Measuring Return and Risk for a Portfolio of More than one Asset.

EXPECTED RETURN ON PORTFOLIO WITH EQUAL SHARES IN ASSET A AND ASSET B.

-

calculate the expected value of the return (mean return) of the portfolio as:
4

i 1

i 1

1 A 1 B
ri ri
2
2

P1
= E(r ) pi ri pi
P1

P1

1 4
1 4
1
1
A
p
r

pi ri B A B

i i
2 i 1
2 i 1
2
2

= (1/2)[12.5%] + (1/2)[32.5%] = 22.5%

expected return on a portfolio of two assets is equal to the weighted average of

each assets expected return, where the weights equal the share of the portfolio
invested in each asset.

Question: If this portfolio was 40% invested in Asset A and 60% in Asset B what
is its expected return?
P1 = E(rP1) = (.4)[12.5%] + (.6)[32.5%] = 10% + 19.5% = 29.5%

RISK IN PORTFOLIO OF EQUAL SHARES IN ASSET A AND ASSET B.

-

calculate the variance of a portfolios returns vary from its mean return.

Can use the formula for the variance of the portfolios return to show how it is related to
the variance and covariance of the two assets in the portfolio. (This is just algebra.)
var(r )
P1

p r
i 1

P1

P1 2

1
1
pi ri A ri B
2
i 1
2
4

1
1
B
pi ri A A ri B
2
2

i 1
4

1 A
ri A
4

pi
i 1

1 B
B
ri
4

1 A 1 B
2 2

1
4

= (1/4)var(rA) + (1/4)var(rB) + (1/2) cov(rA, rB)

A
ri A

ri B B

Measuring Return and Risk for a Portfolio of More than one Asset.
RISK IN PORTFOLIO OF EQUAL SHARES IN ASSET A AND ASSET B, CONTINUED.
-

We can use this formula to calculate the variance of the portfolios returns.

cov(rA, rB) = covariance of returns on Assets A and B, measures the amount by which
the returns on the assets move together under the different events. We calculate the
covariance of the two assets here using the table in the example as:
cov(rA, rB)

p r
i 1

A
i

- A

B
i

- B = .0718

calculate variance for example Portfolio 1 as:

var(rP1) = (1/4)var(rA) + (1/4)var(rB) + (1/2) cov(rA, rB)

= (.25)(.037625) + (1/4)(.208625) + (1/2) )(.0781)
var(rP1) = 0.101

Expected Risk for Portfolio 1 return is:

stdev(rP1) = .3172 = 31.72 %

Looking at the expected return/risk tradeoff for Portfolio 1, we find that even though we
combined two different assets we didnt really receive a better trade-off between risk
and return than we already had with Asset B on its own. Why?

In contrast, the expected return/risk tradeoff for Portfolio 2 is much better than we could
get with either with Asset A or C individually. Why?

Diversification and Risk Reduction I

Combining a large number of assets (say N assets) with the same expected return and the
same variance into a portfolio. Extending formula developed for two assets to N assets.
1. Each asset has an equal share in the portfolio, so that the share of each is equal to 1/N.
2. All asset returns have zero covariance with one another, asset returns are independent.

EXPECTED RETURN ON PORTFOLIO OF EQUAL SHARES IN N INDEPENDENT ASSETS.

- we are assuming that the expected return and variance of each asset is identical, thus

E r k , k2 2

k , (upside down A means for all k i.e. all assets.)

E[rP]

i 1

pi ri P pi
N

1
N

i 1

pi rik
k 1 i 1

N r

k 1

1
N

k 1

1
N
N

RISK IN PORTFOLIO OF EQUAL SHARES IN N INDEPENDENT ASSETS.

- calculate a measure of how much the portfolio returns vary from its mean return, its variance.
k
j
Assume assets are independent so cov r , r 0

var(r )
P

pi ri
i 1

1

N

2 N

P 2

var r
k 1

1

k 1 N
N

1

N

p r
i 1

k j .
k

1
N 2
2
N

As we add more and more independent risks, each with smaller and smaller weight in our
portfolio, (N goes to infinity), then the variance of the expected return goes to zero. This is
known as the insurance principle, and relies on the Law of Large Numbers.

Diversification and Risk Reduction II

- combining assets can also reduce risk (i.e. portfolio variance) by choosing assets with
negative covariances. Return to our two asset example portfolio where Assets A and B are held
with equal weight. then:
E[rP]

1 A 1 B

2
2

var(rP) = (1/4)var(A) + (1/4)var(B) + (1/2) cov(A,B)

1. Choosing assets with negative covariances reduces the risk of the portfolio even more than
for two independent assets.
2. Choosing assets with positive covariances increases the risk of the portfolio beyond that of
two independent assets.