Data-Driven Business Decisions

CHAPTER 13

Using the Relationship between Shares to Build a Portfolio

13.0. Introduction: What Is the Issue?

What is the relationship between the current 10-year bond interest rate and the level of the national stock market index? Most people know that the relation is negative—when one goes up the other tends to go down. I need to decide how much of my assets to put in stocks and how much to put in bonds. Even though stocks usually give a better average return than bonds, I want to reduce my risk by investing in both. How much will I reduce my risk and how should I allocate my money? To answer this you need to know more about the relationship of stock and bond prices than that they are negatively related. You need a numerical measure of the relationship, of the extent to which one variable varies with the other.

Most business problems require an understanding between the relationships of the main driving variables. Indeed, this will be the main topic for the rest of the book—understanding, measuring, and appreciating the implications of the relationships between business variables.

This chapter serves as a nice entry into this general area. It also covers some financial concepts and some applications of the mean and standard deviation in the context of finance. The new element will be how to measure the relationship between the returns on two financial assets, using correlation. This allows us to construct a financial portfolio. Correlation is used much more widely than in finance, ...