Q3. Jamie Wong is considering building an investment portfolio containing two stocks, L and M. Stock L will represent 40% of the dollar value of the portfolio, and stock M will account for the other 60%. The expected returns over the next 6 years, 2013–2018, for each of these stocks are shown in the following table.
a. Calculate the expected portfolio return, rp, for each of the 6 years.
b. Calculate the expected value of portfolio returns, , over the 6-year period.
c. Calculate the standard deviation of expected portfolio returns, over the 6-year period.
d. How would you characterize the correlation of returns of the two stocks L and M?
e. Discuss any benefits of diversification achieved by Jamie through creation of the portfolio.
Let the expected returns be as follows
1 2 3 4 5 6
L 5 6 7 2 2 8
M 4 8 5 7 3 6
expected return on each share:
expected value of portfolio returns
the standard deviation is the square root of the variance
the yield M is greater than the yield L
the yield of M is greater than the yield of L, so the portfolio needs to include more securities of M