Chapter

Risk, Return and

5 the Historical
Record

Bodie, Kane, and Marcus

Essentials of
Investments
12th Edition
 5.1 Rates of Return

• Holding-Period Return (HPR)

• Rate of return over given investment period

PEnding  PBeginning  DivCash

HPR 
PBeginning

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 5.1 Rates of Return: Example
• What is the HPR for a share of stock that was
purchase for $25, sold for $27 and distributed
$1.25 in dividends?

$27.00 – $25.00  $1.25

HPR   0.13  13.00%
$25.00

• The HPR is the sum of the dividend yield plus the

capital gains yield

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 5.1 Rates of Return: Measuring over Multiple Periods
• Arithmetic average
• Sum of returns in each period divided by
number of periods
• Geometric average
• Single per-period return
• Gives same cumulative performance as
sequence of actual returns
• Dollar-weighted average return
• Internal rate of return on investment

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 Table 5.1 Annual Cash Flows & Rates of Return of a
Mutual Fund

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 5.1 Rates of Return: Measuring over Multiple Periods

• Arithmetic average: The sum of the returns

divided by the number of years.
r1  r2  ...  rn
rArithmetic 
n
10  25  20  20
  .0875  8.75%
4

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 5.1 Rates of Return: Measuring over Multiple Periods
• Geometric average: Single period return that gives
the same cumulative performance as the sequence
of actual returns

rGeometric  [(1  r1 )  (1  r2 )  ...  (1  rn )]1/ n  1

 1.10 1.25  .80 1.20   1  0.0719  7.19%
1/4

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 5.1 Rates of Return
• Dollar-weighted average return
• The internal rate of return on an investment

• Annualizing Rates of Return

• APR = Annual Percentage Rate
• Per-period rate × Periods per year
• Ignores Compounding

• EAR = Effective Annual Rate

• Actual rate an investment grows
• Does not ignore compounding

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 5.1 Rates of Return: EAR vs. APR

n-Periods of Compounding: Continuous Compounding:

 APR 
n
EAR  e APR  1
EAR  1   1
 n 

APR  [( EAR  1)1/ n  1]  n APR  ln( EAR  1)

where
n  compounding per period

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5.2 Inflation and The Real Rates of Interest
• Nominal Interest and Real Interest
1  rNom
1  rReal 
1 i
where
rReal  Real Interest Rate
rNom  Nominal Interest Rate
i  Inflation Rate

• Example: What is the real return on an investment that

earns a nominal 10% return during a period of 5% inflation?
1  .10
1  rReal   1.048
1  .05
r  .048 or 4.8%

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5.2 Inflation and The Real Rate of Interest

• Equilibrium Nominal Rate of Interest

• Fisher Equation (5.9)

rNom  rReal  E (i )

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 5.2 Inflation and The Real Rate of Interest

• U.S. History of Interest Rates, Inflation, and

Real Interest Rates
• Since the 1950s, nominal rates have increased
roughly in tandem with inflation
• 1930s/1940s: Volatile inflation affects real rates
of return
• Figure 5.1

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Figure 5.1 Inflation and Interest rates (1927-2018)

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 5.3 Risk and Risk Premiums
• Scenario Analysis and Probability Distributions
• Scenario analysis: Possible economic scenarios;
specify likelihood and HPR
• Probability distribution: Possible outcomes with
probabilities
• Expected return: Mean value
• Variance: Expected value of squared deviation from
mean
• Standard deviation: Square root of variance

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 Spreadsheet 5.1 Scenario Analysis for a Stock Index Fund

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 5.3 Risk and Risk Premiums
• The Normal Distribution

• Transform normally distributed return into

standard deviation score:

• Original return, given standard normal return:

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 Figure 5.3 Normal Distribution r = 10% and σ = 20%

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 5.3 Risk and Risk Premiums

• Normality over Time

• When returns over very short time periods are
normally distributed, HPRs up to 1 month can be
treated as normal
• Use continuously compounded rates where
normality plays crucial role

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 5.3 Risk and Risk Premiums: Value at Risk

• Value at risk (VaR):

• Measure of downside risk
• Worst loss with given probability, usually 1% or
5%

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 5.3 Risk and Risk Premiums
• Deviation from Normality and Value at Risk
• Kurtosis: Measure of fatness of tails of probability
distribution; indicates likelihood of extreme
outcomes
• Skew: Measure of asymmetry of probability
distribution
• The Sharpe (Reward-to-Volatility) Ratio
• Ratio of portfolio risk premium to standard
deviation

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 5.3 Risk and Risk Premiums
• Risk Premiums and Risk Aversion
• Risk-free rate: Rate of return that can be earned
with certainty
• Risk premium: Expected return in excess of that
on risk-free securities
• Excess return: Rate of return in excess of risk-
free rate
• Risk aversion: Reluctance to accept risk
• Price of risk: Ratio of risk premium to variance

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 5.3 Risk and Risk Premiums
• Mean-Variance Analysis
• Ranking portfolios by Sharpe ratios

Portfolio Risk Premium E (rp )  rf

SP 
Standard Deviation of Excess Returns P
where
E (rp )  Expected Return of the portfolio
rf  Risk Free rate of return
 P  Standard Deviation of portfolio excess return

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 5.4 The Historical Record
• Using Time Series of Return
• Scenario analysis derived from sample history of returns
• Variance and standard deviation estimates from time
series of returns:
1
   rt  rt 
2
Var (rt ) 
n 1

SD(rt )  Var (rt )

1
rt   rt
n
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 5.4 The Historical Record: World Portfolios
• World Large stocks: 24 developed countries,
~6000 stocks
• U.S. large stocks: Standard & Poor's 500 largest
cap
• U.S. small stocks: Smallest 20% on NYSE,
NASDAQ, and Amex
• World bonds: Same countries as World Large
stocks
• U.S. Treasury bonds: Barclay's Long-Term
Treasury Bond Index

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 Table 5.3: Historical Return and Risk

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 Figure 5.4: Treasury Bills

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 Figure 5.4: 30-year Treasury Bonds

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 Figure 5.4: Common Stocks

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 5.5 Asset Allocation across Portfolios
• Asset Allocation
• Portfolio choice among broad investment
classes
• Complete Portfolio
• Entire portfolio, including risky and risk-free
assets
• Capital Allocation
• Choice between risky and risk-free assets

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 5.5 Asset Allocation across Portfolios

• The Risk-Free Asset

• Treasury bonds (still affected by inflation)
• Price-indexed government bonds
• Money market instruments effectively risk-free
• Risk of CDs and commercial paper is miniscule
compared to most assets

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 5.5 Portfolio Asset Allocation: Expected Return and Risk

Expected Return of the Complete Portfolio

E (rC )  y  E (rp )  (1  y)  r f
where E (rC )  Expected Return of the complete portfolio
E (rp )  Expected Return of the risky portfolio
rf  Return of the risk free asset
y  Percentage assets in the risky portfolio

Standard Deviation of the Complete Portfolio

 C  y  p
where  C  Standard deviation of the complete portfolio
 P  Standard deviation of the risky portfolio

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Figure 5.7 Investment Opportunity Set

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 5.5 Asset Allocation across Portfolios
• Capital Allocation Line (CAL)
• Plot of risk-return combinations available by
varying allocation between risky and risk-free

• Risk Aversion and Capital Allocation

• y: Preferred capital allocation
Available risk premium to variance ratio
y
Required risk premium to variance ratio
[ E (rP )  rf ] /  P2 [ E (rP )  rf ]
 
A A P2
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 5.6 Passive Strategies and the Capital Market Line

• Passive Strategy
• Investment policy that avoids security analysis

• Capital Market Line (CML)

• Capital allocation line using market-index
portfolio as risky asset

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Table 5.5: Excess Returns Statistics for the Market Index

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5.6 Passive Strategies and the Capital Market Line

• Cost and Benefits of Passive Investing

• Passive investing is inexpensive and simple
• Expense ratio of active mutual fund averages 1%
• Expense ratio of hedge fund averages 1%-2%,
plus 10% of returns above risk-free rate
• Active management offers potential for higher
returns

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