Risk and Return Analysis: Correlation, Beta, and Portfolio Returns

This report analyzes the concepts of risk and return in finance, emphasizing the importance of portfolio diversification to minimize risk and maximize returns. It discusses the correlation between stocks, highlighting how negatively correlated stocks can reduce overall portfolio risk. The report examines the role of beta in measuring stock volatility relative to market movements, illustrating how stocks with negative betas can perform well during market downturns. The analysis includes specific examples of News Media and HR Resources stocks, demonstrating how their negative correlation and different betas contribute to a diversified portfolio. The report concludes that a diversified portfolio, consisting of negatively correlated stocks, can effectively mitigate losses and provide stable returns. The bibliography includes references to relevant literature on investment and market risk.

Risk and Return

Risk and return are two primary functions in finance. As the risk increases, the investors
require an increase in the return through an added premium for undertaking the additional
risk (Pollet & Wilson, 2007). For forming a portfolio which maximises the returns and
minimizes the risk, it is important to consider the correlation between stocks present in the
portfolio. Correlation is relationship between two asset prices. Two stocks are said to be
positively correlated if the prices of the stocks move in the same direction and vice versa. In a
diversified portfolio, the stocks will be negatively correlated and a low correlation brings
diversification.
The beta of a stock measures the volatility of the stock returns with that of the market. Beta
more than 1 means stock highly volatile and if the market return goes up, the stock return
increases more than the market returns (Solutions). Correlation and beta are not the same
rather correlation measures the strength of the consistency of the volatility measured by beta
(Apt, 2014)
The stocks of News Media and HR Resources have a negative covariance which means that
when the returns on one of the above stocks are high, the returns of the other stock would be
low. Correlation measures how strongly the stocks move in relation to each other. Both the
above stocks have a correlation of -0.47 which means that when stock prices of one stock
increases, the stock prices of other stock decreases by 47%. We see the portfolio standard
deviation is 0.04 which means the portfolio is well diversified as both the stocks in the
portfolio are negatively correlated. New Media has a beta of -1.3 which means that when the
market returns increase by 1%, the returns of New Media decreases by 1.3% and the beta of
HR Resources is 2.5 which means that when the market returns increases by 1%, the returns
of this stock increase by 2.5%. We see that both stocks have beta of more than 1. This shows
higher volatility of the stocks to the market returns. This even strengthens the correlation
coefficient between the stocks as higher volatility means the stocks move vigorously in
opposite directions, thus diversifying the portfolio. A diversified portfolio offers higher
returns and lower risk as the risk is diversified by the negatively correlated stocks. When
market returns decrease, the returns of New Media will increase by more than 1.2% as
compared to the market because the stock has a negative beta and the returns of HR
Resources will decrease by 2.5%. In case of individual stocks, the investor of HR Resources
would have incurred losses, however since the investor has a portfolio consisting of both
negatively correlated stocks, he has been able to minimise his losses by making profits on

News Media stocks, thus we can say the portfolio is properly diversified to minimize risks
and maximise returns.
Bibliography
Apt, A. (2014). The Alpha and Beta of Investing. Advisor Perspectives , Inc.
Pollet, J., & Wilson, M. (2007). Average Correlation and Stock Market Returns.
Solutions, I. (n.d.). Understanding Beta and Market Risk. Retrieved September 10, 2017, from
Investor Solutions: http://investorsolutions.com/knowledge-center/investment-articles/
understanding-beta-and-market-risk/