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

= 20.49%.

Using either the correlation coefficient or the covariance, the Variance on a Two-Asset 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%,

= 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. Example Problems

Stock 1 Expected Return: Standard Deviation:

12.5 5.12

Stock 2 % %
20 20.49

% %

Correlation Coefficient:

-1

Portfolio Expected Standard Weight 1 Return Variance Deviation

50

Diversification
The example on the Portfolio Risk and Return page illustrated that a portfolio formed from risky securities can have a lower standard deviation than either of the individual securities. On this page we shall explore this concept further to demonstrate that the benefits of diversification, i.e., the reduction in risk, depends upon the correlation coefficient (or covariance) between the returns on the securities comprising the portfolio. Consider stocks C and D. Stock C has an expected return of 8% and a standard deviation of 10%. Stock D has an expected return of 16% and a standard deviation of 20%. The concept of diversification will be illustrated by forming portfolios of stocks C and D under three different assumptions regarding the correlation coefficient between the returns on stocks C and D.

Case 1: Correlation Coefficient = 1

The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals 1. Portfolio Portfolio Weight of Expected Standard Stock C Return Deviation 100% 90% 8% 8.8% 10% 11%

80% 70% 60% 50% 40% 30% 20% 10% 0%

9.6% 10.4% 11.2% 12% 12.8% 13.6% 14.4% 15.2% 16%

12% 13% 14% 15% 16% 17% 18% 19% 20%

Opportunity Set and Efficient Set Opportunity Set - The opportunity set depicts the set of risk return choices that can be achieved by forming a portfolio of stocks C and D. It is represented by the entire curves plotted on the graohs on this page. Efficient Set - The efficent set (or efficient frontier) is the positively sloped portion of the opportunity set. It is the set of risk return choices which offer the highest expected return for a given level of risk. When the correlation coefficient between the returns on two securities is equal to +1 the returns are said to be perfectly positively correlated. As can be seen from the table and the plot of the opportunity set, when the returns on two securities are perfectly positively correlated, none of the risk of the individual stocks can be eliminated by diversification. In this case, forming a portfolio of stocks C and D simply provides additional risk/return choices for investors.

Case 2: Correlation Coefficient = -1

The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals -1. Portfolio Portfolio Weight of Expected Standard Stock C Return Deviation 100% 90% 80% 8% 8.8% 9.6% 10% 7% 4%

70% 66.67% 60% 50% 40% 30% 20% 10% 0%

10.4% 10.67% 11.2% 12% 12.8% 13.6% 14.4% 15.2% 16%

1% 0% 2% 5% 8% 11% 14% 17% 20%

When the correlation coefficient between the returns on two securities is equal to -1 the returns are said to be perfectly negatively correlated or perfectly inversely correlated. When this is the case, all risk can be eliminated by investing a positive amount in the two stocks. This is shown in the table above when the weight of Stock C is 66.67%.

Case 3: Correlation Coefficient = 0

The table below provides the expected return and standard deviation for portfolios formed from stocks C and D under the assumption that the correlation coefficient between their returns equals 0. Portfolio Portfolio Weight of Expected Standard Stock C Return Deviation 100% 90% 80% 70% 60% 50% 40% 30% 20% 8% 8.8% 9.6% 10.4% 11.2% 12% 12.8% 13.6% 14.4% 10% 9.22% 8.94% 9.22% 10% 11.18% 12.65% 14.32% 16.12%

10% 0%

15.2% 16%

18.03% 20%

When the correlation coefficient between the returns on two securities is equal to 0 the returns are said to be uncorrelated. In this case, some risk can be eliminated via diversification. Notice that when the weight of Stock C is between 100% and 60% the portfolios have a higher expected return than Stock C and a lower standard deviation than either Stocks C or D. This is depicted in the graph by the inward curve in the opportunity set.

The Real World

In practice, the correlation coefficient between most stocks ranges between 0.5 to 0.7. When this is the case, the opportunity set will have a similar shape to that shown in the case in which the returns were uncorrelated. Thus, risk can be reduced via diversification. You can utilize the Two Asset Portfolio Calculator to explore this relationship. Moreover, the benefits of diversification increase as more stocks are added to the portfolio.

Two Asset Portfolio Calculator

Two Asset Portfolio Calculator Stock 1 Expected Return: Standard Deviation: Correlation Coefficient: Expected Standard Weight 1 Return Variance Deviation
100 90 80 70 60 50

Stock 2 % % % %

% % % % % %

% % % % % %

% % % % % %

40 30 20 10 0

% % % % %

% % % % %

% % % % %

For assistance in using the calculator see the Two Asset Portfolio Calculator: Introduction.

Two Asset Portfolio Calculator: Introduction

The Two Asset Portfolio Calculator can be used to find the Expected Return, Variance, and Standard Deviation for portfolios formed from two assets. 1. Expected Return Fields - Enter the Expected Return on Stocks 1 and 2 in these fields. 2. Standard Deviation Fields - Enter the Standard Deviation on

Stocks 1 and 2 in these fields. 3. Correlation Coefficient Fields - Enter the Correlation Coefficient between the returns on Stocks 1 and 2 in this field. 4. Buttons - Press the Calculate button to calculate the Expected Return, Variance and Standard Deviation on portfolios formed from Stocks 1 and 2. Press the Clear button to clear the calculator. 5. Portfolio Returns - The Expected Return, Variance, and Standard Deviation for the portfolios formed from Stocks 1 and 2 are displayed in this table. For each row in the table, the first column indicates the weight of Stock 1 in the portfolio (the weight of Stock 2 is 100% minus the weight of Stock 1), the second column provides the Expected Return on the portfolio, the third column provides the Variance of the portfolio, and the fourth column provides the Standard Deviation of the portfolio.

Expected Return
The future is uncertain. Investors do not know with certainty whether the economy will be growing rapidly or be in recession. As such, they do not know what rate of return their investments will yield. Therefore, they base their decisions on their expectations concerning the future. The expected rate of return on a stock represents the mean of a probabilty distribution of possible future returns on the stock. The table below provides a probability distribution for the returns on stocks A and B. Return on Return on Stock A Stock B 5% 10% 15% 20% 50% 30% 10% -10%

State Probability 1 2 3 3 20% 30% 30% 20%

In this probability distribution, there are four possible states of the world one period into the future. For example, state 1 may correspond to a recession. A probability is assigned to each state. The probability reflects how likely it is that the state will ocurr. The sum of the probabilities must equal 100%, indicating that something must happen. The last two columns present the returns or outcomes for stocks A and B that will occur in the four states. Given a probability distribution of returns, the expected return can be calculated using the following equation:

where E[R] = the expected return on the stock, N = the number of states, pi = the probability of state i, and Ri = the return on the stock in state i. Expected Return on Stocks A and B Stock A

Stock B

So we see that Stock B offers a higher expected return than Stock A. However, that is only part of the story; we haven't yet considered risk.
Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
30 20

%2 %

10

%3

30

15

%4

20

20

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
30 20

%2 %

10

%3

30

15

%4

20

20

% Expected Return:

Example Problems Find the Expected Return on a stock given the following

Probability Return

probability distribution of returns for the stock. State Probability Return 1

20 20

% %

5 20

%2

30

10

%3

30

15

%4

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
20 20

% %

5 20

%2

30

10

%3

30

15

%4

20

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
20 20

% %

5 20

%2

30

10

%3

30

15

%4

30

10

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
20 20

% %

5 20

%2

30

10

%3

30

15

%4

30

15

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
20 20

% %

5 20

%2

30

10

%3

30

15

%4

20

20

% Expected Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
5 20

% % Expected

%2

30

% %

10

%3

30

15

%4

20

20

Return:

Example Problems Find the Expected Return on a stock given the following probability distribution of returns for the stock. State Probability Return 1
30 20

%2 %

10

%3

30

15

%4

20

20

% Expected Return:

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 Stock A Stock B 5% 10% 15% 20% 50% 30% 10% -10%

State Probability 1 2 3 3 20% 30% 30% 20%

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 than Stock A's. This, however, is only part of the picture because most investors choose to hold securities as part of a diversified portfolio. Example Problems Find the Expected Return, Variance, and Standard Deviation on a stock given the following probability distribution of returns for the stock. State 1 2 3 4 Probability
20 30 30 20

Return
5 10 15 20

% % % % Expected Return: Variance:

% % % % %

Standard Deviation: Example Problems

Find the Expected Return, Variance, and Standard Deviation on a stock given the following probability distribution of returns for the stock.

1 2 3 4

20 30 30 20

% % % % Expected Return: Variance: Standard Deviation:

5 10 15 20

% % % % %