Chapter 4: Expected Return and Risk

Tuan Minh Nguyen

Learning Objectives

• Understand the meaning and calculation of expected return and risk

measures for an individual security.
• Recognize what it means to talk about modern portfolio theory.
• Calculate portfolio return and risk measures as formulated by Markowitz.
• Understand how diversification works.
Content

• Probability Distribution
• Security Risk and Return
• Portfolio Risk and Return
1. Probability Distributions

• The return an investor will earn from investing is not known; it must be
estimated.
• Investors are often overly optimistic about expected returns.
• To deal with the uncertainty of returns, investors need to think explicitly
about a security’s distribution of probable returns.
1. Probability Distributions

• A probability distribution for a security brings together the likely outcomes that
may occur along with the probabilities associated with these likely outcomes.
• The set of probabilities in a probability distribution must sum to 1.0 or 100 percent.
• With a discrete probability distribution, a probability is assigned to each possible
outcome.
• With a continuous probability distribution, an infinite number of possible outcomes
exist.
2. Security Risk and Return

• Calculating expected return for a security

2. Security Risk and Return

• Calculating risk
• The variance and standard deviation measure the dispersion of a random
variable around its mean. The larger this dispersion, the larger the
variance or standard deviation.
2. Security Risk and Return

• Risk
• The standard deviation is simply a weighted average of the deviations from the
expected value.
• Calculating a standard deviation using probability distributions involves making
subjective estimates of the probabilities and the likely returns.
• Standard deviations calculated using historical data may be convenient, but they are
subject to errors when used as estimates of the future.
2. Security Risk and Return

• Risk example
Problems

• Q1: Calculate the expected return and risk (standard deviation) for
General Foods for 2014, given the following information:
Probabilities 0.15 0.2 0.4 0.1 0.15
Expected Returns 20 16 12 5 -5
(%)
3. Portfolio Risk and Return

• When we analyze investment returns and risks, we must consider the total
portfolio held by an investor.
• A security may have high risk if held by itself, but much less risk when
held in a portfolio of securities.
3. Portfolio Risk and Return

• Portfolio weight
• Percentages of portfolio funds invested in each security
• The combined portfolio weights sum to 100 percent of total investable funds
3. Portfolio Risk and Return

• Portfolio expected return

• The expected return on any portfolio p can be calculated as a weighted average of
the individual security expected returns
3. Portfolio Risk and Return

• Portfolio risk
• Portfolio risk (as measured by the variance or standard deviation) is not a weighted
average of the risk of the individual securities in the portfolio.

• Portfolio risk is always less than a weighted average of the risks of the securities in the
portfolio unless the securities have outcomes that vary together exactly, which is an
almost impossible occurrence
3. Portfolio Risk and Return

• Diversification
• There are two general sources of risk, firm‐specific and market risk.
• Adding securities reduces the firm‐specific risk, but not the market risk.
• The process of adding securities to a portfolio to reduce firm ‐specific risk is referred
to as diversification.
• Diversification is the key to the management of portfolio risk because it allows
investors to significantly lower portfolio risk without adversely affecting return.
3. Portfolio Risk and Return

• Components of portfolio risk

• The weighted individual security risks (i.e., the variance of each individual security,
weighted by the percentage of funds invested in the security).
• The weighted comovements between securities’ returns (i.e., the weighted
covariance between each security’s returns and the returns of all other securities in
the portfolio).
3. Portfolio Risk and Return

• Covariance
• An absolute measure of the extent to which two variables tend to covary, or move
together.
• Positive, indicating that the returns on the two securities tend to move in the same
direction.
• Negative, indicating that the returns on the two securities tend to move inversely.
• Zero, indicating that the returns on the two securities are independent and have no
tendency to move together.
3. Portfolio Risk and Return

• Covariance formula
3. Portfolio Risk and Return

• Correlation coefficient
• A statistical measure of the extent to which two variables are associated.
• The correlation is simply a standardized covariance measure.

• Correlation is a relative measure of association that is bounded by +1.0 and −1.0.

3. Portfolio Risk and Return

• Calculating portfolio risk

• The two-security case

The variance of each security, as shown by and

The covariance between securities, as shown by 1 2
The portfolio weights for each security, as shown by the w1 and w2
3. Portfolio Risk and Return

• Example
Stock A Stock B
Return 10.1 15.4
Standard deviation 16.8 27.5
Correlation 0.29

Calculate the expected return and standard deviation of the portfolio.

3. Portfolio Risk and Return

• Solution
Portfolio return: E(Rp) = w1R1 + w2R2 = 0.5(10.1%) + 0.5(15.4%) = 12.75%
Portfolio risk: σp = [+2(w1)(w2)(p1,2σ1σ2)]

= [(0.5)2(0.168)2+(0.5)2(0.275)2+2(0.5)(0.5)(0.29)(0.168)(0.275)]1/2
= 0.181  18.1%
3. Portfolio Risk and Return

• Solution
Portfolio return: E(Rp) = w1R1 + w2R2 = 0.5(10.1%) + 0.5(15.4%) = 12.75%
Portfolio risk: σp = [+2(w1)(w2)(p1,2σ1σ2)]

= [(0.5)2(0.168)2+(0.5)2(0.275)2+2(0.5)(0.5)(0.29)(0.168)(0.275)]1/2
= 0.181  18.1%
3. Portfolio Risk and Return

• The impact of portfolio correlation

• The standard deviation of the portfolio is directly affected by the correlation between
the two stocks. Portfolio risk is reduced as the correlation coefficient moves
downward from +1.0.
3. Portfolio Risk and Return

• Example
Stock A Stock B
Return 10.1 15.4
Standard deviation 16.8 27.5
Correlation 0.29

Calculate the standard deviation of the portfolio if the correlation is 1, 0.5 and 0.
3. Portfolio Risk and Return

• The impact of portfolio weights

• The size of the weights as signed to each security has an effect on portfolio risk,
holding the correlation coefficient constant.
• To minimize risk in general, it is necessary to select optimal weights.
3. Portfolio Risk and Return

• Example
Stock A Stock B
Return 10.1 15.4
Standard deviation 16.8 27.5
Correlation 0.29

Calculate the standard deviation of the portfolio if the weight of stock A is 90%, 70%, 30%
and 10%.
Problems

• Q2: Assume expected returns and standard deviations as follows:

Calculate the expected return and standard deviation for a portfolio

consisting of all two securities under the following conditions:
a. The portfolio weights are 60% in EG&G, 40% in GF
b. The portfolio weights are 20% in EG&G, 80% in GF
3. Portfolio Risk and Return

• The n-security case:

Problems

• Q3: Assume some information of REE and SAM as follows:

REE SAM
Probabilities (%) Return (%) Probabilities (%) Return (%)
0,2 -3% 0,2 -8
0,5 10% 0,5 18%
0,3 20% 0,3 30%
a. Calculate expected return and stand deviation for REE and SAM.
b. Assume an investor has $10,000 and plans to allocate $4,000 in REE and
$6,000 in SAM. Calculate portfolio expected return and risk.