PORTFOLIO

RISK

PREPARED BY
MS. KIMBEARLY R. CHENG, MBA
NOTE: FOR THE 3-STOCK PORTFOLIO

THE EXPECTED RETURN

WHEREIN:
ȓ = RETURN OF PROBABILITY DATA
w = WEIGHTED AVERAGE OF THE RETURNS
 What is the expected return of a portfolio made up of 60%
Stock A and 40% Stock B when the expected return for Stock A
is 10% and the expected return for Stock B is 20%?

OR!

 OPTION A OPTION B OPTION C

GOOGLE (GOOGL) GOOGLE (GOOGL) TESLA (TSLA)

MICROSOFT (MSFT) GOOGLE (GOOGL)

APPLE (AAPL) DEUTSCHE BANK (DBK)

BANDAI NAMCO

INTEL (INTC)
HOLDINGS INC. (7832)
 OPTION A OPTION B OPTION C

GOOGLE (GOOGL) GOOGLE (GOOGL) TESLA (TSLA)

MICROSOFT (MSFT) GOOGLE (GOOGL)

APPLE (AAPL) DEUTSCHE BANK (DBK)

BANDAI NAMCO

INTEL (INTC)
HOLDINGS INC. (7832)
 OPTION A OPTION B OPTION C

GOOGLE (GOOGL) GOOGLE (GOOGL) TESLA (TSLA)

MICROSOFT (MSFT) GOOGLE (GOOGL)

APPLE (AAPL) DEUTSCHE BANK (DBK)

BANDAI NAMCO

INTEL (INTC)
HOLDINGS INC. (7832)

No diversification! High correlation: Not

well-diversified!

WELL
DIVERSIFIED
 OPTION C

WHY?! TESLA (TSLA)

Low correlation since stocks are
GOOGLE (GOOGL)
not in the same industry.
If one industry tanks, the rest DEUTSCHE BANK (DBK)
may still be okay!
BANDAI NAMCO
HOLDINGS INC. (7832)

WELL
DIVERSIFIED
SOLUTIONS
MEASURING DIVERSIFICATION

A. COVARIANCE OF 2 SECURITIES
 WHAT DOES THIS
MEAN?

IF THE COVARIANCE OF A AND B IS:

EQUAL TO 0 = THE TWO INVESTMENTS HAVE NO RELATIONSHIP

AT ALL

NEGATIVE = THE TWO INVESTMENTS ARE MOVING IN OPPOSITE

DIRECTIONS; IF ONE INCREASES, THE OTHER DECREASES.

POSITIVE = THE TWO INVESTMENTS MOVE TOGETHER IN ONE

DIRECTION.

BY WHAT DEGREE IS THIS MOVEMENT? WE WON'T KNOW UNTIL WE MEASURE THEIR ACTUAL CORRELATION!
B. THE CORRELATION COEFFICIENT

WHEREIN:
Cov (A,B) = Covariance of A and B
SA = Standard Deviation of A
SB = Standard Deviation of B

VALUE: -1 < R < 1

IF THE CORRELATION COEFFICIENT IS:
0 = THE TWO INVESTMENTS HAVE NOTHING IN
COMMON.

- 1 = THE TWO ARE PERFECTLY CORRELATED

NEGATIVELY. THIS IS A GOOD THING SINCE YOU CAN
MAXIMIZE THE DIVERSIFICATION!

1 = THE TWO INVESTMENT ARE COMPLETELY WORKING

IN TANDEM. THERE'S NOTHING TO DIVERSIFY AWAY!
THE VARIANCE OF AN N-ASSET
PORTFOLIO
NOTES

 SO: THE VARIANCE OF N-ASSET PORTFOLIO

FOR A 3-ASSET PORTFOLIO

FOR A 2-ASSET PORTFOLIO

THE 2-STOCK PORTFOLIO
EXAMPLE:
Consider a two-stock portfolio in which 60% of your money is invested in stock
A and 40% of your money is invested in stock B. Stock A has a standard
deviation of 50% and stock B has a standard deviation of 70%. The correlation
between the returns for stock A and stock B are 0.30.

You want to find the standard deviation of this portfolio.

OR!

THE 3-STOCK PORTFOLIO

EXAMPLE:
THE EFFICIENT SET
GIVEN THESE DATA, YOU CAN COMPUTE FOR THE VALUES ON THE TABLE!
THE RISK-FREE ASSET
THE RISK-FREE ASSET'S STANDARD DEVIATION IS 0!
TREASURY SECURITIES ARE USUALLY USED AS PROXY FOR THE RISK-
FREE ASSET SINCE IT'S BACKED BY THE GOVERNMENT. SO YOU
KNOW FOR SURE THAT UNTIL MATURITY, YOUR INTEREST IS GOING
TO BE PAID AND YOU WILL GET YOUR CAPITAL BACK.
IF YOU CHOOSE IN-BETWEEN THE RISK-FREE ASSET AND THE
MARKET PORTFOLIO, IT MEANS THAT PART OF YOUR MONEY IS IN
AN ALMOST (IF NOT ACTUAL) WELL-DIVERSIFIED FUND - THE
MARKET PORTFOLIO, AND THE REST ARE CLOSER (IF NOT ON) THE
RISK-FREE INVESTMENT.
IF YOU GO BEYOND THE MARKET PORTFOLIO, IT MEANS THAT YOU
HAVE NOT JUST INVESTED YOUR MONEY ON THE MARKET
PORTFOLIO, BUT YOU BORROWED AGAINST THE RISK-FREE RATE
AND PUT THAT MONEY IN THE MARKET PORTFOLIO TO PLACE YOU
ABOVE THE MARKET LINE.
ONCE THE RISK-FREE ASSET IS INTRODUCED, THE EFFICIENT
FRONTIER BECOMES A STRAIGHT LINE.
WHAT IF...
THE CAPM
THE CAPITAL ASSET PRICING MODEL
MARKET RISKS VS. FIRM-SPECIFIC RISKS

MARKET RISKS ARE NON-DIVERSIFIABLE! While market risk impacts all stocks, it
FIRM-SPECIFIC RISKS CAN BE DIVERSIFIED! does not impact all stocks equally!!!

THIS IS WHY WE NEED A TOOL

TO MEASURE SENSITIVITY:
THE BETA (β)
THE BETA
The Beta tells us how a particular stock moves in
relation to the rest of the stock market as a whole. It
can be computed using the following formulas:

OR!
THE BETA
the portfolio beta is the weighted average of individual stock betas and
can be computed using this formula:
 DECISION-MAKING:
WHICH SHOULD I USE
TO GAUGE RISK?

STANDARD DEVIATION
VS.
BETA
THE SECURITY
MARKET LINE (SML)
One of the key components of this model is the Security Market Line (SML) which states
that the required rate of return for a stock is dependent on the beta of that stock. While
technically, the SML is a subset of the larger model (CAPM), in practice the two terms are
typically used interchangeably. Thus, think of them as the same basic model:

NOTE: Risk-free interest rate is often approximated by the yield on 10-year Treasury bond
CAPM Example:

THE SECURITY MARKET LINE SHOWS THE

EXPECTED MARKET RETURN PER GIVEN BETA.

03
THE SML GRAPH
SUMITOMO MITSUI AND AJINOMOTO ARE BOTH ON THE SML AND THEY ARE
IN EQUILIBRIUM. THEY CAN BE INCLUDED IN THE PORTFOLIO.

SUNTORY AND BANDAI NAMCO ARE BOTH BELOW THE SML, SO THEY ARE
OVERVALUED.WHAT THEY ARE EXPECTED TO EARN ARE BELOW WHAT
THEY SHOULD YIELD. DO NOT TOUCH THEM. IF YOU HAVE THEM IN YOUR
PORTFOLIO, GET RID OF THEM.

KADOKAWA SHOTEN IS UNDERVALUED. THIS MEANS IT IS EXPECTED TO BE

WORTH MORE THAN IT SHOULD YIELD. GET IT. IT'S A GOOD STOCK.

REMEMBER: THE SML IS YOUR YARDSTICK! IT'S YOUR BENCHMARK!

EQUILIBRIUM OVERVALUED UNDERVALUED

(ON THE SML) (BELOW THE (ABOVE THE SML)
SML)
 THIS SECURITY IS:
SINCE THE EXPECTED RETURN IS 13.35% UNDERVALUED!
AT A MARKET BETA OF 1.07%,..
ENDE