Calculating the Variance

To calculate the variances of the returns on our two stocks, we first determine the squared deviations from the expected return. We then multiply each possible squared deviation by its probability. We add these up, and the result is the variance. The standard deviation, as always, is the square root of the variance.

To illustrate, let us return to the Stock U we originally discussed, which has an expected return of E(^) = 20%. In a given year, it will actually return either 30 percent or 10 percent. The possible deviations are thus 30% - 20% = 10% and 10% - 20% = -10%. In this case, the variance is:

Variance = ct2 = .50 X (10%)2 + .50 X (-10%)2 = .01

The standard deviation is the square root of this:

Table 13.4 summarizes these calculations for both stocks. Notice that much larger variance.

When we put the expected return and variability information for our gether, we have:

Stock L has a two stocks to-

Table 13.4 summarizes these calculations for both stocks. Notice that much larger variance.

When we put the expected return and variability information for our gether, we have:

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