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Chapter Outline

1.Statistics and concepts

1.1. Univariate statistics
1.2. Bivariate statistic

2. Risk and Return

2.1. Risk and return trade-off relation
2.2. Risk appetite
Chapter 2: 3. Portfolio diversification
Risk and Return 3.1. Definition of portfolio
3.2. Benefits of portfolio diversification

1. Statistics and Concepts 1.1 Univariate statistics

When one measurement is made on each observation,
univariate analysis is applied.
If more than one measurement is made on each observation,
multivariate analysis is applied.
A population is a collection of units being studied. This might be
the set of all people in a country. Units can be people, places,
objects, years, drugs, or many other things. The term population is
also used for the infinite population of all possible results of a
sequence of statistical trials, for example, tossing a coin. .

A parameter is a numerical value of a population, such as the

population mean. The population values are often modelled from a
distribution. Then the shape of the distribution depends on its
parameters. For example the parameters of the normal distribution
are the mean, μ and the standard deviation, σ

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Univariate statistics Mean (μ)

A sample is a group of units, selected from a larger group (the The Mean is a measure of the “middle”, sometimes called the
population). By studying the sample it is hoped to draw valid “average”. It is often given the symbol μ
conclusions (inferences) about the population. A sample is usually
used because the population is too large to study in its entirety. The To calculate the mean, sum all the data values, and divide by the
sample should be representative of the population. This is best number of them
achieved by random sampling. The sample is then called a random
sample.

An estimator is a quantity calculated from the sample data, which is

used to give information about an unknown quantity (usually a
[2-1]
parameter) in the population. For example, the sample mean is an
estimator of the population mean.

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Calculate the expected return of the following stock:

link

Date Price ($)

Arithmetic Mean and Geometric Mean
Arithmetic Mean:
2-Jan 12.9
Date Price Return
3-Jan 13.2
1 5$ N/A
4-Jan 10.7
2 6$ 0.2
5-Jan 11.6
3 5$ -0.166666667
6-Jan 13.9
Example

7-Jan 13.5 The arithmetic mean of return rate is 1.68%!

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Arithmetic Mean and Geometric Mean Variance (σ2)

Geometric Mean: The variance is a measure of variability, and is often denoted by

σ2
Date Price Return Gross Return
1 5$ N/A
2 6$ 0.2 1.2
3 5$ -0.166666667 0.833333
[2-2]

The geometric mean of return rate= SQRT(1.2x0.833333) –

= 0%

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Example: Standard deviation (σ)

Calculate the variance of this data values link In simple statistical methods the square root of the variance, σ,
which is called the standard deviation, is often used more. The
standard deviation has the same units as the data themselves
Quarter 1 Quarter 2 Quarter 3 Quarter 4 and is therefore easier to interpret than the variance

15 16 14 18 It is a “typical” distance from the mean

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1.2 Multivariate statistics Covariance (Covar)

In this section, we focus on bivariate statistics, where exactly two Covariance is a statistic representing the degree to which two variables
measurements are made on each observation vary together.

Note that the two parameters always have the same sign (positive,
Bivariate statistics describe the paired relation between
negative, or 0). When the sign is positive, the variables are said to
observations of 2 different variables
be positively correlated; when the sign is negative, the variables are said
to be negatively correlated; and when the sign is 0, the variables are said
to be uncorrelated.

However, covariance has an absolute value, therefore it doesn’t worth much

in estimating the correlation level of 2 different variables

[2-3]
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Example Correlation coefficient (ρ)

Calculate the covariance of stock price value and bond price Correlation coefficient is a scaled version of covariance (correlation
value: link is a standardized measure of covariance)
Variable Quarter 1 Quarter 2 Quarter 3 Quarter 4
A correlation coefficient is a statistical measure of the degree to
which changes to the value of one variable predict change to the
Stock price 10.3 12.3 11.4 13.6
value of another.
Bond price 5.2 4.7 4.9 4.3 Correlation coefficients are expressed as values between +1 and -1.
A coefficient of +1 indicates a perfect positive correlation. A
coefficient of -1 indicates a perfect negative correlation

[2-4]
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Example Risk - return trade off

Calculate the correlation coefficient between 2 variables: stock One important principle is “risk-return trade off relation always
price and bond price in the above example exists in Finance”

Return measured by μ, let us know the central value of

link

observations.

Risk measured by σ, let us know how deviate observations are from

the central value.

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Risk appetite Definition of investment portfolio

People can be risk averse, risk neutral, or risk loving
A risk averse investor will generally take a guaranteed outcome
even if it has a lower expected payout than a gamble
A risk neutral investor is indifferent to risk when making an
investment decision (only considers the expected return of each
investment, and ignores the potential downside risk)
A risk lover will choose a higher risk option with an expectation of
receiving higher return
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A portfolio is a grouping of financial assets such as stocks, bonds
and cash equivalents.
Portfolios are held directly by investors and/or managed by
financial professionals. Prudence suggests that investors should
construct an investment portfolio in accordance with risk
tolerance and investing objectives
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The importance of diversification

Diversification is a technique that reduces risk by allocating

investments among various financial instruments, industries and
other categories. It aims to maximize return by investing in
different areas that would each react differently to the same
event.

If assets in a portfolio move in opposite direction, a negative

covariance between these assets will make standard deviation
of portfolio lower -> reduce risk

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