Portfolio Expected Returns

Let's go back to Stocks L and U. You put half your money in each. The portfolio weights are obviously .50 and .50. What is the pattern of returns on this portfolio? The expected return?

To answer these questions, suppose the economy actually enters a recession. In this case, half your money (the half in L) loses 20 percent. The other half (the half in U) gains 30 percent. Your portfolio return, RP, in a recession is thus:

Table 13.5 summarizes the remaining calculations. Notice that when a boom occurs, your portfolio will return 40 percent:

As indicated in Table 13.5, the expected return on your portfolio, E(RP), is 22.5 percent.

We can save ourselves some work by calculating the expected return more directly. Given these portfolio weights, we could have reasoned that we expect half of our money to earn 25 percent (the half in L) and half of our money to earn 20 percent (the half in U). Our portfolio expected return is thus:

'Some of it could be in cash, of course, but we would then just consider the cash to be one of the portfolio assets.

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

V. Risk and Return

13. Return, Risk, and the Security Market Line

© The McGraw-Hill Companies, 2002

CHAPTER 13 Return, Risk, and the Security Market Line

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