PORTFOLIO RISK AND RETURN CONCEPTS

Portfolio Return - represents the weighted average of the expected returns on the securities comprising
that portfolio with weights being the proportion of total funds invested in each security (the total of
weights must be 100).

Portfolio Risk - includes the interactive risk of asset in relation to the others, measured by the
covariance of returns. Covariance is a statistical measure of the degree to which two variables
(securities’ returns) move together. Thus, covariance depends on the correlation between returns on
the securities in the portfolio.

Diversification - is a venerable rule of investment which suggests “Don’t put all your eggs in one basket”,
spreading risk across a number of securities.

NOTE: It is impossible to reduce portfolio risk to zero by increasing the number of securities in the
portfolio. As the number of securities selected randomly held in the portfolio increase, the total risk of
the portfolio is reduced, though at a decreasing rate. Thus, degree of portfolio risk can be reduced to a
large extent with a relatively moderate amount of diversification.

SYSTEMIC VS UNSYSTEMIC RISK

Systemic risk - also known as non- diversifiable risk which arises because of the forces that affect the
overall market, such, as changes in the nation’s economy, fiscal policy of the Government, monetary
policy of the Central bank, change in the world energy situation etc. (Market/Macro-level risks)

Unsystemic risk - known as diversifiable risk caused by such random events as law suits, strikes,
successful and unsuccessful marketing programmes, winning or losing a major contract and other events
that are unique to a particular firm. (Entity-level/Company-specific risks)

BETA VS STANDARD DEVIATION

Standard deviation - a statistical measure of security’s volatility. It indicates the tendency of the returns
to rise or fall drastically in a short period of time. A volatile security is also considered higher risk
because its performance may change quickly in either direction at any moment. The standard deviation
of a fund measures this risk by measuring the degree to which the security fluctuates in relation to its
mean return.

Beta - While standard deviation determines the volatility of a fund according to the disparity of its
returns over a period of time, beta, another useful statistical measure, compares the volatility (or risk)
of a fund to its index or benchmark. A fund with a beta very close to one means the fund's performance
closely matches the index or benchmark. A beta that is greater than one indicates greater volatility than
the overall market, and a beta less than one indicates less volatility than the benchmark.

A wise philosopher once said − “JONEEEELLL”

ILLUSTRATIVE SAMPLE:

The following probability distribution for the returns on stocks A and B are provided:

State of Economy Probability Return on Stock A Return on Stock B

PEAK 20% 5% 50%
EXPANSION 30% 10% 30%
CONTRACTION 30% 15% 10%
TROUGH 20% 20% -10%

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%.

Requirements:
1. Expected return of Stock A
2. Expected return of Stock B
3. Portfolio return of Stocks A and B if the available funds are invested under the following
combinations:
a. 50% Stock A, 50% Stock B
b. 75% Stock A, 25% Stock B
c. 40% Stock A, 60% Stock B

4. Covariance and Correlation between the returns on Stocks A and B

5. Variance and Standard Deviation on Portfolio of Stocks A and B if the available funds are invested
under the following combinations:
a. 50% Stock A, 50% Stock B
b. 75% Stock A, 25% Stock B
c. 40% Stock A, 60% Stock B

SOLUTION

1. Expected return of Stock A (apply concept of expected value)

RA = (20% x 5%) + (30% x 10%) + (30% x 15%) + (20% x 20%)

RA = 12.5%

2. Expected return of Stock B

RB = (20% x 50%) + (30% x 30%) + (30% x 10%) + (20% x -10%)

RB = 20%

“Rampapampapampam”
3. Portfolio return of Stocks A and Stocks B

a. 50% Stock A, 50% Stock B

RAB = (12.5%) (50%) + (20%) (50%)

RAB = 16.25%

b. 75% Stock A, 25% Stock B

RAB = (12.5%) (75%) + (20%) (25%)

RAB = 14.38%

c. 40% Stock A, 60% Stock B

RAB = (12.5%) (40%) + (20%) (60%)

RAB = 17%

4. Covariance and Correlation between the returns on Stocks A and B

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.

A wise man once said − “Don’t stop when you’re tired, stop once you’re done”
See Table for the easy application of the above formula
State of STOCK A STOCK B
Probability COVARIANCE*
Economy Return Expected Diff. Return Expected Diff.
PEAK 20% 5% 12.5% -7.5% 50% 20% 30% -0.45%
EXPANSION 30% 10% 12.5% -2.5% 30% 20% 10% -0.075%
CONTRACTION 30% 15% 12.5% 2.5% 10% 20% -10% -0.075%
TROUGH 20% 20% 12.5% 7.5% -10% 20% -30% -0.45%
TOTAL - 1.05%
*Probability x Difference (Stock A) x Difference (Stock B)

Accordingly, COVARIANCE between returns on Stocks A and B is equal to -1.05% or -0.0105. Coefficient
of CORRELATION is computed as follows:

−0.0105
AB =
(0.0512)(0.2049)

AB = - 1

5. Variance and Standard Deviation on Portfolio of Stocks A and B

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 portfolio equals the positive square root of the variance.

a. 50% Stock A, 50% Stock B


AB = VARIANCE
AB = STANDARD DEVIATION

AB = (50%) 2 (0.0512)2 + (50%) 2 (0.2049)2 + 2 (50%)(50%)(-0.0105)
AB = 0.0059
AB = √𝟎. 𝟎𝟎𝟓𝟗 = 0.0768 = 7.68%

b. 75% Stock A, 25% Stock B

AB = (75%) 2 (0.0512)2 + (25%) 2 (0.2049)2 + 2 (75%)(25%)(-0.0105)

AB = 0.00016
AB = √𝟎. 𝟎𝟎𝟎𝟏𝟔 = 0.0128 = 1.28%

Mataba + Marupok = Marupork

 c. 40% Stock A, 60% Stock B (Apply the same formula)

AB = (40%) 2 (0.0512)2 + (60%) 2 (0.2049)2 + 2 (40%)(60%)(-0.0105)

AB = 0.0105
AB = √𝟎. 𝟎𝟏𝟎𝟓 = 0.1024 = 10.24%

SUMMARY OF RELATIONSHIPS

RISK
RETURN DIRECT
STANDARD DEVIATION DIRECT
VARIANCE DIRECT
CORRELATION INVERSE
NUMBER OF INVESTMENTS INVERSE (subject to limit)

Explanations:
1. Relationship of risk to return, standard deviation and variance are all self-explanatory.
2. The relationship of correlation and risk is inverse because the more the data are correlated;
unknown variables are more predictable, thus, reducing the risk.
3. As the number of investments increases through diversification, the risk is reduced. However,
too much diversification can negatively affect the overall return of the portfolio.

A great philosopher once said, “Maiiyak ka na lang while you’re crying”