Total return on stock depends on…
- Dividends
- Capital Gains (increase in share price)
Formula for Total Return
Total Return = Dividends / Share Price at Year 1 + Capital Gain (end – start / start)
Formula for Total Dollar Return
Total Dollar Return = Dividend Income + Capital Gain/Loss
What does individual security variance (standard deviation) measure?
Individual security variance (or standard deviation) can be appropriate risk measure of a security only of an investor’s portfolio consists of just one security
What are the four rules of portfolio return and risk?
- Rule 1: mean or expected return for an asset is the probability weighted average returns from all scenarios
- Rule 2: variance of an asset’s return is the expected value of the squared deviations from the expected return
- Rule 3: rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights
- Rule 4: When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the risky asset’s weighting
- Rule 5: when two risky assets with variances σ1² and σ2² are combined into a portfolio with portfolio weights w1 and w2, the portfolio variance is given by the formula
What are the two difficulties to use past returns to predict the future expected returns?
- Do not know what investors expected in the past, can only observe the actual returns that were realized
- Average return is just an estimate of the true expected return
Formula for Standard Deviation
SD (average of independent, identical risks) = SD (individual risk) / √Number of observations
r=1 is a ______ correlation
positive
r=-1 is a ______ correlation
negative
Mean or expected return for an asset is the _____________ from all scenarios
Mean or expected return for an asset is the probability weighted average returns from all scenarios
Variance of an asset’s return is the _____________ from the expected return
Variance of an asset’s return is the expected value of the squared deviations from the expected return
Rate of return on a portfolio is a _____________ of each asset comprising the portfolio, with the portfolio proportions as _____
Rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights
When a risky asset is combined with a _________, the portfolio standard deviation equals the ___________ multiplied by the _______________
When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the risky asset’s weighting
Portfolio risk depends on how _______ the pairs of assets in the portfolio are
correlated
Positive covariance _____ portfolio variance
increases
Negative covariances ______ portfolio variance
reduces
Why are there benefits to diversification?
- Benefits to diversification arise because stocks are not perfectly correlated
- When one asset does well or badly, its performance is not amplified by the performance of the other asset
Stocks from different industries typically display _____ correlation than stocks from the same industry
lower
If you mix stocks from different industries, portfolio risk is?
Portfolio risk is reduced
- stocks from different industries typically display lower correlation than stocks from the same industry
What does adding foreign stocks lead to.
Adding foreign stocks leads to additional variance reduction
- Stocks in different countries move together even less because countries tend to be at different stages of the business cycle
Variance of an internationally diversified portfolio is less than 50% of the variance of a domestic portfolio with an equal number of stocks
