With regards to portfolio diversification decisions, the correlation coefficient is comparatively more important since in order to maximise the diversification benefits, it is essential that the positive correlation between the stocks should be minimal. It would be still preferable if stocks with negative correlation can be used for formation of portfolio. Covariance on the other hand reflects the product of correlation coefficient with the respective standard deviation of both stock returns. As a result, the information about the magnitude of the correlation coefficient is hidden to some extent. Hence, correlation coefficient is more preferred (Damodaran, 2014).
In order to choose the appropriate two stocks, the correlation between the two chosen stock should be negative or if positive should have the least magnitude so as to allow maximisation of the diversification benefits (Petty et. al., 2015). Based on the correlation matrix highlighted above, it is apparent that the two shares that would be selected are CSL Ltd and JB Hi Fi Ltd. Assume that 40% is invested in JB Hi Fi and remaining 60% of the money is invested in CSL Ltd.
Based on the monthly returns of the two stocks, the mean and standard deviation is as highlighted below.
σp = √ (0.42*0.08912 + 0.62*0.05162 + 2*0.4*0.6*0.18*0.0891*0.0516) = 0.0512 or 5,12%
The beta can be computed by the following formula (Brealey, Myers, and Allen, 2015).
Here, ri is the return on the concerned stock for whom beta has to be computed while rm is the return on the market index.
Using the data provided, the above computation has been performed in the attached excel and the value of the beta of two individual stocks have come out as follows.
Beta of portfolio = 0.4*0.94 + 0.6*0.89 = 0.91
Hence, from the above computations, it can be concluded that the beta of the portfolio is 0.91. Considering that the beta of the individual companies and also the portfolio is lower than 1, hence, it can be concluded that the individual companies and also the portfolio are all defensive in nature since the underlying risk is lesser than the market which has a beta of 1 (Damodaran, 2014).
Brealey, R. A., Myers, S. C., and Allen, F. (2015) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.
Damodaran, A. (2014). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.
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