Now throughout this class we'll be dealing with portfolios quite a lot.

And so, the idea of a portfolio is you have a collection of assets that you want to invest in, and then you just spread your wealth amongst those different assets and you create a portfolio. So, a portfolio is a just a collection of assets you're going to invest in. So let's look at a case where we have a two asset portfolio. So, we're at, say we have V dollars to invest in, so you have $1000 to invest in, and two assets to invest in, and I like Northwest stocks. So we can have, Amazon and Boeing, all right. A and B. And, and so. We define a portfolio by how much of our wealth. We invest in each of the securities. And, we define. The, these portfolio shares. Say XA. Or, or this would be the share of our initial wealth. That we have invested in Amazon. So if we have $1,000, and we put half of our wealth in Amazon, then our portfolio share would be 50 percent in Amazon. And then, if we have 50 percent in Amazon, and then we would have the remaining 50 percent in Boeing, then XB would be also equal to 50%. If we put you know, $100 in Amazon, 100 divided by 1,000 would be ten%, then XA would be ten%, and then XB would be 90%. So these portfolios shares just tell us from a percentage point of view what is the fraction of our wealth invested in the different securities. And when we study portfolios, we generally assume that we exhaust all of our wealth amongst the assets that we have. So, if we have $1000, and we have two assets to invest in, we assume that we put all of our money in one of these two assets. Okay? So then our portfolio is completely determined by the portfolio shares. Different portfolios are just different values of XA and XB. So now what we wanna do is you wanna think about. What is the rate of return. On a portfolio, over a given holding period?

And how does that rate of return on the portfolio. Relate to the rates of return on the individual securities A and B? [laugh] This should be capital D. If I had my tablet PC I could scribble that out, but, thank you, I'll fix that. Alright. So, what about the, So we wanna do. What is the rate of return on a portfolio? So the idea is that we invest in, XA of Amazon, XB of Boeing today. We hold that portfolio for one month, and then we sell it at the end of the month. What's the rate of return on that portfolio? So we can define the, the future value of the portfolio. So we start with our initial investment, and that investment grows to one plus the portfolio rate of return. And so we want to determine, what is this portfolio rate of return? Well. We have our initial investment v and so, we have two components to the portfolio we have Amazon and we have Boeing. And so this is. V one+, RA. So this is the future value if we invested everything in Amazon, but we wanna weight that by the fraction of wealth that we put in, in Amazon. So this the, portion of our portfolio that, grows with our investment in Amazon. And then this is the portion of our portfolio that grows with our investment in Boeing. So if we had invested everything in Boeing, then this would be the future value of the investment. But we only invest XB is Boeing, so this is what we get, out of our investment in Boeing. So now we can take this relationship we can split it up because we have xa times one, xa times ra, xb times one, xb times rb. So that gives us xa + xb and then we have xara xbrb. But the portfolio shares are assumed to add to 100%. Xa Plus XV is equal to one. So that reduces down to one. So we see that our. Future value of our portfolio is equal to V times one plus. Xara plus XVRB. So we can. So that, this looks just likes this.

Where the return on the portfolio is XA, RB, A. Xara equals XVRB. So we have this very nice result that we have a portfolio of assets. The rate of return on the portfolio is how much you invest in asset A times the rate of return on asset A plus how much you invest in asset B times the rate of return on asset B. So rates of returns on portfolios are linear combinations of rates of returns on the individual securities. That's a nice result. 'Kay. So here's an example. Say you have a portfolio of Microsoft and Starbucks. All right, so we purchased ten shares of each stock at the end of month t-1, and the prices of these stocks are 80 and 30. And again we have ten shares of each. So the initial value of the portfolio at time t-1 is our ten shares of Microsoft. Plus the ten shares of Starbucks, so that we have $1100 initially in our portfolio. And where are portfolio shares? We are sure that wealth in Microsoft is equal to our ten share times 80 divided by 1100 dollars and so that's 72 percent of our growth is in Microsoft and our present size of portfolio in star bucks is ten share times 3300 divided by our portfolio value so we have 27 percent in stocks. Notice that these portfolio rates add upto one. Now at the end of month T, my price of Microsoft has gone from 80 to 90, but the price of Starbucks has gone from 30 to 28. So we made money on Microsoft and we loss money on Starbucks. What is the rate of return on our portfolio? So we just use our formula, it's the portfolio shares times the rates of returns on the individual securities. Okay. So the rate of return on Microsoft is percentage change in price over the month, so that's 5.88%, the rate of return on Starbucks percent change in price, and that's -6.7%, so my portfolio return is how much I invest in Microsoft times the rate of return on Microsoft plus how much I invest in Starbucks times the rate of return on Starbucks, and that is 2.45%. And so my portfolio grew at 2.45 [inaudible], 2.45 percent over the month. So my $1,100 grew to $1126.95, okay? So, it's an illustration of a portfolio

rate of return calculation. Alright, So very often when we do calculations it's easiest to do the calculation when you have two assets you know, just to get the intuition of what the formula looks like. And then very often the, the formula is generalized to you know, more than two assets relatively easily. And this is true with a portfolio rate of return calculation. So, suppose you have a portfolio that has N assets, and N can be big, like 500. So you invest in the S and P 500 Stock Index, there are 500 assets in that portfolio. What's the rate of return on the S and P 500? Well it's a weighted average of the rates of return on each of the securities in the S and P 500. So my portfolio rate of return is the sum of all the portfolio weights, times the rates of return on the individual securities. So we get X1, R1T, XN, RNT. So another thing to, to illustrate as well, so when we get to more than two assets, our formulas for you know, showing the results you know, here involves some summations. What we'll see when we start studying fort folio theory a little bit more is that the formulas that we used involving summations are gonna get kinda long and messy. And, and it turns out that we're gonna be able to simplify the expressions of these formulas, using a little bit of matrix algebra. And that is, we can consider a vector of portfolio weights, and a vector of returns. And this portfolio return is a weighted average here, but if you know a little bit of matrix algebra, this is just the cross product of two vectors.