In: Other Topics

Submitted By pinkpanda57

Words 930

Pages 4

Words 930

Pages 4

A few pointers

PORTFOLIO THEORY

Expected returns

• As we talk about annual expected returns, keep in mind what they are:

E(D1 ) + E ( P1 )

E(ri ) =

-1

P0

E(D1 ) E(P1 ) - P0

=

+

P0

P0

Risk

• As time passes, realized stock prices and dividends may differ from what you expected.

• Such future deviations from expectations represent, from today’s perspective, risk.

• Standard deviation measures this risk

(“average deviation from expectation”).

Portfolios

• When you form portfolios of securities, you combine the “expected returns” and “risks” of the individual securities in a particular way.

• There are two ways to calculate the portfolio’s expected return and standard deviation from information about the individual securities.

Method 1

STEP 1: Compute the return distribution of the portfolio. STEP 2: Then compute the expected value and the standard deviation of that distribution.

Method 1 Example

• Consider a “50-50” portfolio of two securities.

• You are provided with the individual return distributions of the two securities:

State

Probability

Return Security A

Return Security B Portfolio Return

1

20%

50%

30%

.5*50%+.5*30%

2

60%

0%

0%

0%

3

20%

-50%

-30%

-.5*50%-.5*30%

• STEP 1: Compute the portfolio return distribution.

Method 1 Example

State

Probability

Portfolio Return

1

20%

40%

2

60%

0%

3

20%

-40%

• STEP 2: Compute the expected value and standard deviation of the portfolio return distribution.

– Expected portfolio return: 0%

– Portfolio return variance: (.4-0)^2*20%+(0-0)^2*60%+(-.40)^2*20%=6.4%

– Portfolio standard deviation: (.064)^(1/2)=29.3%

(When squaring or taking the root of percentages, first convert to decimal numbers.)

Method 1 Example

• What if I change the original distribution a…...