178 RISK, RETURN, AND VALUATION [CHAP.

Portfolio Risk
Unlike returns, the risk of a portfolio ( p) is not simply the weighted average of the standard
deviations of the individual assets in the contribution, for a portfolio’s risk is also dependent on the
correlation coefficients of its assets. The correlation coefficient () is a measure of the degree to which
two variables ‘‘move’’ together. It has a numerical value that ranges from 1.0 to 1.0. In a two-asset
(A and B) portfolio, the portfolio risk is defined as:
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
p ¼ w2A A2 þ w2B B2 þ 2wA wB  AB A B

where  A and  B = standard deviations of assets A and B, respectively

wA and wB = weights, or fractions, of total funds invested in assets A and B
AB = the correlation coefficient between assets A and B
Portfolio risk can be minimized by diversification, or by combining assets in an appropriate manner.
The degree to which risk is minimized depends on the correlation between the assets being combined. For
example, by combining two perfectly negative correlated assets ( = 1), the overall portfolio risk can be
completely eliminated. Combining two perfectly positive correlated assets ( = +1) does nothing to help
reduce risk. (See Example 7.7.) An example of the latter might be ownership of two automobile stocks or
two housing stocks.

EXAMPLE 7.7 Assume the following:

Asset r W
1
A 20% 3
2
B 10% 3

The portfolio risk then is:

qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
p ¼ w2A A2 þ w2B B2 þ 2wA wB  AB A B
qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
¼ ð13Þ2 ð0:2Þ2 þ ð23Þ2 ð0:1Þ2 þ 2AB ð13Þð23Þð0:2Þð0:1Þ
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
¼ 0:0089 þ 0:0089AB

(a) Now assume that the correlation coefficient between A and B is +1 (a perfectly positive correlation).
This means that when the value of asset A increases in response to market conditions, so does the
value of asset B, and it does so at exactly the same rate as A. The portfolio risk when  = +1 then
becomes:
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
p ¼ 0:0089 þ 0:0089AB ¼ 0:0089 þ 0:0089ð1Þ ¼ 0:0178 ¼ 0:1334 ¼ 13:34%

(b) If  = 0, the assets lack correlation and the portfolio risk is simply the risk of the expected returns on the
assets, i.e., the weighted average of the standard deviations of the individual assets in the portfolio.
Therefore, when AB = 0, the portfolio risk for this example is:
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffi
p ¼ 0:0089 þ 0:0089AB ¼ 0:0089 þ 0:0089ð0Þ ¼ 0:0089 ¼ 0:0943 ¼ 9:43%

(c) If  = 1 (a perfectly negative correlation coefficient), then as the price of A rises, the price of B declines
at the very same rate. In such a case, risk would be completely eliminated. Therefore, when AB = 1, the
portfolio risk is
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi pffiffiffi
p ¼ 0:0089 þ 0:0089AB ¼ 0:0089 þ 0:0089ð1Þ ¼ 0:0089  0:0089 ¼ 0 ¼ 0