Risk and Return Part 2

• Standard Deviation measures

  total risk
• Stand-alone risk

  risk of an asset by itself
• If you invest all your money in one risk, what happens?

  lose your money

  by putting all your eggs in one basket
• What are you supposed to do then?

  diversify
• Diversify means

  to invest in many different things ( assets/stocks)
• What is the benefit of diversifying

  it reduces risk
• The goal of diversification is to

  reduce risk without losing return
• Portfolio collection on assets main concern is

  portfolio risk and its return

  not individual assets in the portfolio
• Relevant risk and return of a security

  how it impacts the risk and return of the portfolio
• Portfolio Return (Rp)

  is a weighted average of return on the portfolio
• Portfolio Return formula

  Rp = E wi x Ri
• Expected Return of Portfolio

  E(Rp) = E wi x E(R)

  E wi x Ri
• Portfolio weight

  wi = value of asset i / value of portfolio
• Stock, Value, Return

  a, 300, 20%

  b, 600, 10%

  c,500,-8%

  d,600,15%

  Find Rp

  .085 -> 8.5%
• The portfolio return answer can't be

  outside of the return range

  has to be higher than the lowest and lowest then the higher
• Portfolio Risk op

  it is NOT a weighted average of the standard deviation of the the individual asset in the portfolio
• Why is op, not a weighted average because of

  correlation

  movement of assets
• Op _____ E wi x oi

  less than
• You don't want stock in the same industry why

  because the industry can go bad, so your portfolio will go down
• If you have stock in different industries, securities


  it is good because if one goes down you have other stock in a different industry
• Correlation (p)

  co-movement, tendency of things to move together
• Positive Correlation

  tend to more the same direction

  (p < 0)
• Negative Correlation


  tend to move opposite direction

  (p < 0)
• Which correlation movement is the best?

  negative

  reduce risk, because the movement cancel each other out
• Which correlation movement is the most common?

  positive in stock
• p= -1


  perfectly negative correlation

  always move (proportionally) exactly together
• Perfect Negative Correlation effect on the risk of combining?

  can eliminate risk

  there are none of these
• p= +1

  perfectly positive correlation

  always more (proportionally) exactly together

  ( up up ) ( down down)
• Perfect Positive Correlation effect on the risk of combining?

  no reduction of risk because there is no diversification

  none of these

  only if you buy the same stockfromm the same company on different days
• As long as p< +1

  some risk is reduced by combining assets
• Lower the correlation

  more of risk is reduced
• portfolio risk is ____ weighted average

  Less than

  its the different of what your gaining by diversify
• Diversification Benefit

  reduction in risk (op) due to the correlation of assets
• Lower correlation

  ( closer to -1)

  greater the diversification benefit
• portfolio : recess=13.7% normal=15% expand=17.5%

  E(Rp)= 15.3125%

  op = 1.36%

  
• Stock A is dominated by portfolio because the portfolio has a higher return and lower risk.

  Stock B isn’t dominated by portfolio because it has a higher return

  
• If you own stock A, how risky is stock B?

  not risky because risk is reduced due to correlation

  (risk of A lower and risk of B higher -> cancel each other out )