The term "portfolio" refers to a collection of financial assets held by an

individual, institution, or investment fund. These assets can include stocks,

bonds, mutual funds, exchange-traded funds (ETFs), cash equivalents, and other
investment instruments. The purpose of forming a portfolio is to achieve
specific financial objectives, such as capital appreciation, income generation, or
risk diversification.

The concept of diversification is closely tied to Principle 2: There Is a

Risk-Return Tradeoff. This principle suggests that in the world of investing, higher
potential returns are usually associated with higher levels of risk. Diversification, as
highlighted in the chapter, allows investors to mitigate some of that risk without
sacrificing the expected rate of return. By spreading investments across different
asset classes, industries, or geographic regions, an investor can create a portfolio that
is less susceptible to the poor performance of any single investment. This risk
reduction is achieved by the fact that different assets may react differently to
various economic conditions or events. Diversification exemplifies the principle by
illustrating that careful selection and distribution of assets can optimise the
risk-return tradeoff, enabling investors to achieve a balance that aligns with their risk
tolerance and financial goals.

For example, consider a scenario where an investor puts all their funds into a
single stock. If that particular company experiences a downturn, the entire investment
is at risk. However, by diversifying across multiple stocks in different industries or
sectors, the impact of a poor-performing stock can be mitigated by the positive
performance of others. This way, the investor can potentially maintain or even enhance
the expected rate of return while lowering the overall risk of the portfolio.
Diversification exemplifies the principle that to seek higher returns, one must usually
accept higher risk, but strategic diversification allows for a more balanced approach to
managing this risk-return tradeoff.

● What we learn in this chapter is that some risks can be eliminated by

diversification and that those risks that can be eliminated are not necessarily
rewarded in the financial marketplace. To understand this, we must delve into
the computation of portfolio expected return and portfolio risk

Calculating the Expected Return of a Portfolio

The expected rate of return for a portfolio of investments is simply a weighted

average of the expected rates of return of the individual investments in that portfolio.
To calculate a portfolio’s expected rate of return, we weight each individual
investment’s expected rate of return using the fraction of the portfolio invested in
that particular investment portfolio.
For instance, if you put half your money in the stock of ExxonMobil (XOM), with
an expected rate of return of 12 percent, and the other half in General Electric
(GE) stock, with an expected rate of return of 8 percent, then we can calculate
the expected rate of return of the portfolio as follows: (1/2 x 12%) + (1/2 x
8%) = 10%.

Portfolio Expected Return = (Fraction of Portfolio Invested in Asset 1 x

Expected Rate of Return on Asset 1) + (Fraction of Portfolio Invested in Asset
2 x Expected Rate of Return on Asset 2) + (Fraction of Portfolio Invested in
Asset 3 x Expected Rate of Return on Asset 3) + . . . + (Fraction of Portfolio
Invested in Asset n x Expected Rate of Return on Asset n)

SHORT VERSION: FORMULA

E(rPortfolio) = [W1 x E(r1)] + [W2 x E(r2)] + [W3 x E(r3)] + . . . + [Wn * E(rn)]

Important Definitions and Concepts:

● E(rPortfolio) = the expected rate of return on a portfolio of n assets.
● W1, W2, and W3 = the portfolio weight for assets 1, 2, and 3,
respectively.
● E(r1), E(r 2), and E(r3) = the expected rates of return earned by assets 1,
2, and 3, respectively. In this chapter, we will assume that these
calculations have already been made and that the expected rates of
return for risky assets are known.
● [W1 3 E(r1)] = the contribution of asset 1 to the portfolio expected
return.
● Note that the expected rate of return on a portfolio of n assets is simply
a weighted average of the expected rates of return on the n individual
assets

EXAMPLE:

Penny Simpson has her first full-time job and is considering how to invest her
savings. Her dad has suggested she invest no more than 25 percent of her
savings in the stock of her employer, Emerson Electric (EMR), so she is
considering investing the remaining 75 percent in a combination of U.S.
Treasury bills, a risk-free investment currently paying 4 percent, and
Starbucks (SBUX) common stock. Penny’s father has invested in the stock
market for many years and has suggested that Penny might expect to earn 8
percent on the Emerson shares and 12 percent from the Starbucks shares.
Penny decides to put 25 percent in Emerson, 25 percent in Starbucks, and the
remaining 50 percent in Treasury bills. Given Penny’s portfolio allocation, what
rate of return should she expect to receive on her investment?

STEP 1: Picture the problem

STEP 2: Decide on a solution strategy

Expected Return Weight (W) Product

[E(r)]

U.S.Treasury bills 4.0% .50

Emerson Electric 8.0% .25

Starbucks 12.0% .25

Portfolio E(r)

The portfolio expected rate of return is simply a weighted average of the

expected rates of return of the investments in the portfolio. So we use
Equation (8–1) to calculate the expected rate of return for Penny’s portfolio. Fill
in the shaded cells under the Product column in the following table to calculate a
weighted average

STEP 3: Solve

Expected Return Weight (W) Product

[E(r)]

U.S.Treasury bills 4.0% .50 2.0%

Emerson Electric 8.0% .25 2.0%

Starbucks 12.0% .25 3.0%

Portfolio E(r) 7.0%

E(rPortfolio) = WTreasury billsE(rTreasury bills) + WEMRE(rEMR) +

WSBUXE(rSBUX) = (1/2 x .04) + (1/4 x .08) + (1/4 x .12) = .07, or 7%
Alternatively, by filling out the table described above, we get the same result

STEP 4: Analyze

The expected rate of return for the portfolio with 50 percent invested in
Treasury bills, 25 percent in Emerson Electric stock, and the remaining 25
percent in Starbucks stock is 7 percent. Note that we have referred to the
Treasury bill rate as its expected rate of return. This is technically accurate
because this return is assumed to be risk-free. That is, if you purchase a
Treasury bill that promises to pay you 4 percent, this is the only possible
outcome because this security is risk-free. This is not the case for either of
the other investment alternatives. We can calculate the expected rate of
return for the portfolio in exactly the same way, regardless of the risk of the
investments contained in the portfolio. However, as we learn next, the risk of
the portfolio is affected by the riskiness of the returns of the individual
investments contained in the portfolio.

STEP 5: Check yourself

Evaluate the expected return for Penny’s portfolio if she places a quarter of
her money in Treasury bills, half in Starbucks stock, and the remainder in
Emerson Electric stock. ANSWER: 9 percent.

Evaluating Portfolio Risk

In the last section, we showed that the expected rate of return of a portfolio
is simply the weighted average of the expected rates of returns of the
individual investments that make up the portfolio. Next, we calculate the risk of
a portfolio using the standard deviation of portfolio returns. However, as we will
illustrate in this section, the standard deviation of a portfolio’s return is
generally not equal to the weighted average of the standard deviations of the
returns of the individual investments held in the portfolio. To understand why
this is the case, we must look deeper into the concept of diversification

Portfolio Diversification
In most cases, combining investments in a portfolio leads to risk reduction. The
effect of reducing risk by including a large number of investments in a portfolio
is called diversification. As a consequence of diversification, the standard
deviation of a portfolio’s return is typically less than the average of the
standard deviations of the returns of the portfolio’s individual investments.

Diversification is a risk management strategy that involves combining

different investments in a portfolio to reduce overall risk. The idea is that by
holding a variety of assets that are not perfectly correlated with each other,
the portfolio's overall risk is lowered. This is because when some investments in
the portfolio perform poorly, others may perform well, offsetting losses and
potentially leading to a more stable overall return.

The standard deviation is a measure of the dispersion or variability of a

set of values. In the context of investment returns, it measures how much the
returns of an investment or portfolio deviate from their average (mean) return.
When you combine multiple investments in a portfolio, the movements of
individual investments are likely to offset each other to some extent.

The key to understanding why the standard deviation of a diversified

portfolio is typically less than the average of the standard deviations of its
individual investments lies in the concept of correlation. Correlation measures
the degree to which the returns of two investments move in relation to each
other. If two investments have a low or negative correlation, their returns are
less likely to move in the same direction at the same time.

To illustrate this, suppose you open a shop to cater to the tourist trade on a
beautiful Caribbean island. The two products that you consider selling are
sunglasses and umbrellas. Sunglasses generate a 20 percent rate of return
during the sunny season and a 0 percent return during the rainy season. In
contrast, umbrellas generate a 0 percent rate of return during the sunny
season, but during the rainy season, the umbrella business will generate a 20
percent return. So if the probability of a rainy year is 50 percent and the
probability of a mostly sunny year is 50 percent, then the expected rate of
return from each of these items is 10 percent. The problem comes into play
when rainy and sunny seasons vary in length. For example, if you sell only
sunglasses and the sunny season lasts for only 2 months, you will not do very well
at all; likewise, if you invest only in umbrellas and the sunny season lasts for 10
months, you will do poorly. In this example, the revenues from both products,
when viewed in isolation, are quite risky. However, if you invest half of your
money in sunglasses and the other half in umbrellas, you will earn 10 percent on
your total investment, regardless of how long the sunny season lasts, because at
all times one of your products will be returning 20 percent while the other will
be returning 0 percent. In effect, when you combine sunglasses and umbrellas,
you completely eliminate risk

Do you always get this diversification benefit

when two investments are combined? Not necessarily.
For example, if you are currently selling sunglasses and add sunscreen, which
also returns 20 percent in the sunny season and 0 percent in the rainy season,
there will be no benefit to diversification because the returns of the sunscreen
and sunglasses investments are perfectly correlated.

Diversification Lessons
We can take away two key lessons from this initial look at portfolio risk and
diversification:
1. A portfolio can be less risky than the average risk of its individual
investments.
2. The key to reducing risk through diversification is to combine investments
whose returns do not move together and thus are not perfectly positively
correlated.

Calculating the Standard Deviation of a Portfolio’s Returns

Patty has just received $20,000 from her Aunt Gladys, who suggests she invest
the money in the stock market. Patty tells her aunt that she is considering the
possibility of investing the money in the common stock of either Apple (AAPL)
or Coca-Cola (KO). When Aunt Gladys hears this, she advises Patty to put half
the money in Apple stock and half in Coca-Cola stock. So if we assume that
Apple and Coca-Cola stocks both have the same expected rate of return of 14
percent and Patty invests in each equally, then the portfolio consisting of both
stocks will have the same expected rate of return as the individual stocks, or 14
percent:

To analyze Aunt Gladys’s suggested investment strategy, let’s calculate the

expected return and standard deviation of a portfolio that includes both Apple
and Coca-Cola stocks. We saw from Equation (8–1) that the expected return is
simply the weighted average of the expected returns of the individual
securities in the portfolio.

E(rPortfolio) = WAppleE(rApple) + WCoca-ColaE(rCoca-Cola) = (1 / 2 * .14)

+ (1 / 2 * .14) = .14, or 14%

Now let’s consider the riskiness of Patty’s portfolio. To measure the portfolio’s
risk, we use the standard deviation of the portfolio. As we noted earlier, the
standard deviation of the portfolio is not simply a weighted average of the
respective standard deviations of the two stock investments. Indeed, if the
returns on investing in Apple stock are less than perfectly correlated with the
returns on Coca-Cola stock, the standard deviation of the portfolio that
combines the two firms’ shares will be less than this simple weighted average of
the two firms’ standard deviations. This reduction in portfolio standard
deviation is due to the effects of diversification. The magnitude of the
reduction in the portfolio’s standard deviation resulting from diversification will
depend on the extent to which the returns are correlated.
Correlation tells us the strength of the linear relationship between two assets.
It can take on a value that ranges from –1.0, meaning these two assets move in a
perfectly opposite linear manner as in the sunglasses and umbrellas example, to
+1.0, which means that these two assets move in a perfectly linear manner
together as in the sunglasses and sunscreen example. A value of 0.0 would mean
that there is no linear relationship between the movements of the two assets.

Now let’s look at the calculation of the standard deviation of Patty’s two-asset
portfolio and allow the correlation coefficient to vary between –1.0 and +1.0.
Let’s also assume the following:

● Patty invests half of her money in each of the two companies’ shares.
● The standard deviation for both Apple’s and Coca-Cola’s individual stock
returns is .20.
● Correlation between the stock returns of Apple and Coca-Cola is .75.
Substituting Apple stock for asset 1 and Coca-Cola stock for asset 2 into
Equation (8–2), we get the following result:

Because the standard deviation of each of the stocks is equal to .20, a simple
weighted average of the standard deviations of the Apple and Coca-Cola stock
returns would produce a portfolio standard deviation of .20. However, a
correlation coefficient of .75 indicates that the stocks are not perfectly
correlated and produces a portfolio standard deviation of 0.187. To see how the
correlation between the investments influences the portfolio standard
deviation, let’s look at what happens when we substitute a correlation
coefficient of 1.0 into Equation
When the two stocks’ rates of return are perfectly positively correlated (move
in unison), the standard deviation of the portfolio is simply the weighted
average of the stocks’ individual standard deviations. When this is the case,
there is no benefit to diversification. However, when the correlation coefficient
is less than 11.0, the standard deviation of the portfolio is less than the
weighted average of the individual stocks’ standard deviations, indicating a
benefit from diversification.

Diversification and the Correlation Coefficient—Apple and Coca-Cola

The effects of diversification on the risk of the portfolio are contingent

on the degree of correlation between the assets included in the portfolio.
If the correlation is 11 (meaning the two assets are perfectly correlated
and move together in lockstep, as was the case with sunglasses and
sunscreen), then there is no benefit to diversification. However, if the
correlation is –1 (meaning the two assets move in lockstep in opposite
directions, as was the case with sunglasses and umbrellas), it is possible
to construct a portfolio that completely eliminates risk.