Table 134

Calculation of Variance

Stock L has a higher expected return, but U has less risk. You could get a 70 percent return on your investment in L, but you could also lose 20 percent. Notice that an investment in U will always pay at least 10 percent.

Which of these two stocks should you buy? We can't really say; it depends on your personal preferences. We can be reasonably sure that some investors would prefer L to U and some would prefer U to L.

You've probably noticed that the way we have calculated expected returns and variances here is somewhat different from the way we did it in the last chapter. The reason is that in Chapter 12, we were examining actual historical returns, so we estimated the average return and the variance based on some actual events. Here, we have projected future returns and their associated probabilities, so this is the information with which we must work.

Going back to Example 13.1, what are the variances on the two stocks once we have unequal -1

probabilities? The standard deviations?

We can summarize the needed calculations as follows:

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