Question

Risk and return You are considering an investment in the stock market and have identified two potential stocks, they are Westpac Banking Corp. (ASX: WBC) and Singapore Airlines Ltd. (SGX: C6L). The historical prices for the past 10 years are shown in the table below.

Year	ASX:WBC	SGX:C6L
2011	23.70	13.82
2012	22.85	14.76
2013	21.01	11.1
2014	27.85	10.99
2015	30.85	11.03
2016	31.71	9.90
2017	30.96	11.31
2018	24.55	9.65

1. Which stocks would you prefer to own? Would everyone make the same choice? Explain your answer(s).

2. Calculate the correlation coefficient between the two stocks. Does it appear that a portfolio consisting of WBC and C6L would provide good diversification? Explain your answer(s).

3. Calculate the expected (annual) return if you owned a portfolio consisting of 50% in WBC and 50% in C6L. Would you prefer the portfolio to owning either of the stocks alone?

Answer 1

Year	ASX:WBC	SGX:C6L	Annual return (ASX:WBC)	Annual return (SGX:C6L)
(n)	r1	r2	(r1n/r1n-1)-1	(r2n/r2n-1)-1
2011	23.70	13.82
2012	22.85	14.76	-3.59%	6.80%
2013	21.01	11.10	-8.05%	-24.80%
2014	27.85	10.99	32.56%	-0.99%
2015	30.85	11.03	10.77%	0.36%
2016	31.71	9.90	2.79%	-10.24%
2017	30.96	11.31	-2.37%	14.24%
2018	24.55	9.65	-20.70%	-14.68%
Mean			1.63%	-4.19%

1). Given that the average return over the 8 years is negative for SGX, it would be preferable to own WBC stock as it is giving a positive average return. However, depending upon the duration of one's investment, some may prefer SGX over WBC.

2). Correlation coefficient is calculated as:

Applying the above formula, we have

0.043633/(0.167707*0.106283)^1/2 = 0.3268 (correlation coefficient)

The two stocks have a weak correlation with each other so investing in both can provide good diversification.

3). Using the average return over the 8 years, the portfolio return will be (50%*1.63%)+(50%*-4.19%) = -1.28%

If one is investing over the 8 year period then it would be preferable to invest in WBC alone as that will give higher average return.