bre44380_ch08_192-220.indd 196 10/09/15 10:05 PM bre44380_ch08_192-220.indd 197 10/09/15 10:05 PM
196 Part Two RiskIn practice, you are not limited to investing in just two stocks. For example, you could decide
to choose a portfolio from the 10 stocks listed in the first column of Table 8.1. After analyzing
the prospects for each firm, you come up with forecasts of their returns. You are most optimis-
tic about the outlook for Ford, and forecast that it will provide a return of 18.8%. At the other
extreme, you predict a return of only 2% for Newmont. You use data for the past five years to
estimate the risk of each stock and the correlation between the returns on each pair of stocks.^5
Now look at Figure 8.4. Each diamond marks the combination of risk and return offered by
a different individual security.(^5) There are 45 different correlation coefficients, so we have not listed them in Table 8.1.
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◗ FIGURE 8.4
Each diamond shows the
expected return and stan-
dard deviation of 1 of the 10
stocks in Table 8.1. There are
many possible combinations
of expected return and stan-
dard deviation from investing
in a mixture of these stocks.
If you like high expected
returns and dislike high
standard deviations, you will
prefer portfolios along the
red line. These are efficient
portfolios. We have marked
the three efficient portfolios
described in Table 8.1 (A, B,
and C).
C
Standard deviation (σ), %
B
A
Expected return (
r ), %
0
2
4
6
8
10
12
14
16
20
18
01510252035 035
Three Efficient Portfolios—Percentages
Allocated to Each Stock (%)
Expected Return (%) Standard Deviation (%) A B C
Caterpillar 17.6 29.2 0 0
Microsoft 12.5 20.7 13 11
Consolidated Edison 8.3 13.8 27 22
Newmont 18.1 30.0 11 18
Apple 15.3 25.2 4 8
Johnson & Johnson 8.0 13.2 10 0
Campbell Soup 1.0 16.6 15 17
Walmart 9.3 15.3 17 10
Ford 18.8 31.0 2 9 100
Dow Chemical 16.7 27.5 3 5
Expected portfolio return 10.61 12.84 18.8
Portfolio standard deviation 9.14 10.35 31.0
❱ TABLE 8.1 Examples of efficient portfolios chosen from 10 stocks.
Note: Standard deviations and the correlations between stock returns were estimated from monthly returns, November 2009–October 2014. Efficient portfolios
are calculated assuming that short sales are prohibited.