Expected return ( )
If the outcomes are equally likely i.g. for historical data set than the expected value is calculated as
follows:
=
If the outcomes are not equally likely and if Pij is the probability of the jth return on the ith asset, then
expected return is:
= ∙
= the expected value of
= the jth possible outcome for the return on security i
=the probability of the jth return on the ith security
= the number of possible outcomes
The tighter the probability distribution, the more likely is that the actual outcome will be close to the
expected value and consequently, the less likely it is that the actual return will end up far below the
expected return. Thus, the tighter the probability distribution of expected return, the smaller the risk of a
given investment.
The measure of tightness of the probability distribution is the standard deviation, which we calculate as
follows:
1
Variance ( ! )
If each return is equally likely, i.g. for historical data set, the formula for variance of the return on the ith
asset would be1:
#
( − )
!
=
If the observations are not equally likely, than the formula for variance of the return on the ith asset
becomes:
#
!
= $∙ ( − ) %
Standard deviation ( )
Standard deviation is just the square root of the variance and is designated by σ' .
#
)( − )
=
#
= * $∙ ( − ) %
The smaller the standard deviation, the tighter the probability distribution and accordingly, the less risky
the stock. The standard deviation provides an idea how far above or below the expected value the actual
value is likely to be.
-30 -15 0 15 30 45 60
Returns (%)
#
1
( − )
If we have more than 50 observations, then we use following formula for calculation of variance:
!
=
−1
2
- the actual return will be within ± 1 standard deviation of the expected return 68.26% of the time
If a probability distribution is a normal distribution2, then we can apply six-sigma rule:
-./̂ − 1 ≤ 3 ≤ /̂ + 15 ≅ 68.26%
- the actual return will be within ± 2 standard deviation of the expected return 9.,46% of the time
-./̂ − 2 ∙ 1 ≤ 3 ≤ /̂ + 2 ∙ 15 ≅ 95.46%
- the actual return will be within ± 3 standard deviation of the expected return 99.74% of the time
-./̂ − 3 ∙ 1 ≤ 3 ≤ /̂ + 3 ∙ 15 ≅ 99.74%
Standard deviation can be used as an absolute measure of risk meaning that if the standard deviation is
larger, the uncertainty of the actual outcome is greater and consequently. So if a choice has to be made
between two investments that have the same expected returns but different standard deviations, most
people would choose the one with lower standard deviation and therefore the lower risk.
In order to perform comparisons of alternative investments with different expected rates of return, you
cannot use the standard deviation. In that case we use another measure of risk called the coefficient of
variation (CV) which shows the risk per unit of return.
@A =
Coefficient of variation (@A)
So, portfolio of securities consists of two and / or more securities in which the investor invests money in
specific ratios to reduce the risk. Diversification of risk is achieved by the successful combination of
securities. The successful combination of securities is done by selecting the securities that are each
weakly correlated with each, and whose yields move inversely. So we can use the benefits of
(B ≠ 1).
diversification in terms of risk reduction until the securities are not perfectly positively correlated
D = (E ∙ )
G
H = the expected return on a portfolio
= the expected returns on the individual asset
3 =the weights or the fraction of the investor’s funds invested in the ith asset
I = the number of assets in the portfolio
2
Rate of return is continuous variable, we have large number of iterations and because of that we will take
approximation with normal distribution.
3
Variance of a portfolio ( )
The risk of the portfolio is as with the individual securities expressed by the variance and standard
deviation of returns. However, the risk of the portfolio is not simply the weighted mean of individual
securities standard deviations, because the risk of a portfolio depends not only on the riskiness of the
securities that make up the portfolio, but also the relationships that exist between these securities.
F F F
!
D = JE!K ∙ K L + (EK
!
∙ E ∙ K )
KG KG G
MK
JK, − K L ∙ J, − L
=
K
When the joint outcomes are not equally likely, the covariance can be expressed as:
K = D ∙ JK, − K L ∙ J, − L
G
K = OK ∙ K ∙
coefficient (BP ) can range from +1,0, denoting that two variables move up and down in perfect
This is a standardized statistical measure of linear relationship between two variables. The correlation
synchronization (perfect positive correlation), to -1,0, denoting that the variables always move in exactly
opposite directions (perfect negative correlation). A correlation coefficient of zero indicates that two
variables are not related to each other.
K
OK =
K ∙
Thus, the risk of the portfolio or portfolios or standard deviation of a portfolio ( !D ) depends on:
- variances of individual securities and the
- covariance between different pairs of securities (which are crucial for large portfolios)
The goal of a successful diversification is the combination of securities which are each slightly with each
dependent (as measured by covariance and correlations) and whose rates of returns move inversely.
4
The effect of diversification is present when the BP ≠1, and we have the maximum effect of
diversification when BP =-1.
Formula for the variance of an equally weighted portfolio (where Xi = 1/N for i = 1, …, N securities) is
(
σ P = 1/N σ j − σ kj + σ kj
2 2
)
σ j = the average variance of the stocks in the portfolio
2
If the portfolio contains only one security, then the portfolio’s average variance is equal to the average
variance across all securities, σ 2j .
If instead an equally weighted portfolio contains a very large number of securities, then its variance will
be approximately equal to the average covariance of the pairs of securities in the portfolio, σ kj .
Therefore, the fraction of risk that of an individual security that can be eliminated by holding a large
portfolio is expressed by the following ratio:
σ i2 − σ kj
σ i2
TWO-ASSETS PORTFOLIOS
D = ER ∙ R + ES ∙ S
D)
!
Variance of a portfolio (
!
D = E!R ∙ !
R + E!S ∙ !
S + ! ∙ ER ∙ ES ∙ RS
RS = ORS ∙ R ∙ S
5
THREE-ASSETS PORTFOLIO
D = ER ∙ R+ ES ∙ S + E@ ∙ @
D)
!
Variance of a portfolio (
!
D = E!R ∙ !
R + E!S ∙ !
S + E!@ ∙ !
@ + ! ∙ ER ∙ E S ∙ RS + ! ∙ E R ∙ E@ ∙ R@ + ! ∙ ES ∙ E @ ∙ S@
= ORS ∙ ∙
Covariance between stocks:
RS R S
R@ = OR@ ∙ R∙ @
S@ = OS@ ∙ S∙ @
6
Exercises
Problem 1:
Assume that you are considering selecting assets from among the following four candidates
Asset 1
Market Condition Return Probability
Good 16 1/4
Average 12 1/2
Poor 8 1/4
Asset 2
Market Condition Return Probability
Good 4 1/4
Average 6 1/2
Poor 8 1/4
Asset 3
Market Condition Return Probability
Good 20 1/4
Average 14 1/2
Poor 8 1/4
Asset 4
Market Condition Return Probability
Good 16 1/3
Average 12 1/3
Poor 8 1/3
Assume that there is no relationship between the amount of rainfall and condition of the stock
market.
a) Solve for the expected return and the standard deviation of return for each separate
investment
b) Solve for the correlation coefficient and the covariance between each pair of investments
c) Solve for the expected return and variance of each of the portfolios shown below:
7
Problem 2:
Below is the actual price and dividend data for three companies for each of seven months.
Security A Security B Security C
Time Price Dividend Price Dividend Price Dividend
1 57 6/8 333 106 6/8
2 59 7/8 368 108 2/8
3
3 59 3/8 0,725 368 4/8 1,35 124 0,40
4 55 4/8 382 2/8 122 2/8
5 56 2/8 386 135 4/8
6 59 0,725 397 6/8 1,35 141 6/8 0,42
7 60 2/8 392 165 6/8
a) Compute the rate of return for each company for each month
b) Compute the average rate of return for each company
c) Compute the standard deviation of the rate of return for each company
d) Compute the correlation coefficient between all possible pairs of securities
e) Compute the average return and standard deviation for the following portfolios:
½ A+1/2 B; ½ A+1/2 C; ½ B+1/2 C; 1/3 A+1/3 B+1/3 C
Problem 3:
Assume that the average variance of return for an individual security is 50 and that the average
covariance is 10. What is the expected variance for an equally weighted portfolio of 5,10,20,50 and
100 securities?
Problem 4:
In previous problem how many securities need to be held before the risk of a portfolio is only 10%
more than minimum?
Problem 5:
For the Italy data and Belgium data from the Table below, what is the ratio of the difference between
the average variance minus average covariance and the average covariance?
If the average variance of a single security is 50, what is the expected variance of a portfolio of 5, 20
and 100 securities?
Table: Percentage of the Risk on an Individual Security that Can Be Eliminated by holding a random Portfolio of
Stocks within Selected National Markets and among National Markets
United States 73
U.K. 65,5
France 67,3
Germany 56,2
Italy 60,0
Belgium 80,0
Switzerland 56,0
Netherlands 76,1
International stocks 89,3
3
A dividend entry on the same line as a price indicates that the return between that time period and the previous
period consisted of a capital gain (or loss) and the receipt of the dividend.
8
Problem 6:
For the data presented in the Table below suppose an investor desires an expected variance less than 8.
What is the minimum number of securities for such a portfolio?
9
Problem 7:
The portfolio included three stock with following data:
Weight Expected Return Standard deviation
A 15% 15% 18%
B 35% 19% 16%
C 50% 10% 20%
O(R S ) = T, U
O(S @) = −T, !
O(R @ ) = T, G
10