Most investors do not hold stocks in isolation.
Instead, they choose to hold a portfolio of several stocks. When this is the case, a portion of an individual stock's risk can be eliminated, i.
This principle is presented on the Diversification page. First, the computation of the expected return, variance, and standard deviation of a portfolio must be illustrated.
Once again, we will be using the probability distribution for the returns on stocks A and B. From the Expected Return and Measures of Risk pages we know that the expected return on Stock A is The Expected Return on a Portfolio is computed as the weighted average of the expected returns on the stocks variance of market portfolio return comprise the portfolio.
Measures of Risk - Variance and Standard Deviation
The weights reflect the proportion of the portfolio invested in the stocks. This can be expressed as follows:.
Two measures of how the returns on a pair of stocks vary together are the covariance and the correlation coefficient. The Covariance between the returns on two stocks can be calculated using the following equation:.
The Correlation Coefficient between the returns on two stocks can be calculated using the following equation:. Using either the correlation coefficient or the covariance, the Variance on a Two-Asset Portfolio can be calculated as follows:.
Portfolio Returns and Risks; Covariance and the Coefficient of Correlation
This is the essence of Diversificationby forming portfolios some of the risk inherent in the individual stocks can be eliminated. Two Asset Portfolio Calculator.
Expected Return and Variance for a Two Asset Portfolio - Finance Train
Two Asset Portfolio Exercise. Portfolio Risk and Return Most investors do not hold stocks in isolation. State Probability Return on Stock A Return on Stock B 1. Covariance and Correlation Coefficent between the Returns on Stocks A and B. Variance and Standard Deviation on a Portfolio of Stocks A and B.