Portfolio Variance

From our earlier discussion, the expected return on a portfolio that contains equal investment in Stocks U and L is 22.5 percent. What is the standard deviation of return on this portfolio? Simple intuition might suggest that because half of the money has a standard deviation of 45 percent and the other half has a standard deviation of 10 percent, the portfolio's standard deviation might be calculated as:

Unfortunately, this approach is completely incorrect!

Let's see what the standard deviation really is. Table 13.6 summarizes the relevant calculations. As we see, the portfolio's variance is about .031, and its standard deviation is less than we thought—it's only 17.5 percent. What is illustrated here is that the variance on a portfolio is not generally a simple combination of the variances of the assets in the portfolio.

We can illustrate this point a little more dramatically by considering a slightly different set of portfolio weights. Suppose we put 2/11 (about 18 percent) in L and the other 9/11 (about 82 percent) in U. If a recession occurs, this portfolio will have a return of:

If a boom occurs, this portfolio will have a return of:

Notice that the return is the same no matter what happens. No further calculations are needed: This portfolio has a zero variance. Apparently, combining assets into portfolios can substantially alter the risks faced by the investor. This is a crucial observation, and we will begin to explore its implications in the next section.

Portfolio Variance and Standard Deviation

In Example 13.3, what are the standard deviations on the two portfolios? To answer, we first have to calculate the portfolio returns in the two states. We will work with the second portfolio, which has 50 percent in Stock A and 25 percent in each of Stocks B and C. The relevant calculations can be summarized as follows:

State of Economy

Probability of State of Economy

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