Risk and return – Stocks vs.

Bonds

1
Investment management process

2
Returns
Holding-period return Real vs. nominal returns
𝑃𝑃𝑡𝑡+1 + 𝐷𝐷𝑡𝑡+1 1 + 𝑅𝑅𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛
𝑅𝑅𝑡𝑡+1 = −1 1 + 𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 =
𝑃𝑃𝑡𝑡 1 + 𝐼𝐼𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛
𝐷𝐷𝑡𝑡+1 𝑃𝑃𝑡𝑡+1 − 𝑃𝑃𝑡𝑡
= +
𝑃𝑃𝑡𝑡 𝑃𝑃𝑡𝑡 𝑅𝑅𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 ≈ 𝑅𝑅𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 − 𝐼𝐼𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛
= income yield + capital gain/loss

where
𝑃𝑃𝑡𝑡 : price today
𝑃𝑃𝑡𝑡+1 : price tomorrow
𝐷𝐷𝑡𝑡+1 : dividend tomorrow

Stocks and Bonds 3

Risk
Summarize risk through standard deviation, 𝜎𝜎, as a measure
of dispersion

If 𝑅𝑅1 , 𝑅𝑅2 , … , 𝑅𝑅𝑇𝑇 are returns

𝑇𝑇
1 2
𝜎𝜎 = � 𝑅𝑅𝑡𝑡 − 𝑅𝑅�
𝑇𝑇
𝑡𝑡=1

Stocks and Bonds 4

S&P 500 over 1926 to 2023
Mean = 11.9%, StDev = 19.3%
Standard deviation gives an idea of the range of possibilities
There is roughly 2/3rd chance that the return will be in the range
[Mean−StDev Mean+StDev]=[−7.4% 31.3%]

5
U.S. historical record
Over 1926-2023
Corporate Government
Stocks Bonds Bonds T-Bills Inflation
Mean 11.9% 6.2% 5.8% 3.4% 3.0%
StDev 19.3% 8.8% 9.8% 3.1% 3.9%

Stocks and Bonds 6

Risk and return

Stocks and Bonds 7

Stocks or bonds – Nominal growth

Note the log scale

Stocks and Bonds 8

Stocks or bonds – Real growth

Note the log scale

Stocks and Bonds 9

Risk (1) – Value of $1 in one year
If history repeats itself

Stocks and Bonds 10

Risk (2) – Chances of losing money
Volatility gives you an idea of what is the chance that you will
lose next year

 If (stock) return has mean of 10% and volatility of 20%, there is a

31% chance that your return next year will be negative
 If (bond) return has mean of 6% and volatility of 10%, there is a
27% chance that you will be in the red next year
 If (T-bill) return has mean of 3% and volatility of 3%, there is a 16%
chance that you will be in the red next year

Stocks and Bonds 11

Risk (2) – Long vs. recent history
1926-2023 2000-2023

Stocks and Bonds 12

Risk (4) – What is it?
Aggregate stock market

Stocks and Bonds 13

U.S. versus World
U.S. World

Source: Credit Suisse Global Investment Returns Sourcebook 2024

Stocks and Bonds 14

U.S. versus Switzerland
U.S. Switzerland

Source: Credit Suisse Global Investment Returns Sourcebook 2024

Stocks and Bonds 15

Estimating expected returns
1. Historical approach

2. Survey approach

3. Implied approach

Stocks and Bonds 16

Historical approach
Limitations
 Assume that the risk aversion of investors / riskiness of
stocks has not changed in a systematic way across time

Stocks and Bonds 17

Survey approach
Limitations
 No constraints on reasonability (the survey could produce
negative risk premiums or risk premiums of 50%)
 Forecasts are extremely volatile
 Forecasts tend to be short term; even the longest surveys
do not go beyond one year

Stocks and Bonds 18

Implied approach
Gordon growth formula
P = D / (R – G)
E(R) = D/P + E(G)
D/P ≈ 2%
E(G) ??

Stocks and Bonds 19

Stock (over)valuation

Stocks and Bonds 20

P/E ratios and stock returns

Stocks and Bonds 21

Where does one go from here?
Economic analysis of the country
• Identify business cycles

Stocks and Bonds 22

Choice between risky and risk-free
Split investment funds between safe and risky assets
• Risk free asset: T-bills
• Risky asset: stock index

Risky and Riskfree 23

Portfolio statistics
Individual assets
• Portfolio weights: 𝑤𝑤 [in risky] and 1 − 𝑤𝑤 [in risk-free]
• Expected (mean) returns: 𝜇𝜇 and 𝑟𝑟𝑓𝑓
• Variances of returns: 𝜎𝜎 2 and 0

Portfolio mean return = 𝑤𝑤 × 𝜇𝜇 + 1 − 𝑤𝑤 × 𝑟𝑟𝑓𝑓

Portfolio variance = 𝑤𝑤 2 × 𝜎𝜎 2
• Standard deviation = 𝑤𝑤 × 𝜎𝜎

Risky and Riskfree 24

Example
Risk-free return of 7%
Stock with mean 15% and volatility 22%

Borrow at the risk-free rate and invest in stock using 50%

leverage
• Portfolio return = −0.5×7% + 1.5×15% = 19%
• Portfolio standard deviation = 1.5×22% = 33%

Risky and Riskfree 25

Example …

Risky and Riskfree 26

Example …

Risky and Riskfree 27

Example …
𝑈𝑈 = 𝜇𝜇 − 0.5𝐴𝐴𝜎𝜎 2

28
Optimal allocation
Optimal allocation to stock
𝑤𝑤𝑆𝑆 = 𝜇𝜇𝑆𝑆 − 𝑟𝑟𝑓𝑓 � 𝐴𝐴𝜎𝜎𝑆𝑆2
= 8%/(4 × 22%2 )
= 41.3%

Optimal portfolio statistics

𝜇𝜇𝑃𝑃 = 10.31%
𝜎𝜎𝑃𝑃 = 9.09%

Optimal utility = 0.08653

Risky and Riskfree 29

Two risky assets
Portfolio weights
• 𝑤𝑤1 and 𝑤𝑤2 [Note that 𝑤𝑤1 + 𝑤𝑤2 = 1.0]

Expected (mean) returns

• 𝜇𝜇1 and 𝜇𝜇2

Variances of returns
• 𝜎𝜎12 and 𝜎𝜎22

Covariance of returns
• 𝜎𝜎12 = 𝜌𝜌12 𝜎𝜎1 𝜎𝜎2
Two risky 30
Portfolio statistics
Portfolio mean
𝑤𝑤1 𝜇𝜇1 + 𝑤𝑤2 𝜇𝜇2

• Weighted sum of individual asset returns

Portfolio variance
𝑤𝑤12 𝜎𝜎12 + 𝑤𝑤22 𝜎𝜎22 + 2𝑤𝑤1 𝑤𝑤2 𝜎𝜎12

• Not weighted sum of individual asset variances

• The third term involving covariance is very important

Two risky 31
Example
Two assets – bond and stock
• Means of 8% and 13%
• Standard deviations of 12% and 20%
• Correlation of 0.3

Equal-weighted portfolio
• Portfolio return = 0.5×8% + 0.5×13% =10.5%
• Portfolio variance = 0.52×(12%)2 + 0.52×(20%)2
+2×0.5×0.5×(0.3×12%×20%) = 0.0172
• Portfolio standard deviation = 0.0172 = 13.11%

Two risky 32
Example …

Allocation Statistics
Standard
Bond Stock Mean deviation
1 0% 100% 13.0% 20.00%
2 10% 90% 12.5% 18.40%
3 20% 80% 12.0% 16.88%
4 30% 70% 11.5% 15.47%
5 40% 60% 11.0% 14.20%
6 50% 50% 10.5% 13.11%
7 60% 40% 10.0% 12.26%
8 70% 30% 9.5% 11.70%
9 80% 20% 9.0% 11.45%
10 90% 10% 8.5% 11.56%
11 100% 0% 8.0% 12.00%

Two risky 33
Example: Portfolio mean

Two risky 34
Example: Portfolio volatility

Two risky 35
Example: Risk-return tradeoff

Two risky 36
Example: MVP
Minimum variance portfolio: the portfolio composed of risky
assets with smallest standard deviation

𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎22 − 𝜎𝜎12

𝑤𝑤1 = 2
𝜎𝜎1 + 𝜎𝜎22 − 2𝜎𝜎12

𝑤𝑤𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 = 82%, 𝑤𝑤𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 18%

𝜇𝜇𝑚𝑚𝑚𝑚𝑚𝑚 = 8.9%
𝜎𝜎𝑚𝑚𝑚𝑚𝑚𝑚 = 11.45%

Two risky 37
Example: MVP …
With correlation = +1
𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎2 𝑚𝑚𝑚𝑚𝑚𝑚 −𝜎𝜎1
𝑤𝑤1 = , 𝑤𝑤2 =
𝜎𝜎2 − 𝜎𝜎1 𝜎𝜎2 − 𝜎𝜎1

With correlation = −1
𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎2 𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎1
𝑤𝑤1 = , 𝑤𝑤2 =
𝜎𝜎2 + 𝜎𝜎1 𝜎𝜎2 + 𝜎𝜎1

With correlation = 0
𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎22 𝑚𝑚𝑚𝑚𝑚𝑚 𝜎𝜎12
𝑤𝑤1 = 2 2, 𝑤𝑤2 = 2
𝜎𝜎2 + 𝜎𝜎1 𝜎𝜎2 + 𝜎𝜎12

38
Example: Which portfolio to choose?
𝜇𝜇𝐴𝐴 = 8.9%
𝜎𝜎𝐴𝐴 = 11.45%
(82% bond, 18% stock)

𝜇𝜇𝐵𝐵 = 9.5%
𝜎𝜎𝐵𝐵 = 11.70%
(70% bond, 30% stock)

Two risky 39
Example: Optimal portfolio
Using the utility function 𝑈𝑈 = 𝜇𝜇 − 12𝐴𝐴𝜎𝜎 2

𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝜎𝜎22 − 𝜎𝜎12 + 𝜇𝜇1 − 𝜇𝜇2 ⁄𝐴𝐴

𝑤𝑤1 =
𝜎𝜎12 + 𝜎𝜎22 − 2𝜎𝜎12

𝑤𝑤𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 = 51%, 𝑤𝑤𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 = 49%

𝜇𝜇𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 = 10.5%
𝜎𝜎𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 = 13.04%
for 𝐴𝐴 = 4

40
Introduce risk-free asset
Maximize the slope of the CAL for any possible portfolio, P

The objective function is the slope (Sharpe ratio):

𝜇𝜇𝑃𝑃 − 𝑟𝑟𝑓𝑓
𝑆𝑆𝑃𝑃 =
𝜎𝜎𝑃𝑃

Two risky 41
Example …
𝜇𝜇𝐴𝐴 = 8.9%
𝜎𝜎𝐴𝐴 = 11.45%
8.9% − 5%
𝑆𝑆𝐴𝐴 = = 0.34
11.45%

𝜇𝜇𝐵𝐵 = 9.5%
𝜎𝜎𝐵𝐵 = 11.70%
9.5% − 5%
𝑆𝑆𝐵𝐵 = = 0.38
11.70%

Two risky 42
Example …

Two risky 43
Example …
𝜇𝜇1𝑒𝑒 𝜎𝜎22 − 𝜇𝜇2𝑒𝑒 𝜎𝜎12
𝑤𝑤1𝑃𝑃 =
𝜇𝜇1𝑒𝑒 𝜎𝜎22 + 𝜇𝜇2𝑒𝑒 𝜎𝜎12 − 𝜇𝜇1𝑒𝑒 + 𝜇𝜇2𝑒𝑒 𝜎𝜎12

8 − 5 × 400 − 13 − 5 × 72
𝑤𝑤1𝑃𝑃 = = 0.40
3 × 400 + 8 × 144 − 3 + 8 × 72
𝑤𝑤2𝑃𝑃 = 0.60

𝜇𝜇𝑃𝑃 = 0.4 × 8% + 0.6 × 13% = 11%

𝜎𝜎𝑃𝑃2 = 0.42 × 144 + 0.62 × 400 + 2 × 0.4 × 0.6 × 72 = 201.6
𝜎𝜎𝑃𝑃 = 201.6 = 14.2%
11% − 5%
𝑆𝑆𝑃𝑃 = = 0.42
14.2%
Two risky 44
Example …
Optimal allocation to P
𝐴𝐴 = 4, 𝑤𝑤𝑃𝑃 = 𝜇𝜇𝑃𝑃 − 𝑟𝑟𝑓𝑓 � 𝐴𝐴𝜎𝜎𝑃𝑃2 = 0.7439

Two risky 45
Example …
𝜇𝜇𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 = 𝑤𝑤𝑃𝑃 𝜇𝜇𝑃𝑃 + 1 − 𝑤𝑤𝑃𝑃 𝑟𝑟𝑓𝑓 = 9.46%

𝜎𝜎𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 = 𝑤𝑤𝑃𝑃 𝜎𝜎𝑃𝑃 = 10.56%

9.46% − 5%
𝑆𝑆𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 = = 0.42 = 𝑆𝑆𝑃𝑃
10.56%

Two risky 46