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Principles of Corporate Finance, 14th

Edition
Chapter 7: Introduction to Risk, Diversification,
and Portfolio Selection
Brealey, Myers, Allen, and Edmans

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Topics Covered
The relationship between risk and return.
How to measure risk.
How diversification reduces risk.
Systematic risk is market risk.
Should companies diversify?

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 Figure 7.1 How an Investment of $1 at the End of
1899 Would Have Grown by the End of 2020
How an investment of $1 at the start of 1900 would have grown by the end of
2020, assuming reinvestment of all dividend and interest payments.

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 Figure 7.2 How an Investment of $1 at the End of 1899
Would Have Grown in Real Terms by the End of 2020

How an investment of $1 at the start of 1900 would have grown in real terms by
the end of 2020, assuming reinvestment of all dividend and interest payments.
Compare this plot with Figure 7.1, and note how inflation has eroded the
purchasing power of returns to investors.

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 Table 7.1 Average annual rates of return

U.S. Treasury bills, government bonds, and stocks, 1900–2020.

Average Annual Rate of Return

Average Risk Premium (Extra

Nominal Real Return versus Treasury Bills)
Treasury bills 3.7% 0.9% 0%
Government bonds 5.4 2.6 1.7
Stocks 11.5 8.5 7.8

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years of Global
Investment Returns (Princeton. N J: Princeton University Press. 2002), with updates provided by the
authors.

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 Figure 7.3 Average market risk premiums

Nominal Return on Stocks Minus Nominal Return on Bills 1900–2020

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 Figure 7.4 The Stock Market Is a Variable
Investment
Stock Market Index Returns.

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 Figure 7.5 Histogram of the Annual Rates of Return
From the Stock Market in the United States

1900–2020.

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 Diversification and Portfolio Risk
Variance.

• The expected (or average) value of (ri  ri ) 2 .

• A measure of volatility.

Standard Deviation.
• The square root of the variance.
• A measure of volatility.

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 Figure 7.6 Daily Price Changes for IBM

Price changes versus normal distribution 1997–2019.

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 Figure 7.7 Investment A
Standard Deviation Versus Expected Return.

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 Figure 7.7 Investment B
Standard Deviation Versus Expected Return.

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 Figure 7.7 Investment C
Standard Deviation Versus Expected Return.

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 Table 7.2 The Coin Tossing Game: Calculating
Variance and Standard Deviation

(5)
(1) Percent (2) Deviation From (3)Squared Probability ×
Rate of Return Expected Return Deviation (4) Squared
r~ (r~−r) (r~ − r)2 Probability Deviation
+40 +30 900 .25 225
+10 0 0 .5 0
In the following table, read ‘r~ ' as r-tilde; read
‘(r~ − r)' as r-tilde minus r; read ‘(r~ − r)2' as r-
tilde minus r the whole squared;

−20 −30 900 .25 225

Variance  expected value of ( r  r ) 2  450

Standard deviation  variance  450  21

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 Standard Deviation and Variance for Different
Securities

1900–2020
Portfolio Standard Deviation (σ) Variance (σ2)

Treasury bills 2.8% 8.1

Government bonds 8.9 79.7
In the following table, read ' σ2 '
as sigma squared.

Stocks 19.5 381.8

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 Figure 7.8 The Risk (Standard Deviation of
Annual Returns) of Markets Around the World
(1900–2020)

Source: E. Dimson, P. R. Marsh, and M. Staunton, Triumph of the Optimists: 101 Years
of Global Investment Returns (Princeton, NJ: Princeton University Press, 2002), with
updates provided by the authors.
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 How Diversification Reduces Risk
Diversification: Strategy designed to reduce risk by
spreading the portfolio across many investments.
Specific Risk: Risk factors affecting only that firm. Also
called “diversifiable risk.”
Market Risk: Economywide sources of risk that affect the
overall stock market. Also called “systematic risk.”

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 Figure 7.10 The Variance of a Two-Stock
Portfolio Is the Sum of These Four Boxes

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 Portfolio Risk Example 1

Example
Suppose you invest 60% of your portfolio in Southwest
Airlines and the remainder in Amazon. The expected dollar
return on your Southwest investment is 15.0% and on
Amazon is 10.0%. The expected return on your portfolio is:

Expected return   0.60 15   0.40 10   13%

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 Portfolio Risk Example 2

Example
Suppose you invest 60% of your portfolio in Southwest
Airlines and the remainder in Amazon. The expected dollar
return on your Southwest investment is 15.0% and on
Amazon is 10.0%. The standard deviation of returns was
26.6% for Amazon and 27.9% for Southwest Airlines.
Assume a correlation coefficient of 1.0 and calculate the
portfolio variance and standard deviation.
Southwest Amazon

x12 12   0.60    27.9  x1x2 12 1 2  0.40  0.60  1 27.9  26.6

2 2
Southwest

x1x2 12 1 2  0.40  0.60  1 27.9  26.6 x22 22   0.40    26.6 

2 2
Amazon

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 Portfolio Risk Example 3

Example
Suppose you invest 60% of your portfolio in Southwest Airlines
and the remainder in Amazon. The expected dollar return on your
Southwest investment is 15.0% and on Amazon is 10.0%. The
standard deviation of returns was 26.6% for Amazon and 27.9%
for Southwest Airlines. Assume a correlation coefficient of 1.0 and
calculate the portfolio variance and standard deviation.

Portfolio variance   0.60    27.9   0.40    26.6  

  
2 2 2 2

   
+2  0.40  0.60  1 27.9  26.6   749.7

Standard deviation  749.7  27.4%

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 Portfolio Risk Example 4

Example
Suppose you invest 60% of your portfolio in Southwest Airlines
and the remainder in Amazon. The expected dollar return on your
Southwest investment is 15.0% and on Amazon is 10.0%. The
standard deviation of returns was 26.6% for Amazon and 27.9%
for Southwest Airlines. Assume a correlation coefficient of 0.26 and
calculate the portfolio variance and standard deviation.

Portfolio variance   0.60    27.9   0.40    26.6  

  
2 2 2 2

   
+2  0.40  0.60  0.26  27.9  26.6   486.1

Standard deviation  486.1  22.0%

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 Portfolio Risk Example 5

Another Example
Suppose you invest 60% of your portfolio in Southwest Airlines
and the remainder in Amazon. The expected dollar return on your
Southwest investment is 15.0% and on Amazon is 10.0%. The
standard deviation of returns was 26.6% for Amazon and 27.9%
for Southwest Airlines. Assume a correlation coefficient of –1 and
calculate the portfolio variance and standard deviation.

Portfolio variance   0.60    27.9    0.40    26.6  

2 2 2 2

   
+2  0.40  .60   1.00   27.9  26.6   37.2

Standard deviation  37.2  6.1%

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 Portfolio Risk Equations—Two Securities

Expected portfolio return   x1  r1    x2  r2 


Portfolio variance  x1212  x22 22  2 x1 x2121 2 

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 Portfolio Risk Equations—N Securities

N
Portfolio return   x i  ri
i 1

1  1
Portfolio standard deviation   average variance  1    average covariance
N  N
N N
  xi x j ij
i 1 j 1

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 Figure 7.12 Even Random Diversification
Eliminates Specific Risk

Risk that diversification cannot eliminate is market risk,

NYSE, 2010–2019.

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 Harry Markowitz and the Birth of Portfolio
Theory
• Combining stocks into portfolios can reduce standard
deviation, below the level obtained from a simple weighted
average calculation.
• Correlation coefficients make this possible.
• The various weighted combinations of stocks that create
this standard deviation constitute a set of efficient
portfolios.

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 Figure 7.13 Southwest and Amazon
The curved line
illustrates how
expected return and
standard deviation
change as you hold
different
combinations of two
stocks.
Diversification
reduces risk.

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s
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 Table 7.5 Examples of Efficient Portfolios
Chosen from 10 Stocks
Three Efficient Portfolios—Percentages Allocated to Each Stock (%)
Expected Standard
Return (%) Deviation (%) A B T
United States Steel 6.0 76.4 0 0
Tesla 6.5 48.1 1 5
Newmont 5.0 36.7 7 9
Southwest Airlines 10.0 30.5 100 0 17
Amazon 8.0 28.3 1 10
Wells Fargo 6.8 21.6 21 23
ExxonMobil 5.3 19.4 0 0
Consolidated Edison 5.5 16.5 20 33
Johnson & Johnson 4.4 14.4 7 0
Coca-Cola 4.8 12.6 43 5
Expected portfolio return 10.0 5.4 6.8
Portfolio standard deviation 30.5 10.5 12.5

Note: Standard deviations and the correlations between stock returns were estimated from monthly returns, March
2015–February 2020. Efficient portfolios are calculated assuming that short sales are prohibited.

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 Figure 7.14 Efficient Portfolios
Each dot shows the expected return and standard deviation of
stocks. These are efficient portfolios, denoted with A, B, and C.

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 Figure 7.16 Lending and Borrowing
Lending or borrowing at the risk-free rate (rf) allows us to
exist outside the efficient frontier.

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 Sharpe Ratio
The ratio of the risk premium to the standard deviation is
called the Sharpe ratio:

r  rf
Sharpe ratio 


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