Portfolio Return ‘The return of a portfolio comprises the return on individual securities or assets constituting the portfolio. The portfolio retum can be calculated by taking weighted average of retum on individual securities, the weights being taken as the proportion of investment in different securities. The same ‘concept can be applied to determine the portfolio return in the ‘ease of two-asset portfolio. We know from previous chapter that exp, sum of the rates of return under different economic conditions ‘multiplied hy the associated probabilities. We ean say that ER) = Ry X P+ Ry X Py #R, x Py Where, & represents rate of return under different economt ‘conditions and P represents the probability associated with respective rate of retuin. ER) is expected rate of return, ted rate of return on an asset will be equal to the BR)= ER xP, o In ease of two-asset portfolio, the expected rate of return willbe the weighted average, described as follows: Expected Retun on Portfolio = (Expected Return on Asset A) X (Weight of Asset A) + (Expected Return on Asset B) (Weight of Asset B) or (Rp) = wy EUR) + (1 =) X BAR) Q pected Return on two-asset portfolio expected Return on Asset A expected Return on Asset Bt Wy = Proportion of Investment in Asset A as fraction Ww, = Proportion of Investment in Asset B as fraction =(1-wy) Let us take an example to illustrate the concept. Example 5.1 An investor is considering investing his funds in two assets ‘A’ and ‘B°. The possible rates of return on the two assets, under different economic conditions, are given as under. Calculate the expected rate of retum of Asset ‘A’, Asset °B” ‘and portfolio comprising 40 per cent Asset A and 60 per cent Asset B. Economic Probability Returnon —__‘Returnon conditions Asset (%) Asset B(%) Highly ol 2 25 promising Excellent ous 10 20 Very Good 02 8 0 Good 03 5 6 Average ous 4 Poor ou 2 5.2 _Financial Management Solution We can use the formula in Equation (1) to determine the expected rate of return on the two assets as Follows: BR, = 12 X O41 +10 X O15 +8 X 0.245 X03 +4 015 +2 0 ELD+1S+ 16415406402 6 per cent 25 X 0.1 +20 X 0.15 + 10 X 0.24603 + (4) x O15 + 8) x OL 5+30+20+18-06-08 =7.9 per cent FARy) Expected rate of return on portfolio = (Expected Return on Asset A) X (Weight of Asset A) + (Expected Return on Asset B) X (Weight of Asset B). 6X 04479 X06 6444.74 38 per cent ‘Thus, we can say that; Expected Return on Asset A = 6.6 per cent Expected Return on Asset B= 7.9 per cent Expected Retutn on Portfolio = 7.38 per cent ‘Once we know the expected rate of return on each of the (wo assets, we can obtain different returns by selecting different proportion of the two assets. For example, if the expected rate of retum of the two assets Pand Q are say 8 per cent and 12 per cent, then we can get the returns in different options as calculated in the table, as follows: Option Proportion of bwextment in Each Expected Rate Asser of Return of Ponfolio® ‘A Select 100% Asset Pand 0% Asset Q 8% DB Select 755 Asset Pand 25% Asset Q 9% Select SOSH Asset Pand SOG: Asset 10% D Select 255 Asset Pand 75% Asset QS E Select 0% Assot P and 100% Asset Q “EAR y) = ER) XW, + ERY X Wy Based on the above analysis, it appears that the investor would select option (E) 10 get the highest retum on the portfolio of the two assets, However, there is another aspect to this selection of proportion of each asset and that Is the risk of returns, Risk of return of a single asset or a portfolio ‘of assets is represented by the variability which is measured by variance (0) or standard deviation (7) Pause and Think <> Expected rate of return on a portfolio is the weighted average rate of return on individual assets. Ad