VALUATON. Which bank? Part 4. And how to choose your bank for trading and investment (2) – diversification versus risk
The formula for measuring an unbiased estimate of the population variance from a fixed sample of n observations is the following: (s2) = Σ [(xi – x̅)2]/n-1
Here’s what the parts of the formula for calculating variance mean: s2 = Variance Σ = Summation, which means the sum of every term in the equation after the summation sign. xi = Sample observation. This represents every term in the set .x̅ = The mean. This represents the average of all the numbers in the set .n = The sample size. You can think of this as the number of terms in the set
Standard deviation: square root of variance: 4.32
We know that most investors and traders are risk averse and attempt to optimise their yield on their investments and reduce their risk (variance).
We also know that diversification can reduce the risk, provided the percentage placed on each stock is appropriately spread.
So assuming we want to trade into the financial sector, we may choose two or more stocks within that sector.
The art now is to determine the risk (variance) of each stock and the proportion (in capital) that we put into each stock. Then we work out the expected return and variance of the new combined portfolio (consisting of two or much more stocks):
Expected return of the portfolio: x1 E1 + x2E2+…
Where xi is the proportion of capital invested in stock i
Where Ei is the expected return in stock i
The variance of the new combined portfolio is: