Question

4. Portfolio expected return and risk Aa Aa E A collection of financial assets and securities is referred to as a portfolio. Most individuals and institutions invest in a portfolio, making portfolio risk analysis an integral part of the field of finance. Just like stand-alone assets and securities, portfolios are also exposed to risk. Portfolio risk refers to the possibility that an investment portfolio will not generate the investor's expected rate of return. Analyzing portfolio risk and return involves the understanding of expected returns from a portfolio. Consider the following case: Andre is an amateur investor who holds a small portfolio consisting of only four stocks. The stock holdings in his portfolio are shown in the following table: Stock Artemis Inc. Babish & Co. Cornell Industries Danforth Motors Percentage of Portfolio 20% 30% 35% 15% Expected Return 8.00% 14.00% 11.00% 3.00% Standard Deviation 35.00% 39.00% 42.00% 44.00% What is the expected return on Andre's stock portfolio? O 10.10% 7.58% 13.64% 15.15%

Answer 1

A) 10.10%

Explanation :

Expected return= Weight(a) × return(a) + Weight(b) × return(b) + Weight(c) × return(c) + Weight(d) × return(d)

= 0.20 × 8% + 0.30 × 14% + 0.35 × 11% + 0.15 × 3%

= 1.6% + 4.2% + 3.85% + 0.45%

= 10.10%

B) It would gradually settle at about 35%

Explanation : As the correlation between the stocks decrease, the standard deviation of the portfolio will decrease. This is due to the diversification effect, which causes the deviation to decrease due to decrease in correlation. Lower the correlation lower the risk.