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Today Portfolios Return on a Portfolio

Lecture 2.2: Characteristics of Portfolios
Investment Analysis
Fall, 2012
Anisha Ghosh
Tepper School of Business
Carnegie Mellon University
November 8, 2012
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Today Portfolios Return on a Portfolio
Readings and Assignments
Chapter 3 of the course textbook (EGBG) covers related
material.
Homework 2 is available on the Courses Wall for Week 2.
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Today Portfolios Return on a Portfolio
Characteristics of Portfolios
Most investors hold portfolios of a large number of assets rather than
individual assets.
The risk on a portfolio is more complex than a simple average of the risk
of individual assets - it depends on whether the returns on individual
assets tend to move together or whether some assets give good returns
when others give bad returns.
Benets of Diversication
There is risk reduction from holding a portfolio of assets if the assets do
not move in perfect unison.
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Today Portfolios Return on a Portfolio
Characteristics of Portfolios
Most investors hold portfolios of a large number of assets rather than
individual assets.
The risk on a portfolio is more complex than a simple average of the risk
of individual assets - it depends on whether the returns on individual
assets tend to move together or whether some assets give good returns
when others give bad returns.
Benets of Diversication
There is risk reduction from holding a portfolio of assets if the assets do
not move in perfect unison.
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Today Portfolios Return on a Portfolio
Characteristics of Portfolios
Most investors hold portfolios of a large number of assets rather than
individual assets.
The risk on a portfolio is more complex than a simple average of the risk
of individual assets - it depends on whether the returns on individual
assets tend to move together or whether some assets give good returns
when others give bad returns.
Benets of Diversication
There is risk reduction from holding a portfolio of assets if the assets do
not move in perfect unison.
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Today Portfolios Return on a Portfolio
Return on a portfolio
Denition
The return on a portfolio of assets is a weighted average of the return on the
individual assets where the weight applied to each return is the fraction of the
portfolio invested in the asset
R
pj
=
N

i =1
X
i
R
ij
, where
N

i =1
X
i
= 1
X
i
> 0 long position in asset i
X
i
< 0 short position in (short sale of) asset i
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Today Portfolios Return on a Portfolio
Return on a portfolio
Denition
The return on a portfolio of assets is a weighted average of the return on the
individual assets where the weight applied to each return is the fraction of the
portfolio invested in the asset
R
pj
=
N

i =1
X
i
R
ij
, where
N

i =1
X
i
= 1
X
i
> 0 long position in asset i
X
i
< 0 short position in (short sale of) asset i
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Today Portfolios Return on a Portfolio
Return on a portfolio
Denition
The return on a portfolio of assets is a weighted average of the return on the
individual assets where the weight applied to each return is the fraction of the
portfolio invested in the asset
R
pj
=
N

i =1
X
i
R
ij
, where
N

i =1
X
i
= 1
X
i
> 0 long position in asset i
X
i
< 0 short position in (short sale of) asset i
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Today Portfolios Return on a Portfolio
Expected Return on a portfolio
Properties of Expected Return:
1
The expected value of the sum of two returns is equal to the sum
of the expected value of each return:
E (R
1
+R
2
) = E (R
1
) +E (R
2
)
2
The expected value of a constant C times a return is the constant
times the expected return:
E (CR
i
) = CE (R
i
)
Expected Return on a Portfolio
The expected return on a portfolio is:
E (R
p
) = E

i =1
X
i
R
ij

=
N

i =1
E (X
i
R
ij
)
=
N

i =1
X
i
E (R
i
)
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Today Portfolios Return on a Portfolio
Expected Return on a portfolio
Properties of Expected Return:
1
The expected value of the sum of two returns is equal to the sum
of the expected value of each return:
E (R
1
+R
2
) = E (R
1
) +E (R
2
)
2
The expected value of a constant C times a return is the constant
times the expected return:
E (CR
i
) = CE (R
i
)
Expected Return on a Portfolio
The expected return on a portfolio is:
E (R
p
) = E

i =1
X
i
R
ij

=
N

i =1
E (X
i
R
ij
)
=
N

i =1
X
i
E (R
i
)
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Today Portfolios Return on a Portfolio
Expected Return on a portfolio
Properties of Expected Return:
1
The expected value of the sum of two returns is equal to the sum
of the expected value of each return:
E (R
1
+R
2
) = E (R
1
) +E (R
2
)
2
The expected value of a constant C times a return is the constant
times the expected return:
E (CR
i
) = CE (R
i
)
Expected Return on a Portfolio
The expected return on a portfolio is:
E (R
p
) = E

i =1
X
i
R
ij

=
N

i =1
E (X
i
R
ij
)
=
N

i =1
X
i
E (R
i
)
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Today Portfolios Return on a Portfolio
Expected Return on a portfolio
Properties of Expected Return:
1
The expected value of the sum of two returns is equal to the sum
of the expected value of each return:
E (R
1
+R
2
) = E (R
1
) +E (R
2
)
2
The expected value of a constant C times a return is the constant
times the expected return:
E (CR
i
) = CE (R
i
)
Expected Return on a Portfolio
The expected return on a portfolio is:
E (R
p
) = E

i =1
X
i
R
ij

=
N

i =1
E (X
i
R
ij
)
=
N

i =1
X
i
E (R
i
)
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Today Portfolios Return on a Portfolio
Variance of Return on a portfolio
Variance of Return on a portfolio
The variance of a portfolio is the expected value of the squared
deviations of the returns on the portfolio from its mean return:

2
p
= E (R
p
E (R
p
))
2
= E (X
1
R
1j
+X
2
R
2j
[X
1
E (R
1
) +X
2
E (R
2
)])
2
= E (X
1
[R
1j
E (R
1
)] +X
2
[R
2j
E (R
2
)])
2
= E

X
2
1
[R
1j
E (R
1
)]
2
+X
2
2
[R
2j
E (R
2
)]
2
+2X
1
X
2
[R
1j
E (R
1
)] [R
2j
E (R
2
)]

= X
2
1
E [R
1j
E (R
1
)]
2
+X
2
2
E [R
2j
E (R
2
)]
2
+2X
1
X
2
E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
= X
2
1

2
1
+X
2
2

2
2
+ 2X
1
X
2
E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
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Today Portfolios Return on a Portfolio
Variance of Return on a portfolio
Variance of Return on a portfolio
The variance of a portfolio is the expected value of the squared
deviations of the returns on the portfolio from its mean return:

2
p
= E (R
p
E (R
p
))
2
= E (X
1
R
1j
+X
2
R
2j
[X
1
E (R
1
) +X
2
E (R
2
)])
2
= E (X
1
[R
1j
E (R
1
)] +X
2
[R
2j
E (R
2
)])
2
= E

X
2
1
[R
1j
E (R
1
)]
2
+X
2
2
[R
2j
E (R
2
)]
2
+2X
1
X
2
[R
1j
E (R
1
)] [R
2j
E (R
2
)]

= X
2
1
E [R
1j
E (R
1
)]
2
+X
2
2
E [R
2j
E (R
2
)]
2
+2X
1
X
2
E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
= X
2
1

2
1
+X
2
2

2
2
+ 2X
1
X
2
E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
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Today Portfolios Return on a Portfolio
Covariance and Correlation
Covariance: The covariance of two assets is a measure of how returns
on the assets move together:

12
= E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
Correlation: The correlation has the same properties as the covariance
but with a but with a range of 1 to 1:

12
=

12

2
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Today Portfolios Return on a Portfolio
Covariance and Correlation
Covariance: The covariance of two assets is a measure of how returns
on the assets move together:

12
= E [R
1j
E (R
1
)] [R
2j
E (R
2
)]
Correlation: The correlation has the same properties as the covariance
but with a but with a range of 1 to 1:

12
=

12

2
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Today Portfolios Return on a Portfolio
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i
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Today Portfolios Return on a Portfolio
Benets of Diversication
The variance of a portfolio of N assets is

2
p
=
N

i =1
X
2
i

2
i
+
N

i =1
N

k=1
i =k
X
i
X
k

ik
In the case where all the assets are independent, the covariance
between them is zero, and the formula for the variance becomes

2
p
=
N

i =1
X
2
i

2
i