RISK AND RETURN -PORTFOLIO

SIBY M YOHANNAN
 CORRELATION

• Correlation is a statistical measure of the relationship between any two series of

numbers.
• The numbers may represent data of any kind, from returns to test scores. If two series
tend to vary in the same direction, they are positively correlated.
• If the series vary in opposite directions, they are negatively correlated.
 DIVERSIFICATION

• The concept of correlation is essential to developing an efficient portfolio. To reduce

overall risk, it is best to diversify by combining, or adding to the portfolio, assets that
have the lowest possible correlation.

• Combining assets that have a low correlation with each other can reduce the overall
variability of a portfolio’s returns.
 Capital asset pricing model (CAPM

• Diversifiable risk (sometimes called unsystematic risk) represents the portion of an

asset’s risk that is associated with random causes that can be eliminated through
diversification. It is attributable to firm-specific events, such as strikes, lawsuits,
regulatory actions, or the loss of a key account.
• Nondiversifiable risk (also called systematic risk) is attributable to market factors
that affect all firms; it cannot be eliminated through diversification. Factors such as
war, inflation, the overall state of the economy, international incidents, and political
events account for nondiversifiable risk.
 Some Comments on the CAPM

• The capital asset pricing model generally relies on historical data. The betas may or
may not actually reflect the future variability of returns.
• It is based on an assumed efficient market with the following characteristics: many
small investors, all having the same information and expectations with respect to
securities; no restrictions on investment, no taxes, and no transaction costs; and
rational investors, who view securities similarly and are risk averse, preferring
higher returns and lower risk
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