Assets Y and Z have an average return of 16% and a high stock market deviation.
The correlation between different assets tends to rise if we view asset X as having a low-return, low-risk volatility.
Assets Y and Z are high-risk stocks.
Assets X and Y are negatively correlated with the returns of the summer of 2011.
The correlations between the returns of assets X and Z are perfect, they move in exactly the same direction.
The weighted average return on this portfolio is 13.3%.
The average returns of assets X and Y 123 were 12 and 16.
To calculate the portfolio's standard deviation, use the equation shown in Table news announcements with a value of -1.0 for the correlation between X and Y.
A predictable 13.3% return is generated by the larger impact on stock returns.
The correlation of the portfolio is risk-free and has a standard deviation of 0.
Portfolio XZ has an expected return of 13.3%.
The investor update has a standard deviation of 4.2%.
The investor can reduce or eliminate risk by combining the two assets in a portfolio.
The relation between a portfolio's expected return and standard deviation depends on the correlation between assets in the portfolio.
The correlation coefficients are -1.0 in the black line.
It is possible to combine two risky assets in just the right proportions so that the portfolio return is completely predictable.
It would be very foolish for an investor to hold an undiversified position in the least risky asset.
By holding a portfolio of assets rather than just one, the investor moves up and down the black line to earn a higher return while taking less risk.
Increasing the investment in riskier assets pushes the portfolio return and risk higher, so the investor's portfolio moves up and to the right along the second segment of the black line.
When an investor decreases his or her investment in the low-risk asset to hold more of the high-risk asset, the portfolio's expected return rises, but so does its standard deviation.
The lower the correlation, the greater the risk reduction that can be achieved.
Two IMPoRtAnt ConCEPtUAl tools are to the right of the red line.
Not all investors will make the decision to invest in both assets, as it is a matter of risk tolerance.
Diversi fying is definitely the right move when the correlation is less than 1.0, but it is less obvious when the correlation is more than 1.0.
Most of the time, assets are neither negatively correlated nor perfectly posi tively correlated.
Portfolios of two assets lie along an arcs when the correlation coefficients are between the extremes.
When two assets have low cor relation, the arcs may bend back on themselves.
The arcs curve up and to the right when the correlation is higher but still below 1.0.
When the correlation is 1.0, portfolios along the blue arcs earn higher returns for the same risk compared to portfolios along the red arcs.
Diversification is one of the most important considerations when constructing an investment portfolio.
Many opportunities for international diversification are now available.
effec tiveness, methods, and costs are three aspects of international diversification.
That is true in the U.S.
In finance investors as well as for investors in countries with capital markets that offer we usually think about economic more limited opportunities than are available in the factors that cause the returns of the United States.
Diversification benefits from investing in different stocks being more or less correlated.
There are two sources for a recent study.
The first source is that cultural influences affect markets around the world differently.
The correlation between markets is less than 1.0 in some cultures.
The larger the benefits society's tolerance for deviations from diversification is, the stronger the behavioral norms are.
As globalization has brought about more, it tends to be low.
The correlation in returns across national markets has risen as a result of the integration of financial markets and markets for goods and countries.
The benefit of international diversification is reduced by this trend.
According to the number of stock markets, investors are more likely to buy in tighter cultures.
At the beginning of the 20th century fewer than 40 countries in the world had active stock markets, and that leads to highly but by the end of the century the number of stock markets had more than correlated stock returns.
Even if the rising correlation across markets limits these benefits to an extent, investors will still benefit from it.
We discuss how investors can access international markets.
Currency exchange risk is brought about by foreign currency investment.
This risk can be hedged with contracts such as currency forwards, futures, vast array of diversification opportunities, and the fees that and options.
Even if there is no currency exchange risk, investing in U.S. mutual funds abroad is riskier and less convenient than investing in the U.S. You need to know what the rest of the world is like.
You're doing a study.
You should have a clear idea of the benefits being sought and find out how much it will cost to monitor foreign markets.
The next most affordable mutual of foreign companies can be bought by investors.
International mutual funds give foreign investment of 2.21%, more than double the opportunities.
You might wonder if it is possible to achieve the benefits of interna by investing in a portfolio of U.S.-based multinational and Peter tufano.
Yes and no is the answer.
Multinationals generate revenues, costs, and profits in many markets and currencies, so when one part of the world is doing poorly, another part may be doing well.
The benefits of international diversification will not be enjoyed by investors who only invest in U.S.-based multinationals.
To fully realize the benefits of international diversification, it is necessary to invest in firms located outside the United States.
You can find better returns overseas than in the United States, and you can reduce portfolio risk by including foreign investments.
You should not jump to the conclusion that you should invest all of your money in overseas assets.
A successful global investment strategy depends on many things.
The percentage of your portfolio that you should allocate to foreign investments depends on your overall investment goals and risk preferences.
Two-thirds of the allocation to foreign investments should be in established foreign markets and the other third in emerging markets, according to many investment advisers.
It is very costly to invest directly in foreign-currency denominated instruments.
Unless you have hundreds of thousands of dollars to invest, the transaction costs of buying securities directly on foreign markets will be high.
International mutual funds offer diversified foreign investments and the professional expertise of fund man agers, making them a less costly approach to international diversification.
You could make foreign investments in individual stocks with the purchase of ADSs.
With mutual funds or ADSs, you can get international diversification, low cost, convenience, and protection under the U.S. dollars.
The methods of achieving international diversification are compared.
We would expect a return that surpasses what investors can earn on a risk-free investment.
The return that inves tors expect to earn on a risky asset is the same as the risk-free rate.
Diversification of portfolios is a process that is not particularly time consuming or expensive, as we learned in the previous section.
Diversification can't eliminate all risk.
The higher the undiversifiable risk, the higher the risk premium it must offer to attract investors.
The logic behind the theory links return and risk for all assets.
The risk premium depends on how much of the asset's risk is undiversifiable, according to the CAPM.
In this section, we explain how the CAPM quantifies undiversifiable risk and links it to investment returns.
Diversifiable and undiversifiable risk make up the risk of an investment.
Systematic risk is the portion of an investment's risk that can be eliminated.
Even if a port folio is diversified, the risk remains.
Systematic risk is associated with broad forces such as eco nomic growth, inflation, interest rates, and political events that affect all investments and therefore are not unique to any single investment.
Diversifiable risk can be eliminated by holding a diversified portfolio of securities.
Studies have shown that investors can eliminate most diversifiable risk by carefully selecting a portfolio of as few as two or three dozen securities, and most investors hold many more securities than that through investments such as mutual funds and pension funds.
There is no reason for investors to expect a higher return for bearing this kind of risk because it is relatively easy to eliminate.
The risk that investors are taking is more than they have to in order to get a reward for doing so.
There will be some systematic risk no matter how many securities are in the portfolio.
Undiversifiable risk refers to the broad forces that affect most stocks at the same time.
Some stocks are more sensitive than others.
When the economy is booming, companies that produce luxury goods tend to do well, but when the economy goes into a recession, they can't find customers.
Some stocks are insulated from swings in the business cycle.
With the ups and downs of the economy, companies that pro duce food and other basic necessities don't see their revenues and profits rise and fall as much.
The discussion suggests that systematic risk varies from stock to stock, and that stocks with greater systematic risk must offer higher returns to attract investors.
We need a way to measure the undiversifiable risk associated with any particular stock.
The finance discipline has developed theory on the mea surement of risk and its use in assessing returns over the past 50 years.
The capital asset pricing model and the measure of systematic risk are two of the key components of the theory.
Market risk is synonymous with undiversifiable risk because a security's return responds to fluctuations in market returns.
The more sensitive the return of a security is to changes in market returns, the higher it is.
When we talk about returns on the overall market, what we mean by that is something like the return on a broad portfolio of stocks or a stock index.
You gather historical returns on the security and the market to see how they relate to each other in order to calculate a security's alpha.
You don't have to do it yourself; you can get them from a variety of published and online sources.
You should know how to interpret and apply alphas to portfolios.
There is a relationship between a security's return and the market return.
To finance, you need to enter the security ticker symbols and download the historical prices.
The current year-end price is divided by the previous year-end price to calculate annual returns.
In 2010, the annual return for the United Parcel Service was 30.3%.
The previous year's closing price is the present value, the current year's closing price is the future value, and the one-year time interval is the number of periods.
Each green circle shows the return earned by the S&P 500 in a particular year, and each blue diamond shows the return on FedEx in a particular year.
For example, the blue diamond and the green circle diamond in the upper right quadrant of the figure show that FedEx earned a return of about 60%, and the overall market's return was about 30%, you can verify these numbers in the previous table.