Hi Folks – This week we are going to use the math for computing a weighted average and apply it to the investment model we learned about last week, the CAPM. Using a weighted average, you can manipulate the expected risk and return of a portfolio of stocks to match your personal risk tolerance. If you have a stock that has a relatively low Beta, you can use it to reduce the overall risk of a portfolio, even if the returns themselves are not super fantastic. For example, if you were to pair Ford with another higher beta stock, Ford’s low beta would help to off-set the risk of the other stock. Here is how to compute the beta and expected return of a portfolio…
% of portfolio
Contribution to portfolio Beta
Expected Return (CAPM)
Contribution to Portfolio Return
.50 x 1.03 = 0.515
.50 x .097 = .0485 = 4.85%
.50 x 2.2 = 1.1
.50 x .153 = .0765 = 7.65%
.0.515 + 1.1 = 1.6
4.85% + 7.65% = 12.5%
As you can see, the addition of Ford to a portfolio containing a riskier stock decreases the overall risk of the investments and still provides a respectable return of 12.5%.
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