CO SCI 136 Lecture Notes - Lecture 25: Capital Asset Pricing Model, Expected Return, Weighted Arithmetic Mean
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11: optimal portfolio choice and the capital asset pricing model. We can describe a portfolio by its portfolio weights: the fraction of the total investment in the portfolio held in each individual investment in the portfolio. Portfolio weights add up to 1, represent the way we have divided our money between the different individual investments in the portfolio. Given portfolio weights, we can calculate the return on the portfolio. X1, ,xn are the portfolio weights of the n investments in a portfolio, these investments have returns, r1, ,rn. Then the return on the portfolio, rp, is the weighted average of the returns on the investments in the portfolio, where the weights correspond to portfolio weights. The expected return of a portfolio is simply the weighted average of the expected returns of the investments within it, using the portfolio weights. Combining risks: by combining stocks into a portfolio, we reduce risk through diversification.
