IAI Actuarial Core Principles · Economic Modelling · Mean-variance portfolio theory
Two securities A and B have expected returns of 8% and 14% respectively. An investor puts 60% of her wealth in A and 40% in B. What is the expected return of the portfolio?
The expected return is 10.4%. Expected portfolio return is the weighted average of the securities' expected returns, so 0.6 times 8% plus 0.4 times 14% gives 4.8% plus 5.6%. The simple average of 11% wrongly ignores the unequal holdings.
- A10.4%Correct
- B11.0%
- C9.6%
- D12.2%
- 10.0%
Explanation
Portfolio expected return is the weighted average of the individual expected returns: 0.6 x 8% + 0.4 x 14% = 4.8% + 5.6% = 10.4%. The 11.0% option is the simple average of 8% and 14%, which ignores the unequal weights. The 9.6% option swaps the weights.
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