Financial Management

Lecture No. 21
Intro to 2-Stock Portfolio Theory
Risk & Expected Return
Batch 6-1 Oct 12th
Copyright: M. S. H

Recap of Risk Basics

Stand Alone (Single Investment) Risk
Risk: Arises because of Uncertainty, Volatility, Spread - Many Possible
Outcomes (pi) for Expected Rate of Returns (ri)
Measured using Standard Deviation or Variance
Risk = Std Dev = =
( r i - < r i > )2 p i . = Sigma
Bell Curve Assumption: Assume that the forecasted outcome of events will be
distributed in the shape of a Normal Probability Distribution.
Then 68.26% of the times the Actual Future Rate of Return will lie within -1
and +1 range
Coefficient of Variation: Investment Comparison Criterion used to
simultaneously account for Risk & Return:
CV = / < r >.
Objective: Minimize Risk & Maximize Return
Note: < r > = Exp or Weighted Avg ROR =
p i ri .

Copyright: M. S. H

Graphical Standard Deviation

Expected (or Mean)
Return = <r> = 10%
Probability (p)

+/- 1 Std Dev covers

68.26% of the Area
under the Normal
Curve always

-2

-1
-13.24%

+1

+2

+33.24%

Copyright: M. S. H

Return ( r ) %
Our Example
3

Portfolio Risk & Return Collection of Investments

Portfolio is a Collection of Multiple Investments. Portfolios may have 2 or more stocks,

bonds, other securities and investments or a mix of all. We will focus on Stock Portfolios.
Risk is Relative: The RISK from investing in Stock of Company ABC usually
DECREASES as you MAKE MORE INVESTMENTS in Other Stocks of Different
Unrelated Companies.
Diversification: Investing in many Different Shares and Bonds and Projects of Different
Companies in Different Countries can reduce risk. DIVERSIFIED PORTFOLIOS CAN
REDUCE RISK.
Portfolio Risk & Return: What matters is the Overall Risk & Return on the entire Portfolio
(or Collection) of Investments. The Risk & Return of an Individual Investment in a Stock
or Bond should be seen in terms of its Incremental Effect on the Overall Portfolio.
Investment Rule: Investor will try to Maximize Portfolio Return and Minimize Portfolio
Risk. Investor will NOT take on Additional Portfolio Risk UNLESS compensated with
Additional Portfolio Return.

Copyright: M. S. H

Types of Risks for a Stock

2 Types of Stock-related Risks which cause Uncertainty in future possible Returns & Cash Flows:
Total Stock Risk = Diversifiable Risk + Market Risk
Diversifiable Risk
Known as Company-Specific or Unique or or Non-Systematic Risk
Associated with Random events associated with Each Company whose stocks you are investing in
ie. Winning major contract, losing a court case, successful marketing campaign, losing a
charismatic CEO,
Diversifiable Risk can be Reduced using Diversification. The bad random events affecting one
stock will offset the good random events affecting another stock in your portfolio
Market Risk
Known as Non-Diversifiable or Systematic (Country-wide) or Beta Risk
Associated with Macroeconomic or Socio-Political or Global events that systematically affect
Stock investments in every Stock Market in the country ie. Inflation, Macro Market Interest Rates,
Recession, and War
Market Risk can NOT be reduced by Diversification.

Copyright: M. S. H

Portfolio Size vs Risk Graph

Unique or Diversifiable or
Specific or Non-Systematic Risk

Total Risk

Portfolio Risk

Market or Systematic or NonDiversifiable or Beta Risk =

Minimum Possible Portfolio Risk

7
20
40
Number of Investments (Stocks) in the Portfolio

Note: About 100% of the Diversifiable Risk (and 50% of the Total
Risk) can be removed by Diversification across 40 stocks. Just 7
carefully chosen Un-Correlated Stocks might be enough to remove
30% of the Total Risk.Copyright: M. S. H

Portfolio Rate of Return

Portfolios Expected Rate of Return: rP . is the weighted average
of the expected returns of each individual investment in the
portfolio. Formula is similar to Expected Return for Individual
Investment but interpretation is different:
Portfolio Expected ROR Formula:

rP * = r1 x1 + r2 x2 + r3 x3 + + rn xn .
Where there are n different investments (ie. Stocks, Bonds,
Projects,) in your portfolio. r1 represents the expected return
(in % pa) on Investment No. 1 and x1 represents the weight of
Investment No. 1 (fraction of the Rupee value of the total
portfolio that Investment No. 1 represents).

Copyright: M. S. H

Portfolio Return - Example

Suppose that you hold a Portfolio of 2 Stock Investments:
Value of Investment (Rs)
Exp Individual Return (%)
Stock A
30
20
Stock B
70
10
Total Value = 100
Expected Portfolio Return Calculation:
rP * =
rA x A
+
rB x B
= 20%(30/100) + 10%(70/100)
=
6%
+
7%
=
13%

Copyright: M. S. H

2 Stock Investment Portfolio Risk

Portfolio Risk is generally NOT the weighted average risk
of the Individual Investments. In fact, it is usually LESS.
2 Stock (Investment) Portfolio Risk Formula:
p = XA2

A 2 +XB2 B 2

+ 2 (XA XB

AB )

Definition of Terms:
XA is Investment As weight in the total value of the Portfolio. A
is Investment As Individual Risk (or standard deviation). AB is
the Correlation Coefficient that measures the correlation in the
returns of the two investments. Last term is a Covariance term.

Copyright: M. S. H

Portfolio Risk - Example

Complete 2-Stock Investment Portfolio Data:
Value (Rs) Exp Return (%) Risk (Std Dev)
Stock A
30
20
20%
Stock B
70
10
5%
Total Value = 100
Correlation Coeff Ro = + 0.6

2-Stock Portfolio Risk Calculation:

p = XA2 A 2 +XB2 B 2 + 2 (XA XB
={(30/100)2(20%)2 + (70/100)2(5%)2

AB )

+2[(30/100)(70/100)(20%)(5%)(0.6)]}0.5 ={ (0.09)(0.04) + (0.49)(0.0025) +

2[ (0.0021) (0.6) ] } 0.5

={ 0.0036 + 0.001225 + 0.00252 } 0.5 .
= {0.004825 + 0.00252} 0.5 .= {0.007345} 0.5 .
= 0.0857=8.57%

Copyright: M. S. H

10

Risk vs Return Graph

Example with 2-Stock Portfolio with Positive Correlation

Portfolio Return

rP*20%
17%
15%

As Risk INCREASES,
the Investors Required
Return INCREASES

13%
10%

5%

9%

12% 15% 20%

Copyright: M. S. H

Risk 11