The Returns and Risks

from Investing
FIN221: Lecture 3 Notes

Chapters 6 and 7 Chapter 6

Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University

Asset Valuation Return Components

Function of both return and risk Returns consist of two elements:
At the center of security analysis Periodic cash flows such as interest or
How should realized return and risk be dividends (income return)
Yield measures relate income return to a price for
measured? the security
The realized risk-return tradeoff is based on Price appreciation or depreciation (capital
the past gain or loss)
The expected risk-return tradeoff is uncertain The change in price of the asset
and may not occur
Total Return =Yield +Price Change

Risk Sources Risk Types

Interest Rate Risk
Affects income return
Financial Risk Two general types:
Tied to debt financing Systematic (general) risk
Market Risk
Overall market effects Liquidity Risk Pervasive, affecting all securities, cannot be
Inflation Risk Marketability with-out avoided
Purchasing power sale prices Interest rate or market or inflation risks
variability
Exchange Rate Risk Nonsystematic (specific) risk
Business Risk
Country Risk Unique characteristics specific to issuer
Political stability Total Risk =General Risk +Specific Risk

1
 Measuring Returns Measuring Returns
For comparing performance over time or Total Return can be either positive or
across different securities negative
Total Return is a percentage relating all When cumulating or compounding, negative
cash flows received during a given time returns are problem
period, denoted CFt +(PE - PB), to the A Return Relative solves the problem
start of period price, PB because it is always positive
CFt + (PE PB ) CFt + PE
TR = RR = = 1 + TR
PB PB

Measuring Returns Measuring International Returns

To measure the level of wealth created by International returns include any realized
an investment rather than the change in exchange rate changes
wealth, need to cumulate returns over time If foreign currency depreciates, returns lower
Cumulative Wealth Index, CWIn, over n in domestic currency terms
periods, = Total Return in domestic currency =

End Val. of For.Curr.

WI (1 + TR )(1 + TR )...( 1 + TR ) RR Begin Val. of For.Curr. 1
0 1 2 n

Measures Describing a Return

Arithmetic Versus Geometric
Series
TR, RR, and CWI are useful for a given, Arithmetic mean does not measure the
single time period compound growth rate over time
W hat about summarizing returns over Does not capture the realized change in
several time periods? wealth over multiple periods
Does capture typical return in a single period
Arithmetic mean, or simply mean,
Geometric mean reflects compound,
X=
X cumulative returns over more than one
n period

2
 Geometric Mean Adjusting Returns for Inflation
Defined as the n-th root of the product of n Returns measures are not adjusted for
return relatives minus one or G = inflation
[(1 + TR 1)(1 + TR 2 )...( 1 + TR n )]1/ n 1 Purchasing power of investment may change
over time
Difference between Geometric mean and
Consumer Price Index (CPI) is possible
Arithmetic mean depends on the variability
measure of inflation
of returns, s
(1 + TR )
(1 + G )2 (1 + X )2 s2 TR IA = 1
(1 + CPI)

Measuring Risk Risk Premiums

Risk is the chance that the actual outcome Premium is additional return earned or
is different than the expected outcome expected for additional risk
Standard Deviation measures the Calculated for any two asset classes
deviation of returns from the mean Equity risk premium is the difference
between stock and risk-free returns

( X X)
1/2 Bond horizon premium is the difference

2

s =

between long- and short-term government
n1 securities

Risk Premiums The Risk-Return Record

Equity Risk Premium, ERP, = Since 1925, cumulative wealth indexes
(
1 + TR CS ) show stock returns dominate bond returns
(1 + RF ) 1 Stock standard deviations also exceed bond
standard deviations
Annual geometric mean return for the S&P
Bond Horizon Premium, BHP, = 500 is 10.3% with standard deviation of
(
1 + TR GB ) 20.5%

1 + TR( 1
TB )

3
 Copyright 2002 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
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is unlawful. Request for further information should be
Expected Return and Risk
addressed to the Permissions Department, John Wiley &
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Chapter 7
his/her own use only and not for distribution or resale. The
Charles P. Jones, Investments: Analysis and Management,
Publisher assumes no responsibility for errors, omissions, or Eighth Edition, John Wiley & Sons
damages, caused by use of these programs or from the use Prepared by
of the information contained herein. G.D. Koppenhaver, Iowa State University

Investment Decisions Dealing With Uncertainty

Involve uncertainty Risk that an expected return will not be
Focus on expected returns realized
Estimates of future returns needed to Investors must think about return
consider and manage risk distributions, not just a single return
Goal is to reduce risk without affecting Probabilities weight outcomes
returns Should be assigned to each possible outcome
Accomplished by building a portfolio to create a distribution
Diversification is key Can be discrete or continuous

Calculating Expected Return Calculating Risk

Expected value Variance and standard deviation used to
The single most likely outcome from a quantify and measure risk
particular probability distribution Measures the spread in the probability
The weighted average of all possible return distribution
outcomes Variance of returns: s = ( Ri - E(R))pri
Referred to as an ex ante or expected return Standard deviation of returns:
m
s =(s ) 1/2
E (R) = R ipri Ex ante rather than ex post s relevant
i=1

4
 Portfolio Expected Return Portfolio Risk
Weighted average of the individual Portfolio risk not simply the sum of
security expected returns individual security risks
Each portfolio asset has a weight, w, which Emphasis on the risk of the entire portfolio
represents the percent of the total portfolio and not on risk of individual securities in
value
the portfolio
n
Individual stocks are risky only if they add
E (Rp ) = w iE(Ri ) risk to the total portfolio
i=1

Portfolio Risk Risk Reduction in Portfolios

Measured by the variance or standard Assume all risk sources for a portfolio of
deviation of the portfolios return securities are independent
Portfolio risk is not a weighted average of the The larger the number of securities the
risk of the individual securities in the portfolio smaller the exposure to any particular risk
Insurance principle
Only issue is how many securities to hold
n
p2 wi i2
i=1

Risk Reduction in Portfolios Portfolio Risk and Diversification

Random diversification p %
Diversifying without looking at relevant
35 Portfolio risk
investment characteristics
Marginal risk reduction gets smaller and
smaller as more securities are added
20
A large number of securities is not Market Risk
required for significant risk reduction
0
International diversification benefits 10 20 30 40 ...... 100+
Number of securities in portfolio

5
 Measuring Comovements in
Markowitz Diversification
Security Returns
Non-random diversification Needed to calculate risk of a portfolio:
Active measurement and management of Weighted individual security risks
portfolio risk Calculated by a weighted variance using the
Investigate relationships between portfolio proportion of funds in each security
securities before making a decision to invest For security i: (wi i)2
Takes advantage of expected return and risk Weighted comovements between returns
for individual securities and how security Return covariancesare weighted using the
returns move together proportion of funds in each security
For securities i, j: 2wiwj ij

Correlation Coefficient Correlation

Correlation Coefficient
Coefficient
Statistical measure of association When does diversification pay?
mn = correlation coefficient between With perfectly positive correlated securities?
securities m and n Risk is a weighted average, therefore there is no
risk reduction
mn = +1.0 = perfect positive correlation
With zero correlation correlation securities?
mn = -1.0 = perfect negative (inverse)
With perfectly negative correlated securities?
correlation
mn = 0.0 = zero correlation

Covariance Calculating Portfolio Risk

Absolute measure of association Encompasses three factors
Not limited to values between -1 and +1 Variance (risk) of each security
Sign interpreted the same as correlation Covariance between each pair of securities
Correlation coefficient and covariance are Portfolio weights for each security
related by the following equations: Goal: select weights to determine the
m minimum variance combination for a given
AB = [ R A ,i E(R A )][R B ,i E(R B )]pri
i= 1 level of expected return
AB = AB A B

6
 Simplifying Markowitz
Calculating Portfolio Risk
Calculations
Generalizations Markowitz full-covariance model
the smaller the positive correlation between Requires a covariance between the returns of
securities, the better all securities in order to calculate portfolio
Covariance calculations grow quickly variance
n(n-1) for n securities n(n-1)/2 set of covariances for n securities
As the number of securities increases: Markowitz suggests using an index to
The importance of covariance relationships which all securities are related to simplify
increases
The importance of each individual securitys risk
decreases

An Efficient Portfolio An Efficient Portfolio

An Efficient Portfolio An Efficient Portfolio
Smallest portfolio risk for a given level of All other portfolios in attainable set are
expected return dominated by efficient set
Largest expected return for a given level of Global minimum variance portfolio
portfolio risk Smallest risk of the efficient set of portfolios
From the set of all possible portfolios Efficient set
Only locate and analyze the subset known as Part of the efficient frontier with greater risk
the efficient set than the global minimum variance portfolio
Lowest risk for given level of return

Efficient Portfolios Nonsystematic Risk

Efficient Portfolios Nonsystematic Risk
Variability of a securitys total return not
Efficient frontier related to general market variability
B or Efficient set Diversification decreases this risk
x
(curved line from The relevant risk of an individual stock is
E(R) A A to B) its contribution to the riskiness of a well-
y Global minimum diversified portfolio
C variance portfolio Portfolios rather than individual assets most
Risk =
(represented by important
point A)

7
Portfolio Risk and Diversification Capital Asset Pricing Model
p % Total risk Focus on the equilibrium relationship
between the risk and expected return on
35
Diversifiable risky assets
Risk Builds on Markowitz portfolio theory
20 Each investor is assumed to diversify his
Systematic Risk or her portfolio according to the Markowitz
0
model
10 20 30 40 ...... 100+
Number of securities in portfolio

Security Market Line Security Market Line

A securitys contribution to the risk of the Beta = 1.0 implies
SML as risky as market
market portfolio is based on beta E(R)
Securities A and B
Equation for expected return for an A are more risky than
individual stock kM B the market
C
k RF Beta >1.0

E ( Ri ) = RF + i [E ( RM ) RF ]
Security C is less
risky than the
0 0.5 1.0 1.5 2.0 market
Beta M
Beta <1.0

Security Market Line

Beta measures systematic risk
Measures relative risk compared to the
market portfolio of all stocks
Volatility different than market
All securities should lie on the SML
The expected return on the security should be
only that return needed to compensate for
systematic risk