13.

2
Supplement

13.2.1 INDIVIDUAL SECURITIES

In [this supplement], we will examine the characteristics of individual securities. In
particular, we will discuss:
1. Expected Return. This is the return that an individual expects a stock to earn
over the next period. Of course, because this is only an expectation, the actual
return may be either higher or lower. An individual’s expectation may be the
average return per period a security has earned in the past. Alternatively, it may
be based on a detailed analysis of a firm’s prospects, on some computer-based
model, or on special (or inside) information.
2. Variance and Standard Deviation. There are many ways to assess the volatility
of a security’s return. One of the most common is variance, which is a measure
of the squared deviations of a security’s return from its expected return. Standard
deviation is the square root of the variance.
3. Covariance and Correlation. Returns on individual securities are related to one
another. Covariance is a statistic that measures the interrelationship between two
securities. Alternatively, this relationship can be restated in terms of the correla-
tion between the two securities. Covariance and correlation are building blocks
to an understanding of the beta coefficient.

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 13.2.2 EXPECTED RETURN, VARIANCE,
AND COVARIANCE
Expected Return and Variance
Suppose financial analysts believe that there are four unequally likely states of the
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economy next year: depression, recession, normal, and boom times. The returns on the coverage online
Supertech Company, RA, are expected to follow the economy closely, while the returns on
www.mhhe.com/RossCore5e
the Slowpoke Company, RB, are not. The return predictions are as follows:
Want more information
on investing? Take a look
STAT E O F PR O B A B I L I T Y O F S U P E RT E C H R E T U R N S S LOWP O K E R E T U R N S at www.thestreet.com.
ECONO M Y STAT E O F EC O NO M Y RA RB
Depression .10 –30% 0%
Recession .20 –10 5
Normal .50 20 20
Boom .20 50 –5

Variance can be calculated in four steps.1 An additional step is needed to calculate standard
deviation. (The calculations are presented in Table 11.1.) The steps are:

1. Calculate the expected returns, E(RA) and E(RB), by multiplying each possible
return by the probability that it occurs, and then add them up:

Supertech
.10​(− .30)​+ .20​(− .10)​+ .50​(.20)​+ .20​(.50)​= .15 = 15% = E​(​RA​ ​)​

Slowpoke
.10​(.00)​+ .20​(.05)​+ .50​(.20)​+ .20​(− .05)​= .10 = 10% = E​(​RB​ ​)​

2. As shown in the fourth column of Table 11.1, we next calculate the deviation of
each possible return from the expected returns for the two companies.
3. Next, take the deviations from the fourth column and square them as we have
done in the fifth column.
4. Finally, multiply each squared deviation by its associated probability and add the
products up. As shown in Table 11.1, we get a variance of .0585 for Supertech
and .0110 for Slowpoke.
5. As always, to get the standard deviations, we just take the square roots of the
variances:

​Supertech
______
​√.0585 ​= .242 = 24.2% = SD​(​RA​ ​)​= ​𝛔​A​

​Slowpoke
______
​√.0110 ​= .105 = 10.5% = SD​(​RB​ ​)​= ​𝛔​B​

1
Notice we have a different variance calculation in this chapter. In Chapter 10, we were estimating the population variance from a sample of
historical returns. In this chapter, we are calculating the population variance from a known distribution.

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 TABLE 11.1 Calculating Variance and Standard Deviation

( 1) (2 ) (3) ( 4) ( 5) (6)
STATE OF PR O B A B I L I T Y O F STAT E R AT E O F D E V IAT IO N F R O M S Q UA R E D VA LU E P R O D U CT
ECONOMY O F EC O NO M Y RETURN EXPECTED RETURN O F D E V IAT IO N ( 2 ) × (5 )

SUPE RT E C H ( E X P E C T E D R E T U R N = .1 5)
RA RA – E(RA) (RA – E(RA))2
Depression .10 –.30 –.45 .2025 .02025
Recession .20 –.10 –.25 .0625 .01250
Normal .50 .20 .05 .0025 .00125
Boom .20 .50 .35 .1225 .02450
Var(RA) = σ2A = .05850

SLOW P O K E ( E X P E C T E D R E T U R N = .10 )
RB RB – E(RB) (RB – E(RB))2
Depression .10 .00 –.10 .0100 .00100
Recession .20 .05 –.05 .0025 .00050
Normal .50 .20 .10 .0100 .00500
Boom .20 −.05 –.15 .0225 .00450
Var(RB) = σ2B = .01100

Covariance and Correlation

Variance and standard deviation measure the variability of individual stocks. We now wish
to measure the relationship between the return on one stock and the return on another.
Enter covariance and correlation.
Covariance and correlation measure how two random variables are related. We explain
these terms by extending our Supertech and Slowpoke example presented earlier.

Calculating Covariance and Correlation

1 1 .1

We have already determined the expected returns and standard deviations for both Supertech and
Slowpoke. (The expected returns are .15 and .10 for Supertech and Slowpoke, respectively. The standard
EXAMPLE

deviations are .242 and .105, respectively.) In addition, we calculated the deviation of each possible
return from the expected return for each firm. Using these data, covariance can be calculated in two
steps. An extra step is needed to calculate correlation.
1. For
 each state of the economy, multiply Supertech’s deviation from its expected return and
Slowpoke’s deviation from its expected return together. For example, Supertech’s rate of return in a
depression is –.30, which is –.45 (= –.30 – .15) from its expected return. Slowpoke’s rate of return
in a depression is .00, which is –.10 (= .00 – .10) from its expected return. Multiplying the two devia-
tions together yields .0450 [= (–.45) × (–.10)]. The actual calculations are given in the last column of
Table 11.2. This procedure can be written algebraically as

(RA − E(RA)) × (RB − E(RB)) [11.1]

where RA and RB are the returns on Supertech and Slowpoke. E(RA) and E(RB) are the expected
returns on the two securities.

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 TABLE 11.2 Calculating Covariance and Correlation

(1 ) (2) (3 ) ( 4) (5) (6)

D E V IAT IO N S F R O M
PR O B A B I L I T Y EX P E C T E D R E T U R N S
STAT E O F O F STAT E O F PRODUCT OF PRODUCT
EC O NO M Y EC O NO M Y SU PERT E C H S LOWP O K E D E V IAT IO N (2) × (5)

Depression .10 –.45 –.10 .0450 .00450

Recession .20 –.25 –.05 .0125 .00250
Normal .50 .05 .10 .0050 .00250
Boom .20 .35 –.15 –.0525 –.01050
Cov(RA,RB) = σA,B = –.001

2. Once
 we have the products of the deviations, we multiply each one by its associated probability and
sum to get the covariance.
Note that we represent the covariance between Supertech and Slowpoke as either Cov(RA, RB) or
σA,B. Equation 11.1 illustrates the intuition of covariance. Suppose Supertech’s return is generally above
its average when Slowpoke’s return is above its average, and Supertech’s return is generally below its
average when Slowpoke’s return is below its average. This is indicative of a positive dependency or a
positive relationship between the two returns. Note that the term in Equation 11.1 will be positive in any
state where both returns are above their averages. In addition, [11.1] will still be positive in any state
where both terms are below their averages. Thus, a positive relationship between the two returns will
give rise to a positive value for covariance.
Conversely, suppose Supertech’s return is generally above its average when Slowpoke’s return is
below its average, and Supertech’s return is generally below its average when Slowpoke’s return is
above its average. This is indicative of a negative dependency or a negative relationship between the
two returns. Note that the term in Equation 11.1 will be negative in any state where one return is above its
average and the other return is below its average. Thus, a negative relationship between the two returns
will give rise to a negative value for covariance.
Finally, suppose there is no relation between the two returns. In this case, knowing whether the
return on Supertech is above or below its expected return tells us nothing about the return on Slowpoke.
In the covariance formula, then, there will be no tendency for the deviations to be positive or negative
together. On average, they will tend to offset each other and cancel out, making the covariance zero.
Of course, even if the two returns are unrelated to each other, the covariance formula will not equal
zero exactly in any actual history. This is due to sampling error; randomness alone will make the cal-
culation positive or negative. But for a historical sample that is long enough, if the two returns are not
related to each other, we should expect the covariance to come close to zero.
Our covariance calculation seems to capture what we are looking for. If the two returns are positively
related to each other, they will have a positive covariance, and if they are negatively related to each
other, the covariance will be negative. Last, and very important, if they are unrelated, the covariance
should be zero.
The covariance we calculated is –.001. A negative number like this implies that the return on one
stock is likely to be above its average when the return on the other stock is below its average, and vice
versa. However, the size of the number is difficult to interpret. Like the variance figure, the covariance is
in squared deviation units. Until we can put it in perspective, we don’t know what to make of it.
We solve the problem by computing the correlation.
3. To
 calculate the correlation, divide the covariance by the product of the standard deviations of the
two securities. For our example, we have
Cov​(​RA​ ​, ​RB​ ​)​ ____________
− .001
​ρA,B = Corr​(​RA​ ​, ​RB​ ​)​= ___________
​ ​= ​ ​= −.039 [​ 11.2]​
​σ​A​× ​σ​B​ .242 × .105
(continued)

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 where σA and σB are the standard deviations of Supertech and Slowpoke, respectively. Note that we
represent the correlation between Supertech and Slowpoke either as Corr(RA, RB) or ρA,B. Note also
that the ordering of the two variables is unimportant. That is, the correlation of A with B is equal to
the correlation of B with A. More formally, Corr(RA, RB) = Corr(RB, RA) or ρA,B = ρB,A. The same is true
for covariance.
Because the standard deviation is always positive, the sign of the correlation between two variables
must be the same as that of the covariance between the two variables. If the correlation is positive,
we say that the variables are positively correlated; if it is negative, we say that they are negatively
correlated; and if it is zero, we say that they are uncorrelated. Furthermore, it can be proved that the
correlation is always between +1 and –1. This is due to the standardizing procedure of dividing by the
two standard deviations.
We can compare the correlation between different pairs of securities. For example, it turns out
that the correlation between General Motors and Ford is much higher than the correlation between
General Motors and IBM. Hence, we can state that the first pair of securities is more interrelated than
the second pair.
Figure 11.1 shows the three benchmark cases for two assets, A and B. The figure shows two assets
with return correlations of +1, –1, and 0. This implies perfect positive correlation, perfect negative cor-
relation, and no correlation, respectively. The graphs in the figure plot the separate returns on the two
securities through time.

FIGURE 11.1 Examples of Different Correlation Coefficients—Graphs Plotting the Separate Returns on the
Two Securities through Time

Perfect Positive Correlation Perfect Negative Correlation

Corr(RA, RB) = 1 Corr(RA, RB) = -1

B
+ +
Returns

Returns

0 0
A A
- -
B

Time Time
Both the return on Security A and the return Security A has a higher-than-average return
on Security B are higher than average at the when Security B has a lower-than-average
same time. Both the return on Security A and return, and vice versa.
the return on Security B are lower than
average at the same time.

Zero Correlation
Corr(RA, RB) = 0

+
Returns

0
A
- B

Time
The return on Security A is completely
unrelated to the return on Security B.

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 13.2.3 THE RETURN AND RISK FOR PORTFOLIOS
Suppose that an investor has estimates of the expected returns and standard deviations on
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individual securities and the correlations between securities. How then does the investor coverage online
choose the best combination, or portfolio, of securities to hold? Obviously, the investor
www.mhhe.com/RossCore5e
would like a portfolio with a high expected return and a low standard deviation of return. It
is therefore worthwhile to consider:
1. The relationship between the expected return on individual securities and the
expected return on a portfolio made up of these securities.
2. The relationship between the standard deviations of individual securities, the
correlations between these securities, and the standard deviation of a portfolio
made up of these securities.
In order to analyze the above two relationships, we will continue with our example of
Supertech and Slowpoke. The relevant calculations are as follows.

The Expected Return on a Portfolio

The formula for expected return on a portfolio is very simple:

The expected return on a portfolio is a weighted average of the expected returns on

the individual securities.

RELEVANT DATA FROM EXAMPLE OF SUPERTECH AND SLOWPOKE

ITEM SY M B O L VA LU E
Expected return on Supertech E(RSuper) .15 = 15%
Expected return on Slowpoke E(RSlow) .10 = 10%
Variance of Supertech ​σ​2Super​ .0585
Variance of Slowpoke ​σ​2Slow​ .0110
Standard deviation of Supertech ​σ​2Super​ .242, or 24.2%
Standard deviation of Slowpoke ​σ​2Slow​ .105, or 10.5%
Covariance between Supertech and Slowpoke σSuper, Slow –.001
Correlation between Supertech and Slowpoke ρSuper, Slow –.039

Portfolio Expected Returns

EXAMPLE 11.2

Consider Supertech and Slowpoke. From the preceding box, we find that the expected returns on these
two securities are 15 percent and 10 percent, respectively.
The expected return on a portfolio of these two securities alone can be written as:
​Expected return on portfolio = ​X​Super​​(15%)​+ ​X​Slow​​(10%)​= ​R​P​
where XSuper is the percentage of the portfolio in Supertech and XSlow is the percentage of the portfolio in
Slowpoke. If the investor with $100 invests $60 in Supertech and $40 in Slowpoke, the expected return
on the portfolio can be written as:
​Expected return on portfolio = .6 × 15% + .4 × 10% = 13%​
Algebraically, we can write:
​Expected return on portfolio = ​XA​ ​E​(​RA​ ​)​+ ​XB​ ​E​(​RB​ ​)​= E​(​RP​ ​)​ ​[11.3]​
where XA and XB are the proportions of the total portfolio in the assets A and B, respectively. (Because
our investor can only invest in two securities, XA + XB must equal 1, or 100 percent.) E(RA) and E(RB) are
the expected returns on the two securities.

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 Now consider two stocks, each with an expected return of 10 percent. The expected
return on a portfolio composed of these two stocks must be 10 percent, regardless of the
proportions of the two stocks held. This result may seem obvious at this point, but it will
become important later. The result implies that you do not reduce or dissipate your expected
return by investing in a number of securities. Rather, the expected return on your portfolio
is a weighted average of the expected returns on the individual assets in the portfolio.

Variance and Standard Deviation of a Portfolio

THE VARIANCE The formula for the variance of a portfolio composed of two secu-
rities, A and B, is:

​
The Variance of the Portfolio
Var ​(portfolio)​= X​A2σA2 + 2​XA​ ​XB​ ​σ​A,B​+ ​XB​2​σ​2B​ ​[11.4]​

Note that there are three terms on the right-hand side of the equation (in addition to XA and
XB, the investment proportions). The first term involves the variance of A (​​σ​  2A ​​​ ), the second
term involves the covariance between the two securities (σA,B), and the third term involves
the variance of B (​​σ​  2B ​​​ ). (As stated earlier in this chapter, σA,B = σB,A. That is, the ordering
of the variables is not relevant when expressing the covariance between two securities.)
The formula indicates an important point. The variance of a portfolio depends on both
the variances of the individual securities and the covariance between the two securities. The
variance of a security measures the variability of an individual security’s return. Covariance
measures the relationship between the two securities. For given variances of the individual
securities, a positive relationship or covariance between the two securities increases the vari-
ance of the entire portfolio. A negative relationship or covariance between the two securities
decreases the variance of the entire portfolio. This important result seems to square with com-
mon sense. If one of your securities tends to go up when the other goes down, or vice versa,
your two securities are offsetting each other. You are achieving what we call a hedge in finance,
and the risk of your entire portfolio will be low. However, if both your securities rise and fall
together, you are not hedging at all. Hence, the risk of your entire portfolio will be higher.
The variance formula for our two securities, Super and Slow, is:

​2 ​σ​2Super​+ 2​XSuper
​Var ​(portfolio)​= ​XSuper ​ ​XSlow ​2 ​𝛔​2Slow​
​ ​𝛔​Super, Slow​+ ​XSlow

Given our earlier assumption that an individual with $100 invests $60 in Supertech and
$40 in Slowpoke, XSuper = .6 and XSlow = .4. Using this assumption and the relevant data
from the previous box, the variance of the portfolio is:

​.0223 = .36 × .0585 + 2 × ​[.6 × .4 × ​(− .001)​]​+ .16 × .0110​

STANDARD DEVIATION OF A PORTFOLIO We can now determine the stan-

dard deviation of the portfolio’s return. This is:
____________ ______
​𝛔​P​= SD ​(portfolio)​= ​ Var
   √
​(portfolio)​ = ​√.0223 [​11.5]​​
​= .1495, or 14.95%​

The interpretation of the standard deviation of the portfolio is the same as the interpretation
of the standard deviation of an individual security. The expected return on our portfolio is
13 percent. A return of –1.95 percent (=13% – 14.95%) is one standard deviation below
the mean, and a return of 27.95 percent (=13% + 14.95%) is one standard deviation above the
mean. If the return on the portfolio is normally distributed, a return between –1.95 percent
and +27.95 percent occurs about 68 percent of the time.2
2
There are only four possible returns for Supertech and Slowpoke, so neither security possesses a normal distribution. Thus, probabilities
would be somewhat different in our example.

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THE DIVERSIFICATION EFFECT It is instructive to compare the standard
deviation of the portfolio with the standard deviation of the individual securities. The
weighted average of the standard deviations of the individual securities is:

​Weighted average of standard deviations = ​XSuper

​ ​𝛔​Super​+ ​XSlow
​ ​𝛔​Slow​ ​[11.6]​
.187 = .6 × .242 + .4 × .105​

One of the most important results in this chapter concerns the difference between
Equations 11.5 and 11.6. In our example, the standard deviation of the portfolio is less than
a weighted average of the standard deviations of the individual securities.
We pointed out earlier that the expected return on the portfolio is a weighted average
of the expected returns on the individual securities. Thus, we get a different type of result
for the standard deviation of a portfolio than we do for the expected return on a portfolio.
It is generally argued that our result for the standard deviation of a portfolio is due to
diversification. For example, Supertech and Slowpoke are slightly negatively correlated
(ρ = –.039). Supertech’s return is likely to be a little below average if Slowpoke’s return is
above average. Similarly, Supertech’s return is likely to be a little above average if Slowpoke’s
return is below average. Thus, the standard deviation of a portfolio composed of the two
securities is less than a weighted average of the standard deviations of the two securities.
The above example has negative correlation. Clearly, there will be less benefit from
diversification if the two securities exhibit positive correlation. How high must the positive
correlation be before all diversification benefits vanish?
To answer this question, let us rewrite Equation 11.4 in terms of correlation rather than
covariance. First, note that the covariance can be rewritten as:

𝛔Super, Slow = 𝛒Super, Slow 𝛔Super 𝛔Slow ​[11.7]​

The formula states that the covariance between any two securities is the correlation between
the two securities multiplied by the standard deviations of each. In other words, covariance
incorporates both (1) the correlation between the two assets and (2) the variability of each
of the two securities as measured by standard deviation.
From our calculations earlier in this chapter, we know that the correlation between the
two securities is –.039. Thus, the variance of our portfolio can be expressed as:

​Variance of the portfolio’s return

​2 ​​𝛔​2Super​+ 2​XSuper
= ​XSuper ​ ​XSlow ​2 ​𝛔​2Slow​​
​ ​𝛒​Super, Slow​𝛔​Super​𝛔​Slow​+ ​XSlow [11.8]​
.0223 = .36 × .0585 + 2 × .6 × .4 × ​(− .039)​× .242 × .105
+ .16 × .0110

The middle term on the right-hand side is now written in terms of correlation, ρ, not
covariance.
Suppose ρSuper, Slow = 1,the highest possible value for correlation. Assume all the other
parameters in the example are the same. The variance of the portfolio is:

Variance of the = .035 = .36 × .0585 + 2 × (.6 × .4 × 1 × .242 × .105)    

​ ​​     
portfolio’s return               + .16 × .0110

The standard deviation is:

_____
​Standard deviation of portfolio’s return = ​√.035 ​= .187 = 18.7%

Note that Equations 11.9 and 11.6 are equal. That is, the standard deviation of a port-
folio’s return is equal to the weighted average of the standard deviations of the individual
returns when ρ = 1. Inspection of Equation 11.8 indicates that the variance and hence the

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 TABLE 11.3 AS S E T STA N DA R D D E V IAT IO N
Standard Deviations for
Standard & Poor’s 500 S&P 500 Index 15.09%
Index and for Selected
IBM 17.99
Stocks in the Index,
2006–2015 Walt Disney 22.58
Microsoft 24.59
BP 28.98
Google 30.49
Apple 33.02
Amazon.com 38.48
Bank of America 50.02
Ford 58.63

standard deviation of the portfolio must fall as the correlation drops below 1. This leads to
the following result:

As long as ρ < 1, the standard deviation of a portfolio of two securities is less than the
weighted average of the standard deviations of the individual securities.

In other words, the diversification effect applies as long as there is less than perfect
correlation (as long as ρ < 1). Thus, our Supertech-Slowpoke example is a case of over-
kill. We illustrated diversification by an example with negative correlation. We could have
illustrated diversification by an example with positive correlation—as long as it was not
perfect positive correlation.

AN EXTENSION TO MANY ASSETS The preceding insight can be extended to

the case of many assets. That is, as long as correlations between pairs of securities are less
than 1, the standard deviation of a portfolio of many assets is less than the weighted aver-
age of the standard deviations of the individual securities.
Now consider Table 11.3, which shows the standard deviation (based on annual returns)
of the Standard & Poor’s 500 Index and the standard deviations of some of the individual
securities listed in the index over a recent 10-year period. Note that all of the individual
securities in the table have higher standard deviations than that of the index. In general, the
standard deviations of most of the individual securities in an index will be above the stan-
dard deviation of the index itself, though a few of the securities could have lower standard
deviations than that of the index.

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