Week 5 Discussion

Portfolio Returns

A portfolio is any collection of �nancial assets and investments. Let's say that out of $100,000 you invest $50,000 in Stock A and $50,000 in Stock B. This is a two-stock portfolio. You can change the proportion of funds invested in each stock to create various portfolios with different risk-return characteristics. Portfolio returns are calculated by multiplying the stock returns with the proportion of funds invested in each stock and adding them. They are a weighted average.

A measure of the risk of an individual investment is the standard deviation around the expected return. The risk of a portfolio of stocks is each stock’s standard deviation plus/minus the correlation between stocks in the portfolio. This does not necessarily make a portfolio more risky than an individual stock. If the correlation between stocks in a portfolio is less than 100% directly related (their prices move in the same direction), then the portfolio of stocks will have less risk (variation) than an individual stock. In other words, the value of some stocks in a portfolio will not change in the same proportion. Some stock prices may rise more than others, or other prices may fall.

Diversi�cation is a tool to lower the risk in holding �nancial securities. This is the most important bene�t of creating portfolios. The higher the number of stocks in the portfolio, the more the risk is reduced. But the bene�t of adding a stock to the portfolio diminishes as the number of stocks in the portfolio increases.