolio ), where "sqrt" means square root. For simplest case of the portfolio consisting of two securities the variance will be:

Variance(a,b) = A*A * cv(a,a) + A*B*cv(a,b)+B*A*cv(b,a)+B*B*cv(b,b) The covariance of security a with itself cv(a,a) equals to variance of the security, and similarly cv(b,b) equals to variance of security b. Then above formula for portfolio variance takes the form: Variance(a,b) = sq(A)*var(a) + sq(B)*var(b) + 2*A*B*cv(a,b), Where "sq" means square, "var" means, variance, "cv" means covariance, A and B are relative weights of securities a an b in portfolio.