Portfolio Theory
Let us begin our discussion on Portfolio Theory with an example of two investments (assets or securities) – Ace and Bravo. Their return expectations are given in the table below. You will notice that both Ace and Bravo are risky investments because they do not offer a certain return. You can begin by comparing the expected return and risk of Ace and Bravo:
State of Probability Return
Economy of occurrence Ace Bravo
Boom 0.2 +20 15
Growth 0.6 +5 +5
Recession 0.2 10 +25
1. What kind of a correlation do you observe between the two securities? 2. Calculate the expected return and standard deviation of both Ace and Bravo. Interpret the results.
Expected Return = E(R) = ∑ ri.pi …show more content…
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Portfolio standard deviation is less than the weighted average of the standard deviation of the constituent investments (expect for perfectly +vely correlated investments where it is the weighted average). The risk of a portfolio is measured by its standard deviation and calculated as:
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Covariance means the extent to which the returns on two investments move together. It is related to correlation coefficient, but can take on any –ve or +ve value.
Let us learn the above concepts with the help of a solved example:
Let there be two shares A and B, with the following returns for alternative economic states:
State of Economy Probability Returns on A Returns on B 
Boom 0.3 20% 3% 
Growth 0.4 10% 35% 
Recessions 0.3 0% 5%

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