Loan advice

To construct an efficient portfolio, the investor must be able to quantify risk and provide the necessary inputs. As will be explained in the next series of posts, there are three key inputs that are needed: future expected return (or simply expected return), variance of asset returns, and correlation (or covariance) of asset returns.
There are a wide range of approaches to obtain the expected return of assets. Investors can employ various analytical tools that will be discussed throughout this blog to derive the future expected return of an asset. For example, we will see that there are various asset pricing models that provide expected return estimates based on factors that historically have been found to systematically affect the return on all assets. Investors can use historical average returns as their estimate of future expected returns. Investors can modify historical average returns with their judgment of the future to obtain a future expected return. Another approach is for investors to simply use their intuition without any formal analysis to come up with the future expected return.
This input can be obtained for each asset by calculating the historical variance of asset returns. There are sophisticated time series statistical techniques that can be used to improve the estimated variance of asset returns. Some investors calculate the historical variance of asset returns and adjust them based on their intuition.
The covariance (or correlation) of returns is a measure of how the return of two assets vary together. Typically, investors use historical covariances of asset returns as an estimate of future covariances. But why is a covariance of asset returns needed? As will be explained, the covariance is important because the variance of a portfolio’s return depends on it and the key to diversification is the covariance of asset returns.