LOS c, (Part 1): Compute and interpret the expected return for an individual investment and a portfolio.
As a fund manager, Bryan Cole, CFA, is responsible for assessing the risk and return parameters of the portfolios he oversees. Cole is currently considering a portfolio consisting of only two stocks. The first stock, Remba Co., has an expected return of 12% and a standard deviation of 16%. The second stock, Labs, Inc., has an expected return of 18% and a standard deviation of 25%. The correlation of returns between the two securities is 0.25.
Cole has the option of including a third stock in the portfolio. The third stock, Wimset, Inc., has an expected return of 8% and a standard deviation of 10%. If Cole constructed an equally weighted portfolio consisting of all three stocks, the portfolio's expected return would be closest to:
ERportfolio = S(ERstock)(W% of funds invested in each of the stocks)
ER = w1ER1 + w2ER2 + w3ER3, where ER = Expected Return and w = % invested in each stock.
Here, use 1/3 for each of the weightings. (Note: If you use 0.33, you will calculate a slightly different result.)
ER =( 1/3 × 12) + (1/3 × 18) + (1/3 × 8) = 4 + 6 + 2.7 = 12.7%
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