The Returns and Risks form Investing

Risk and Returns from Investing

 Function of both return and risk
 At the center of security analysis
 How should realized return and risk be
measured?
 The realized risk-return tradeoff is based on the
past
 The expected risk-return tradeoff is uncertain and
may not occur.
Sources of Investment Returns
 Investments provide two basic types of return:
 Income returns
 Periodic cash flows such as interest or dividends
(income return) also called “Yield”.
 Changes in price or value
 The owner of an investment receives the benefit of
increases in value and bears the risk for any decreases
in value.
 Total Return = Yield + Price Change
Income Returns
 Cash payments, usually
received regularly over
the life of the
investment.
 Examples: Coupon
interest payments from
bonds, Common and
preferred stock
dividend payments.
Returns From Changes in Value
 Investors also experience
capital gains or losses as
the value of their
investment changes over
time.
 For example, a stock may
pay a $1 dividend while its
value falls from $30 to $25
over the same time period.
Returns
 Dollar Returns
Dividends
 the sum of the cash received
and the change in value of the
asset, in dollars. Ending
market value

Time 0 1
•Relative Return
–the sum of the cash received and the
Initial change in value of the asset divided by
investment the original investment.
What is risk?
 Risk is the uncertainty associated with the return on
an investment.
 Risk can impact all components of return through:
 Fluctuations in income returns;
 Fluctuations in price changes of the investment;
 Fluctuations in reinvestment rates of return.
 Goal is to reduce risk without affecting returns
 Accomplished by building a portfolio
 Diversification is key
Sources of Risk
 Business Risk
 Uncertainty of income flows caused by the nature of a firm’s
business
 Sales volatility and operating leverage determine the level of
business risk.
 Financial Risk
 Uncertainty caused by the use of debt financing.
 Borrowing requires fixed payments which must be paid
ahead of payments to stockholders.
 The use of debt increases uncertainty of stockholder income
and causes an increase in the stock’s risk premium.
Sources of Risk
 Liquidity Risk
 Uncertainty is introduced by the secondary market for an
investment.
 How long will it take to convert an investment into cash?
 How certain is the price that will be received?

 Exchange Rate Risk

 Uncertainty of return is introduced by acquiring securities
denominated in a currency different from that of the investor.
 Changes in exchange rates affect the investors return when
converting an investment back into the “home” currency.
Sources of Risk
 Country Risk
 Political risk is the uncertainty of returns caused by the possibility of a
major change in the political or economic environment in a country.
 Individuals who invest in countries that have unstable political-economic
systems must include a country risk-premium when determining their
required rate of return.
 Interest Rate Risk
 Affects income return
 Market Risk
 Overall market effects
 Inflation Risk
 Purchasing power variability
Types of Risk
 Systematic (General) Risk Factors
 Affect many investment returns simultaneously; their
impact is pervasive.
 Examples: changes in interest rates and the state of the
macro-economy.
 Nonsystematic (Asset-specific) Risk Factors
 Affect only one or a small number of investment returns;
come from the characteristics of the specific investment.
 Examples: poor management, competitive pressures.
 Controllable through diversification

 Total Risk = General Risk + Specific Risk

Measuring Returns
 Dollar Returns
 How much money was made on an investment over some
period of time?
 Total Dollar Return = Income + Price Change
 Holding Period Return
 By dividing the ending value of an investment by the
Purchase value (or Beginning Price), we can better gauge
a return by incorporating the size of the investment made
in order to get the dollar return.
Holding Period Returns (HPR)
Ending Value of Investment
HPR 
Beginning Value of Investment
$220
  1.10
$200

Holding Period Yield (HPY) = HPR – 1

= 1.10 - 1 = 0.10 = 10%

Realized Compouned Yield (RCY) = [HPR]1/2 - 1

Total Returns
 For comparing performance over time or across
different securities.

 Total Return is a percentage relating all cash flows

received during a given time period, denoted by;
CFt +(PE - PB), to the start of period price, PB;

CFt  (PE  PB )
TR 
PB
Relative Returns
 Total Return can be either positive or negative
 When cumulating or compounding, negative
returns are problem
 A Return Relative solves the problem because
it is always positive;

CFt  PE
RR   1  TR
PB
Returns on International
Investments
 Returns on foreign investment generally
needs to be translated back into the home
country return.
 If the exchange rate has changed over the life
of the investment, the home country return
(HCR) can be very different than the foreign
return (FR).
Returns on International Investments
HCR Relative = FR Relative (Current Exchange
Rate/Initial Exchange Rate)

Current Exchange Rate - 1

HCR = (1+FR) Initial Exchange Rate
Measuring Historical Returns
 TR and RR are useful for a given, single time
period, however, we often want to calculate
some measure of the “average” return over
time on an investment.
 Two commonly used measures of average:
 Arithmetic Mean
 Geometric Mean
Arithmetic Mean Return
 The arithmetic mean is the “simple average” of a
series of returns.
 Calculated by summing all of the returns in the
series and dividing by the number of values.
RA = (TR)/n
 Oddly enough, earning the arithmetic mean return
for n years is not generally equivalent to the actual
amount of money earned by the investment over all
n time periods.
Arithmetic Mean Example
Year Total Return
1 10%
2 30%
3 -20%
4 0%
5 20%

RA = (TR)/n = 40/5 = 8%
Geometric Mean Return
 The geometric mean is the one return that, if
earned in each of the n years of an
investment’s life, gives the same total dollar
result as the actual investment.

 It is calculated as the nth root of the product of

all of the n return relatives of the investment.
 [(1+TR1)(1+TR2)(1+TR3)………..(1+TRn)]1/n - 1
Geometric Mean Returns Example
Year Total Return Relative Return
1 10% 1.10
2 30% 1.30
3 -20% 0.80
4 0% 1.00
5 20% 1.20
RG = [(1.10)(1.30)(.80)(1.00)(1.20)]1/5 – 1
RG = .0654 or 6.54%
Arithmetic vs. Geometric Returns
 Arithmetic mean does not measure the
compound growth rate over time
 Does not capture the realized change in wealth
over multiple periods
 Does capture typical return in a single period.

 Geometric mean reflects compound,

cumulative returns over more than one period.
Arithmetic vs. Geometric Returns
To ponder which is the superior measure, consider the
same example with a $1000 initial investment. How
much would be accumulated?
Year Holding Period Return Investment Value
1 10% $1,100
2 30% $1,430
3 -20% $1,144
4 0% $1,144
5 20% $1,373
Arithmetic vs. Geometric Returns
 How much would be accumulated if you earned the
arithmetic mean over the same time period?
Value = $1,000 (1.08)5 = $1,469

 How much would be accumulated if you earned the

geometric mean over the same time period?
Value = $1,000 (1.0654)5 = $1,373

 Notice that only the geometric mean gives the same

return as the underlying series of returns.
Adjusting Returns for Inflation
 Returns measures are not adjusted for inflation
 Purchasing power of investment may change over
time
 Consumer Price Index (CPI) is possible measure
of inflation.

TRIA 
1  TR  1
1  CPI 
Annualized Returns
Annualized HPR = (1 + HPR)1/n – 1

Annualized HPR = (Return Relative)1/n – 1

 With returns computed on an annualized

basis, they are now comparable with all other
annualized returns.
How can we measure risk?
 Since risk is related to variability and uncertainty,
we can use measures of variability to assess risk.
 The variance and its positive square root, the
standard deviation, are such measures.
 Measure “total risk” of an investment, the combined
effects of systematic and asset-specific risk factors.
 Variance of Historic Returns
2 = [(Rt-RA)2]/n-1
Standard Deviation of Historic Returns
Year Total Return
1 10% RA = 8%
2 30% 2 = 370
3 -20%  = 19.2%
4 0%
5 20%

2 = [(10-8)2+(30-8)2+(-20-8)2+(0-8)2+(20-8)2]/4
= [4+484+784+64+144]/4
= [1480]/4
Coefficient of Variation
 The coefficient of variation is the ratio of the
standard deviation divided by the return on the
investment; it is a measure of risk per unit of return.
CV = /RA
 The higher the coefficient of variation, the riskier the
investment.
 From the previous example, the coefficient of
variation would be:
CV =19.2% / 8% = 2.40
A Portfolio of Investments
 The mean historical rate of return for a
portfolio of investments is measured as the
weighted average of the HPYs for the
individual investments in the portfolio.
 A Portfolio of Investments
# Begin Beginning Ending Ending Market Wtd.
Stock Shares Price Mkt. Value Price Mkt. Value HPR HPY Wt. HPY
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 20% 0.05 0.010
B 200,000 $ 20 $ 4,000,000 $ 21 $ 4,200,000 1.05 5% 0.20 0.010
C 500,000 $ 30 $ 15,000,000 $ 33 $ 16,500,000 1.10 10% 0.75 0.075
Total $ 20,000,000 $ 21,900,000 0.095

$ 21,900,000
HPR = = 1.095
$ 20,000,000

HPY = 1.095 -1 = 0.095

= 9.5%
Scenario Analysis
 While historic returns, or past realized returns, are
important, investment decisions are inherently
forward-looking.
 We often employ scenario or “what if?” analysis in
order to make better decisions, given the uncertain
future.
 Scenario analysis involves looking at different
outcomes for returns along with their associated
probabilities of occurrence.
Risk Premiums
 Premium is additional return earned or
expected for additional risk
 Calculated for any two asset classes
 Equity risk premium is the difference between
stock and risk-free returns
 Bond horizon premium is the difference
between long- and short-term government
securities
Risk Premiums
 Equity Risk Premium, ERP, =


 1  TRCS  
1


 1  RF  

Bond Horizon Premium, BHP, =
 


 1  TRGB 



1  TR 
TB 
1
Expected Rates of Return
 Expected rates of return are calculated by
determining the possible returns (R i) for some
investment in the future, and weighting each
possible return by its own probability (P i).
E(R) = Pri Ri
Expected Return Example
Economic Conditions Probability Return
Strong .20 40%
Average .50 12%
Weak .30 -20%

E(R) = .20(40%) + .50 (12%) + .30 (-20%)

E(R) = 8%
Standard Deviation of Expected Returns
Economic Conditions Probability Return
Strong .20 40%
Average .50 12%
Weak .30 -20%
E(R) = 8%
2 = .20 (40-8)2 +.50 (12-8)2 + .30 (-20-8)2
2 = 448
 = 21.2% Note: CV = 21.2%/8% = 2.65
Portfolio Expected Returns
 Weighted average of the individual security
expected returns
 Each portfolio asset has a weight, w, which
represents the percent of the total portfolio
value
n
E(R p )   w iE(Ri )
i1
Portfolio Risk
 Portfolio risk not simply the sum of individual
security risks
 Emphasis on the risk of the entire portfolio
and not on risk of individual securities in the
portfolio
 Individual stocks are risky only if they add
risk to the total portfolio
Portfolio Risk
 Measured by the variance or standard deviation
of the portfolio’s return
 Portfolio risk is not a weighted average of the risk
of the individual securities in the portfolio

n
   wi
2
p i
2

i 1
Risk Reduction in Portfolios
 Assume all risk sources for a portfolio of
securities are independent
 The larger the number of securities the
smaller the exposure to any particular risk
 “Insurance principle”
 Only issue is how many securities to hold
Risk Reduction in Portfolios
 Random diversification
 Diversifying without looking at relevant
investment characteristics
 Marginal risk reduction gets smaller and smaller
as more securities are added
 A large number of securities is not required
for significant risk reduction
 International diversification benefits
Portfolio Risk and Diversification
p %
35 Portfolio risk

20
Market Risk
0
10 20 30 40 ...... 100+
Number of securities in portfolio
Modern Portfolio Theory (MPT)
 Also know as Markowitz portfolio theory (Harry
Markowitz 1952)
 Derives the expected rate of return for a portfolio of
assets and an expected risk measure
 Markowitz demonstrated that the variance of the rate
of return is a meaningful measure of portfolio risk
under reasonable assumptions
 Portfolio risk is not simply a weighted average of
individual security risk, rather, interrelationships
among the securities must be considered while
calculating portfolio risk.
Modern Portfolio Theory (MPT)
 Before calculating the portfolio variance and
standard deviation, several other measures
need to be understood:
 Covariance
 Measures the extent to which two variables move
together
 For two assets, i and j, the covariance of rates of
return is defined as:
Covij or (ij)= ijij
Modern Portfolio Theory (MPT)
 Correlation coefficient (
 Values of the correlation coefficient (r) go from
-1 to +1
 Standardized measure of the linear relationship
between two variables
 ij = +1.0 = perfect positive correlation
 ij = -1.0 = perfect negative (inverse) correlation
 ij = 0.0 = zero correlation
Calculating Portfolio Risk
 Needed to calculate risk of a portfolio:
 Weighted individual security risks
 Calculated by a weighted variance using the
proportion of funds in each security
 For security i: (wi  i)2
 Weighted comovements between returns
 Return covariances are weighted using the proportion
of funds in each security
 For securities i, j: 2wiwj  ij
Calculating Portfolio Risk
n n n
 port   w    w w Cov
i 1
2
i i
2

i 1 i 1
i j ij

where :
 port  the standard deviation of the portfolio
Wi  the weights of the individual assets in the portfolio, where
weights are determined by the proportion of value in the portfolio
 i2  the variance of rates of return for asset i
Cov ij  the covariance between the rates of return for assets i and j,
where Cov ij  rij i j
Calculating Portfolio Risk
 Encompasses three factors
 Variance (risk) of each security
 Covariance between each pair of securities
 Portfolio weights for each security

 Goal: select weights to determine the minimum

variance combination for a given level of expected
return
Implications for Portfolio Formation
 Assets differ in terms of expected rates of
return, standard deviations, and correlations
with one another
 While portfolios give average returns, they give
lower risk
 Diversification works!
 Even for assets that are positively correlated,
the portfolio standard deviation tends to fall
as assets are added to the portfolio
Implications for Portfolio Formation
 Combining assets together with low
correlations reduces portfolio risk more
 The lower the correlation, the lower the portfolio
standard deviation
 Negative correlation reduces portfolio risk greatly
 Combining two assets with perfect negative
correlation reduces the portfolio standard
deviation to nearly zero
An Efficient Portfolio
 Smallest portfolio risk for a given level of
expected return
 Largest expected return for a given level of
portfolio risk
 From the set of all possible portfolios
 Only locate and analyze the subset known as the
efficient set
 Lowest risk for given level of return
Efficient Portfolios
 Efficient frontier or Efficient set (curved line from A to B)
 Global minimum variance portfolio (represented by point A)
 Any portfolio that plots “inside” the efficient frontier (such as
point C) is dominated by other portfolios
 For example, Portfolio A gives the same expected return with lower
risk, and Portfolio B gives greater expected return with the same risk

B
x
E(R)
A

y C
Risk = 
The Efficient Frontier and Investor
Utility
 The optimal portfolio has the highest utility for a given
investor
 It lies at the point of tangency between the efficient frontier
and the utility curve with the highest possible utility
E(R port )
U3’
U2’
U1’

Y
U X
3 U
U
2
1 E( port )
The Efficient Frontier and Investor
Utility
 A relatively more conservative investor would
perhaps choose Portfolio X
 On the efficient frontier and on the highest
attainable utility curve
 A relatively more aggressive investor would
perhaps choose Portfolio Y
 On the efficient frontier and on the highest
attainable utility curve