Return, Risk And The Security Market Line - Expected Return

,
Variance And Standard Deviation Of A ortfo!io
Expected return is calculated as the weighted average of the likely profits of the assets in the portfolio,
weighted by the likely profits of each asset class. Expected return is calculated by using the following
formula:

Written another way, the same formula is as follows: E(R ! w
"
R
"
# w
$
R
%
# ...# w
n
R
n
Example: Expected Return
&or a simple portfolio of two mutual funds, one investing in stocks and the other in bonds, if we expect
the stock fund to return "'( and the bond fund to return )( and our allocation is *'( to each asset
class, we have the following:
Expected return (portfolio ! ('."+('.* # ('.')+('.* ! '.',, or ,(
Expected return is by no means a guaranteed rate of return. -owever, it can be used to forecast the
future value of a portfolio, and it also provides a guide from which to measure actual returns.
.et/s look at another example. 0ssume an investment manager has created a portfolio with 1tock 0 and
1tock 2. 1tock 0 has an expected return of $'( and a weight of 3'( in the portfolio. 1tock 2 has an
expected return of "*( and a weight of 4'(. What is the expected return of the portfolio5
E(R ! ('.3'('.$' # ('.4'('."*
! )( # "'.*( ! ").*(
6he expected return of the portfolio is ").*(.
7ow, let/s build on our knowledge of expected returns with the concept of variance.
Variance
Variance (8
$
is a measure of the dispersion of a set of data points around their mean value. 9n other
words, variance is a mathematical expectation of the average s%uared deviations from the mean. 9t is
computed by finding the probability:weighted average of s%uared deviations from the expected value.
;ariance measures the variability from an average (volatility. ;olatility is a measure of risk, so this
statistic can help determine the risk an investor might take on when purchasing a specific security.
Example: Variance
0ssume that an analyst writes a report on a company and, based on the research, assigns the following
probabilities to next year/s sales:
Scenario ro"a"i!ity Sa!es #$ Mi!!ions%
& '(&' $&)
* '(+' $&,
+ '(+' $&-
+ '(+' $&+
The ana!yst.s expected va!ue for next year.s sa!es is #'(&%/#&)('% 0 #'(+%/#&,('% 0 #'(+%/#&-('% 0
#'(+%/#&+('% 1 $&-(* 2i!!ion(
3a!cu!atin4 variance starts "y co2putin4 the difference in each potentia! sa!es outco2e fro2
$&-(* 2i!!ion, then s5uarin46
Scenario ro"a"i!ity
Deviation fro2 Expected
Va!ue
S5uared
& '(& #&)(' - &-(*% 1 &(7 +(*-
* '(+' #&,(' - &-(*% 1 '(7 '()-
+ '(+' #&-(' - &-(*% 1 - '(* '('-
- '(+' #&+(' - &-(*% 1 - &(* &(--
Variance then 8ei4hts each s5uared deviation "y its pro"a"i!ity, 4ivin4 us the fo!!o8in4
ca!cu!ation6
#'(&%/#+(*-% 0 #'(+%/#'()-% 0 #'(+%/#'('-% 0 #'(+%/#&(--% 1 '(9)
ortfo!io Variance
:o8 that 8e.ve 4one over a si2p!e exa2p!e of ho8 to ca!cu!ate variance, !et.s !ook at portfolio
variance(
The variance of a portfo!io.s return is a function of the variance of the co2ponent assets as 8e!!
as the covariance "et8een each of the2( 3ovariance is a 2easure of the de4ree to 8hich returns
on t8o risky assets 2ove in tande2( A positive covariance 2eans that asset returns 2ove
to4ether( A ne4ative covariance 2eans returns 2ove inverse!y( 3ovariance is c!ose!y re!ated to
;correlation,; 8herein the difference "et8een the t8o is that the !atter factors in the standard
deviation(
<odern portfolio theory says that portfo!io variance can "e reduced "y choosin4 asset c!asses 8ith
a !o8 or ne4ative covariance, such as stocks and "onds( This type of diversification is used to
reduce risk(
ortfo!io variance !ooks at the covariance or corre!ation coefficient for the securities in the
portfo!io( ortfo!io variance is ca!cu!ated "y 2u!tip!yin4 the s5uared 8ei4ht of each security "y
its correspondin4 variance and addin4 t8o ti2es the 8ei4hted avera4e 8ei4ht 2u!tip!ied "y the
covariance of a!! individua! security pairs( Thus, 8e 4et the fo!!o8in4 for2u!a to ca!cu!ate
portfo!io variance in a si2p!e t8o-asset portfo!io6
#8ei4ht#&%<*/variance#&% 0 8ei4ht#*%<*/variance#*% 0 */8ei4ht#&%/8ei4ht#*%/covariance#&,*%
=ere is the for2u!a stated another 8ay6
=ortfolio ;ariance ! w
$
0
+8
$
(R
0
# w
$
2
+8
$
(R
2
#
$+(w
0
+(w
2
+>ov(R
0
, R
2

Where: w
A
and w
B
are portfolio weights, σ
2
(R
A
and σ
2
(R
B

are !ariances and
"o!(R
A
, R
B
is the co!ariance
Exa2p!e6 ortfo!io Variance
?ata on both variance and covariance may be displayed in a covariance matrix. 0ssume the following
covariance matrix for our two:asset case:
Stock >ond
Stock +,' 7'
>ond &,'
?ro2 this 2atrix, 8e kno8 that the variance on stocks is +,' #the covariance of any asset to itse!f
e5ua!s its variance%, the variance on "onds is &,' and the covariance "et8een stocks and "onds is
7'( @iven our portfo!io 8ei4hts of '(, for "oth stocks and "onds, 8e have a!! the ter2s needed to
so!ve for portfo!io variance(
ortfo!io variance 1 8
*
A
/A
*
#R
A
% 0 8
*
>
/A
*
#R
>
% 0 */#8
A
%/#8
>
%/3ov#R
A
, R
>
% 1#'(,%
*
/#+,'% 0
#'(,%
*
/#&,'% 0 */#'(,%/#'(,%/#7'% 1 7B(, 0 +B(, 0 -' 1 &),(
Standard Deviation
Standard deviation can "e defined in t8o 8ays6
&( A 2easure of the dispersion of a set of data fro2 its 2ean( The 2ore spread apart the data, the
hi4her the deviation( Standard deviation is ca!cu!ated as the s5uare root of variance(
*( Cn finance, standard deviation is app!ied to the annua! rate of return of an invest2ent to
2easure the invest2ent.s vo!ati!ity( Standard deviation is a!so kno8n as historical volatility and is
used "y investors as a 4au4e for the a2ount of expected vo!ati!ity(
Standard deviation is a statistica! 2easure2ent that sheds !i4ht on historica! vo!ati!ity( ?or
exa2p!e, a vo!ati!e stock 8i!! have a hi4h standard deviation 8hi!e a sta"!e blue chip stock 8i!!
have a !o8er standard deviation( A !ar4e dispersion te!!s us ho8 2uch the fund.s return is
deviatin4 fro2 the expected nor2a! returns(
Example: #tandard $e!iation
Standard deviation #A% is found "y takin4 the s5uare root of variance6
#&),%
&D*
1 &*(7,E(
Fe used a t8o-asset portfo!io to i!!ustrate this princip!e, "ut 2ost portfo!ios contain far 2ore
than t8o assets( The for2u!a for variance "eco2es 2ore co2p!icated for 2u!ti-asset portfo!ios(
A!! ter2s in a covariance 2atrix need to "e added to the ca!cu!ation(
Let.s !ook at a second exa2p!e that puts the concepts of variance and standard deviation
to4ether(
Exa2p!e6 Variance and Standard Deviation of an Cnvest2ent
@iven the fo!!o8in4 data for :e8co.s stock, ca!cu!ate the stock.s variance and standard deviation(
The expected return "ased on the data is &-E(
Scenario ro"a"i!ity Return Expected Return
Forst
3ase
&'E &'E '('&
>ase 3ase 7'E &-E '(&&*
>est 3ase &'E &7E '('&7
Answer:
A
*
1 #'(&'%#'(&' - '(&-%
*
0 #'(7'%#'(&- - '(&-%
*
0 #'(&'%#'(&7 - '(&-%
*
1 '('''+
The variance for :e8co.s stock is '('''+(
@iven that the standard deviation of :e8co.s stock is si2p!y the s5uare root of the variance, the
standard deviation is '('&B9, or &(B9E(

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