A

collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earn interest; and mutual funds, which are essentially pools of money from many investors that are invested by professionals or according to indices

grouping of financial assets such as stocks, bonds and cash equivalents, as well as their mutual, exchange-traded and closed-fund counterparts. Portfolios are held directly by investors and/or managed by financial professionals.

 The

term portfolio refers to any collection of financial assets such as stocks, bonds and cash. Portfolios may be held by individual investors and/or managed by financial professionals, hedge funds, banks and other financial institutions. It is a generally accepted principle that a portfolio is designed according to the investor's risk tolerance, time frame and investment objectives. The monetary value of each asset may influence the risk/reward ratio of the portfolio and is referred to as the asset allocation of the portfolio. [2] When determining a proper asset allocation one aims at maximizing the expected return and minimizing the risk.

 Portfolios
A

portfolio is a collection of assets. The weights fundamentally define a portfolio. The weights are the proportion invested in each asset Portfolios can contain many assets. A portfolio can be completely comprised of risky assets. If you own only one asset do you still have portfolio? Yes, a pretty simple one.

Diversification The principle of diversification is fundamental to finance. Portfolios allow an investor to become diversified. Which bet do you prefer? Flip a fair coin once; if it is heads I will give a $1000, you get nothing if it is tails. Flip a fair coin 1000 times; each time you flip heads I will give you $1.00. I will give you nothing for tails. Most people prefer the second option; most of the risk is diversified away through multiple flips.

 You

own Dell Suppose you own only one security, Dell Computer Corp. What sources of risk do you face? Systematic risk What is systematic risk? What are some other names for systematic risk?

Prudence suggests that investors should construct an investment portfolio in accordance with risk tolerance and investing objectives. Think of an investment portfolio as a pie that is divided into pieces of varying sizes representing a variety of asset classes and/or types of investments to accomplish an appropriate risk-return portfolio allocation.
For example, a conservative investor might favor a portfolio with large cap value stocks, broad-based market index funds, investment-grade bonds and a position in liquid, high-grade cash equivalents. In contrast, a risk loving investor might add some small cap growth stocks to an aggressive, large cap growth stock position, assume some high-yield bond exposure, and look to real estate, international, and alternative investment opportunities for his or her portfolio.

While making an investment decision, it is important to assess the risk/return profile of any investment. The relation between risk and return raises three basic questions: How do I estimate the percentage return that I will receive on an investment? How much risk does an asset add to a portfolio? What can I do to eliminate some of that risk?

To answer these questions, we need to understand the key statistical concepts that are applied to financial assets. They are: expected returns, variance and standard deviation, and correlation

E(ri) Expected returns for all assets i V(ri) or SD(ri) Variances or standard deviations of return for all assets i Cov(ri,rj) Covariances of returns for all pairs of assets i and j Where do we obtain this data ? Estimate them from historical sample data using statistical techniques (sample statistics). This is the most common approach.

1. PORTFOLIO WEIGHTS A. two stock portfolio B. Many stock portfolio 2.EXPECTED PORTFOLIO RETURNS A. Portfolio of two assets Model B. Portfolio of Many stocks 3.PORTFOLIO VARIANCE AND SD A.Return Variance B. SD 4.COVARIANCES AND CORRELATIONS A. Covariance B. Perfect positive , perfect negative and zero correlation C. Minimum Variance portfolio

 The

percentage of a total portfolio represented by a single specific security. It is calculated by dividing the value of the investment in a specific security by the value of the investment in the total portfolio.

Portfolio optimization engine operates with portfolio weights. The percentage composition of a particular holding in a portfolio. Portfolio weights can be simply calculated using different approaches: the most basic type of weight is determined by dividing the dollar value of a security by the total dollar value of the portfolio. Another approach would be to divide the number of units of a given security by the total number of shares held in the portfolio. Wi=Vi/V Where Vi=nipi Vi is position value of ith instrumnet in the portfolio and V is the total portfolio value.

 The

percentage of an investment portfolio that is held by a single asset. Portfolio weight can be determined by a number of factors including cost, units, sectors, regions, and types of securities. The calculation for portfolio weight by value is computed by dividing the value of a single asset by the value of the entire portfolio. For example, Stock A has a value of $400 and the total portfolio value is $2,000. The portfolio weight of stock A is 20%. (400 / 2,000 = .20 or 20%)

 Preliminaries:

Portfolio Weights Portfolio weights indicate the fraction of the portfoliostotal value held in each asset, i.e. x i = (value held in the ith asset)/(total portfolio value) Portfolio composition can be described by its portfolio weights:x = {x1,x2,,xn} and the set of assets {A1, A2, .An} By definition, portfolio weights must sum to one:x1+x2++xn = 1

Expected Return The expected return is the markets, or an investors, best guess as to the return on an asset. Any technique can be used to arrive at the guess. This section will review two common techniques. One uses a simple average of historical returns. Another technique uses the returns from possible outcomes and the probabilities of those outcomes to arrive at an expected return.

Portfolio Management - Portfolio Calculations Individual Investment The expected return for an individual investment is simply the sum of the probabilities of the possible expected returns for the investment.

Formula Expected Return E(R) = p1R1 + p2R2 + .....+ pnRn

Where: pn = the probability the return actually will occur in state n Rn = the expected return for state n

Example: For Newco's stock, assume the following potential returns. Figure 3.3: Expected returns for Newco's stock price in the various states Scenario Worst Case Base Case Best Case Probability 10% 80% 10% Expected Return 10% 14% 18%

Given the above assumptions, determine the expected return for Newco's stock. Answer: E(R) = (0.10)(10%) + (0.80)(14%) + (0.10)(18%) E(R) = 14.0% The expected return for Newco's stock is 14%.

Portfolio To determine the expected return on a portfolio, the weighted average expected return of the assets that comprise the portfolio is taken.

Formula 17.4 E(R) of a portfolio = w1R1 + w2Rq + ...+ wnRn Example: Assume an investment manager has created a portfolio with the Stock A and Stock B. Stock A has an expected return of 20% and a weight of 30% in the portfolio. Stock B has an expected return of 15% and a weight of 70%. What is the expected return of the portfolio? Answer: E(R) = (0.30)(20%) + (0.70)(15%) = 6% + 10.5% = 16.5% The expected return of the portfolio is 16.5%

Risk and Return: Variance and Standard Deviation Variance and Standard Deviation Risk is the possibility that actual returns might differ, or vary, from expected returns. In fact, actual returns will likely differ from expected returns. It is important for decision-makers to estimate the magnitude and likelihood of the difference between actual and estimated returns. After all, there is a big difference if your predictions result in an error of only $100 versus an error of $1 million. By using the concepts of variance and standard deviation, investors can judge not only how wrong their estimates might be, but also estimate the likelihood, or probability, of favorable or unfavorable outcomes. With the tools of expected return and standard deviation, financial decision-makers are better able to evaluate alternative investments based on risk-return tradeoffs, and their own risk preferences.

In a literal sense, the standard deviation is a measure of how far from the expected value the actual outcome might be. Two stocks may have the same expected return, but have different levels of risk, as measured by variance and standard deviation. Just as the calculation of expected return was based on assumptions, it would be false to assume that variance and standard deviation encompass all aspects of risk. These tools merely give you more information based on past results, or expectedfuture results.

standard deviation (represented by the symbol sigma, ) shows how much variation or "dispersion" exists from the average (mean, or expected value). A low standard deviation indicates that the data points tend to be very close to the mean, whereas high standard deviation indicates that the data points are spread out over a large range of values. The standard deviation of a random variable, statistical population, data set, or probability distribution is the square root of its variance.

Computing Variance and Standard Deviation for an Individual Risk reflects the chance that the actual return on an investment may be very different than the expected return. One way to measure risk is to calculate the variance and standard deviation of the distribution of returns.

Formula 17.5

Formula 17.5
Variance = Where: Pn = probability of occurrence Rn = return in n occurrence E(R) = expected return

Formula 17.6 Standard Deviation =

Example: Variance and Standard Deviation of an Investment Given the following data for Newco's stock, calculate the stock's variance and standard deviation. The expected return based on the data is 14%. Figure: Expected return for Newco in various states Scenario Worst Case Base Case Best Case Probability 10% 80% 10% Return 10% 14% 18% Expected Return 0.01 0.112 0.018

Answer: 2 = (0.10)(0.10 - 0.14)2 + (0.80)(0.14 - 0.14)2 + (0.10)(0.18 - 0.14)2 = 0.0003 The variance for Newco's stock is 0.0003. Given that the standard deviation of Newco's stock is simply the square root of the variance, the standard deviation is 0.0179 or 1.79%.

Covariance The covariance is the measure of how two assets relate (move) together. If the covariance of the two assets is positive, the assets move in the same direction. For example, if two assets have a covariance of 0.50, then the assets move in the same direction. If however the two assets have a negative covariance, the assets move in opposite directions. If the covariance of the two assets is zero, they have no relationship. Covariance is one measure of the degree to which the returns of two risky assets move in tandem. A positive covariance means that asset returns move together, while a negative covariance means returns move inversely (in an opposite direction).

Formula 17.7 Covariancea,b=

 Covariance

and correlation describe how two variables are related. Variables are positively related if they move in the same direction. Variables are inversely related if they move in opposite directions. Both covariance and correlation indicate whether variables are positively or inversely related. Correlation also tells you the degree to which the variables tend to move together.

Example: Calculate the covariance between two assets Assume the mean return on Asset A is 10% and the mean return on Asset B is 15%. Given the following returns over the past 5 periods, calculate the covariance for Asset A as it relates to Asset B.

N 1 2 3 4 5

Ra 10% 15% 5% 13% 8%

Rb 18% 25% 2% 8% 17%

Ra

Rb

Ra- Avg Ra Rb-Avg Rb

Ra- Avg Ra Rb-Avg Rb 0 50 65 -21 -4

1 2 3 4 5 Sum

10 15 5 13 8

18 25 2 8 17

0 5 -5 3 -2

3 10 -13 -7 2

90.00

The covariance would equal 18 (90/5).

Correlation The correlation coefficient is the relative measure of the relationship between two assets. It is between +1 and -1, with a +1 indicating that the two assets move completely together and a -1 indicating that the two assets move in opposite directions from each other.

Formula 17.8

 Example:

Calculate the correlation of Asset A with Asset B. Given our covariance of 18 in the example above, what is the correlation coefficient for Asset A relative to Asset B if Asset A has a standard deviation of 4 and Asset B has a standard deviation of 3.
Answer: Correlation coefficient = 18/(8)(4) = 0.563

Components of the Portfolio Standard Deviation Formula Remember that when calculating the expected return of a portfolio, it is simply the sum of the weighted returns of each asset in the portfolio. Unfortunately, determining the standard deviation of a portfolio, it is not that simple. Not only are the weights of the assets in the portfolio and the standard deviation for each asset in the portfolio needed, the correlation of the assets in the portfolio is also required to determine the portfolio standard deviation. The equation for the standard deviation for a two asset portfolio is long, but should be memorized for the exam. Formula 17.9

Consider the probability distribution for the returns on stocks A and B provided below.

State 1 2 3 3

Probability 20% 30% 30% 20%

Return on Stock A
5% 10% 15% 20%

Return on Stock B
50% 30% 10% -10%

 The

expected returns on stocks A and B were calculated on the Expected Return page. The expected return on Stock A was found to be 12.5% and the expected return on Stock B was found to be 20%. Given an asset's expected return, its variance can be calculated using the following equation: where N = the number of states, pi = the probability of state i, Ri = the return on the stock in state i, and E[R] = the expected return on the stock.

 The

standard deviation is calculated as the positive square root of the variance. Variance and Standard Deviation on Stocks A and BNote: E[RA] = 12.5% and E[RB] = 20% Stock A

Stock

Although Stock B offers a higher expected return than Stock A, it also is riskier since its variance and standard deviation are greater than Stock A's. This, however, is only part of the picture because most investors choose to hold securities as part of a diversified portfolio.

 If

we wish to construct a portfolio with more than one risky asset, we still use the general utility function approach described above. However, the combination line indicating the expected return-variance combinations that can be obtained with more than one risky asset is no longer linear. We need to consider how portfolio variance changes as we change portfolio proportions. Let us look at the simple case, where there are exactly two risky assets (or portfolios), D and E. Then the expected return and variance of returns is given below:

Most investors do not hold stocks in isolation. Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock's risk can be eliminated, i.e., diversified away. This principle is presented on the Diversification page. First, the computation of the expected return, variance, and standard deviation of a portfolio must be illustrated. Once again, we will be using the probability distribution for the returns on stocks A and B. StateProbabilityReturn on Stock AReturn on Stock B120%5%50%230%10%30%330%15%10%320%20%10%From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is 12.5%, the expected return on Stock B is 20%, the variance on Stock A is .00263, the variance on Stock B is .04200, the standard deviation on Stock S is 5.12%, and the standard deviation on Stock B is 20.49%.

Portfolio Expected Return The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks which comprise the portfolio. The weights reflect the proportion of the portfolio invested in the stocks. This can be expressed as follows: where E[Rp] = the expected return on the portfolio, N = the number of stocks in the portfolio, wi = the proportion of the portfolio invested in stock i, and E[Ri] = the expected return on stock i. For a portfolio consisting of two assets, the above equation can be expressed as

 Expected

Return on a Portfolio of Stocks A and BNote: E[RA] = 12.5% and E[RB] = 20% Portfolio consisting of 50% Stock A and 50% Stock B Portfolio consisting of 75% Stock A and 25% Stock B

The variance/standard deviation of a portfolio reflects not only the variance/standard deviation of the stocks that make up the portfolio but also how the returns on the stocks which comprise the portfolio vary together. Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient. The Covariance between the returns on two stocks can be calculated using the following equation: where s12 = the covariance between the returns on stocks 1 and 2, N = the number of states, pi = the probability of state i, R1i = the return on stock 1 in state i, E[R1] = the expected return on stock 1, R2i = the return on stock 2 in state i, and E[R2] = the expected return on stock 2.

 The

Correlation Coefficient between the returns on two stocks can be calculated using the following equation: where r12 = the correlation coefficient between the returns on stocks 1 and 2, s12 = the covariance between the returns on stocks 1 and 2, s1 = the standard deviation on stock 1, and s2 = the standard deviation on stock 2.

 Covariance

and Correlation Coefficent between the Returns on Stocks A and BNote: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, and sB = 20.49%.

 Using

either the correlation coefficient or the covariance, the Variance on a Two-Asset Portfolio can be calculated as follows: The standard deviation on the porfolio equals the positive square root of the the variance.

 Variance

and Standard Deviation on a Portfolio of Stocks A and BNote: E[RA] = 12.5%, E[RB] = 20%, sA = 5.12%, sB = 20.49%, and rAB = -1. Portfolio consisting of 50% Stock A and 50% Stock B Portfolio consisting of 75% Stock A and 25% Stock B

Notice that the portfolio formed by investing 75% in Stock A and 25% in Stock B has a lower variance and standard deviation than either Stocks A or B and the portfolio has a higher expected return than Stock A. This is the essence of Diversification, by forming portfolios some of the risk inherent in the individual stocks can be eliminated. Example Problems Stock 1Stock 2Expected Return: % %Standard Deviation: % %Correlation Coefficient: PortfolioWeight 1Expected Return VarianceStandard Deviation % % %

The measurement of how the actual returns of a group of securities making up a portfolio fluctuate. Portfolio variance looks at the standard deviation of each security in the portfolio as well as how those individual securities correlate with the others in the portfolio. In other words, portfolio variance looks at the covariance or correlation coefficient for the securities in the portfolio. Generally, the lower the correlation between securities in a portfolio, the lower the portfolio variance.Investopedia explains 'Portfolio Variance' Portfolio variance is calculated by multiplying the squared weight of each security by its corresponding variance and adding two times the weighted average weight multiplied by the covariance of all individual security pairs. Modern portfolio theory says that portfolio variance can be reduced by choosing asset classes with a low or negative correlation, such as stocks and bonds. This type of diversification is used to reduce risk. Portfolio variance = (weight(1)^2*variance(1) + weight(2)^2*variance(2) + 2*weight(1)*weight(2)*covariance(1,2)
Read more: http://www.investopedia.com/terms/p/portfoliovariance.asp#ixzz22vzR0qrV