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Overview of Portfolio

# Overview of Portfolio

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08/26/2010

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RISK PREFERENCES

The trade off between Risk and Return
Most, if not all, investors are risk averse

To get them to take more risk, you have to offer higher expected returnsConversely, if investors want higher expected returns, they have to be willingto take more risk.
Ways of evaluating risk
Most investors do not know have a quantitative measure of how much risk thatthey want to takeTraditional risk and return models tend to measure risk in terms of volatility or standard deviation
The Mean Variance View of Risk
In the mean-variance world, variance is the
only
measure of risk. Investorsgiven a choice between tow investments with the same expected returns butdifferent variances, will
always
pick the one with the lower variance.

Estimating Mean and Variance

In theoretical models, the expected returns and variances are in terms of future returns.

In practice, the expected returns and variances are calculated usinghistorical data and are used as proxies for future returns.

Illustration 1: Calculation of expected returns/standard deviation using historical returns

GEThe Home Depo
YearPrice atDividendsReturnsPrice atDividendsReturnsend of yearduring yearend of yearduring yea1989\$ 32.25 \$ 8.131990\$ 28.66 \$ 0.95 -8.19%\$ 12.88 \$ 0.04 58.82%1991\$ 38.25 \$ 1.00 36.95%\$ 33.66 \$ 0.05 161.79%1992\$ 42.75 \$ 1.00 14.38%\$ 50.63 \$ 0.07 50.60%1993\$ 52.42 \$ 1.00 24.96%\$ 39.50 \$ 0.11 -21.75%1994\$ 51.00 \$ 1.00 -0.80%\$ 46.00 \$ 0.15 16.84%Average 13.46%53.26%Standard Deviation 18.42%68.50%
Concept Check
:
While The Home Depot exhibited higher variance in returns, much of the variance seems to come from the stock price going up dramatically between 1989 and 1992? Why is this ìupsideî considered risk?
Should risk not be defined purely in terms of "downside" potential(negative returns)?

Variance of a Two-asset Portfolio

µ
portfolio = w
A

µ
A
+ (1 - w
A
)
µ
B
σ
2 portfolio
= w
A2

σ
2A
+ (1 - w
A
)
2

σ
2B
+ 2 w
A
w
B
ρ
ΑΒ

σ
A
σ
B
wherew
A
= Proportion of the portfolio in asset AThe last term in the variance formulation is sometimes written in terms of the covariancein returns between the two assets, which is
σ
AB
=
ρ
ΑΒ

σ
A
σ
B
The savings that accrue from diversification are a function of the correlationcoefficient.
Illustration 2: Extending the two-asset case - GE and The Home Depot Step 1: Use historical data to estimate average returns and standard deviations inreturns for the two investments.

StockAverage Return (1990-94)Standard Deviation (1990-94)
General Electric 13.46% 18.42%The Home Depot 53.26% 68.50%
Step 2: Estimate the correlation and covariance in returns between the two investmentsusing historical data.

Year  Returns onGE(R
Ge
) Returns on HD(R
H
)(R
GE
- Avge(R
GE
))
2
(R
H
- Avge(R
H
))
2

(R
GE
- Avge(R
GE
)(R
H
-Avge(R
H
)
1990-8.19%58.82%0.04686 0.00309 (0.01203)199136.95%161.79%0.05518 1.17786 0.25494199214.38%50.60%0.00008 0.00071 (0.00024)199324.96%-21.75%0.01322 0.56265 (0.08625)1994-0.80%16.84%0.02034 0.13265 0.05194Total0.13568 1.87696 0.20835Variance in GE Returns = 0.13568/4 = 0.0339 Standard Deviation in GE Returns =0.0339
0.5
= 0.1842Variance in HD Returns = 1.87696/4 = 0.4692 Standard Deviation in HD Returns =0.4692
0.5
= 0.6850

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