๐ฒ
investmentsintermediate25 min
Risk and Return Analysis
Quantify portfolio risk, calculate expected return, and understand the risk-return trade-off.
What You'll Learn
- โCalculate expected return of a portfolio
- โMeasure risk with standard deviation
- โApply CAPM to estimate required returns
1. Expected Portfolio Return
Weighted average of individual asset returns: E(Rp) = w1รE(R1) + w2รE(R2) + ...
Key Points
- โขWeights must sum to 1.0
- โขSimple weighted average
- โขWorks for any number of assets
2. Portfolio Risk
Portfolio variance depends on individual variances AND covariances. Diversification reduces risk when correlation < 1.
Key Points
- โขTwo-asset: ฯpยฒ = w1ยฒฯ1ยฒ + w2ยฒฯ2ยฒ + 2w1w2ฯ12
- โขLower correlation = better diversification
- โขCannot eliminate systematic risk
3. CAPM Application
E(R) = Rf + ฮฒ(Rm-Rf). Beta measures systematic risk. Plot on the Security Market Line.
Key Points
- โขStocks above SML are undervalued
- โขStocks below SML are overvalued
- โขSML prices only systematic risk
Key Takeaways
- โ Diversification is the only free lunch in finance
- โ Total risk = systematic + unsystematic
- โ Standard deviation measures total risk; beta measures market risk
Practice Questions
1. Portfolio: 60% Stock A (E(R)=12%), 40% Stock B (E(R)=8%). Expected return?
0.60ร12% + 0.40ร8% = 7.2% + 3.2% = 10.4%.
2. Stock beta = 0.8, Rf = 3%, MRP = 6%. Fair return?
3% + 0.8ร6% = 7.8%.
FAQs
Common questions about this topic
Yes. Assets like gold sometimes move opposite to the market, giving a negative beta.
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