Chapter 11

Risk and Return in Capital

Markets

Chapter Outline
11.1 A First Look at Risk and Return
11.2 Historical Risks and Returns of Stocks
11.3 The Historical Tradeoff Between Risk
and Return
11.4 Common Versus Independent Risk
11.5 Diversification in Stock Portfolios

Learning Objectives
Identify which types of securities have historically had the
highest returns and which have been the most volatile
Compute the average return and volatility of returns from a
set of historical asset prices
Understand the tradeoff between risk and return for large
portfolios versus individual stocks
Describe the difference between common and independent
risk
Explain how diversified portfolios remove independent
risk, leaving common risk as the only risk requiring a risk
premium

11.1 A First Look at Risk and

Return
Consider how an investment would have
grown if it were invested in each of the
following from the end of 1929 until the
beginning of 2012:

Standard & Poors 500 (S&P 500)

Small Stocks
World Portfolio
Corporate Bonds
Treasury Bills

Figure 11.1 Value of $100 Invested at the End of 1925 in

U.S. Large Stocks (S&P 500), Small Stocks, World Stocks,
Corporate Bonds, and Treasury Bills

Table 11.1 Realized Returns, in Percent (%) for Small

Stocks, the S&P 500, Corporate Bonds, and Treasury Bills,
Year-End 19251935

11.2 Historical Risks and Returns

of Stocks
Computing Historical Returns
Realized Returns
Individual Investment Realized Returns
The realized return from your investment in the
stock from t to t+1 is:
Divt 1 Pt 1 Pt Divt 1 Pt 1 Pt
(Eq. 11.1)
Rt 1

Pt
Pt
Pt

Dividend Yield Capital Gain Yield

Example 11.1 Realized Return

Problem:
Microsoft paid a one-time special dividend of $3.08 on November 15,
2004. Suppose you bought Microsoft stock for $28.08 on November 1,
2004 and sold it immediately after the dividend was paid for $27.39.
What was your realized return from holding the stock?

Example 11.1 Realized Return

Solution:
Plan:
We can use Eq 11.1 to calculate the realized return. We need the
purchase price ($28.08), the selling price ($27.39), and the dividend
($3.08) and we are ready to proceed.

Example 11.1 Realized Return

Execute:
Rt 1

Using Eq. 11.1, the return from Nov 1, 2004 until Nov 15, 2004 is
Divequal
t 1 P
tot 1 Pt 3.08 (27.39 28.08) 0.0851, or 8.51%

Pt
28.08

This 8.51% can be broken down into the dividend yield and the capital
gain yield:
Dividend Yield =

Divt 1
3.08

.1097, or 10.97%
Pt
28.08

Capital Gain Yield =

Pt 1 Pt 27.39 28.08

0.0246, or 2.46%
Pt
28.08

Example 11.1 Realized Return

Evaluate:
These returns include both the capital gain (or in this case a
capital loss) and the return generated from receiving
dividends. Both dividends and capital gains contribute to
the total realized returnignoring either one would give a
very misleading impression of Microsofts performance.

Example 11.1a Realized Return

Problem:
Health Management Associates (HMA) paid a one-time special
dividend of $10.00 on March 2, 2007. Suppose you bought HMA
stock for $20.33 on February 15, 2007 and sold it immediately after
the dividend was paid for $10.29. What was your realized return from
holding the stock?

Example 11.1a Realized Return

Solution:
Plan:
We can use Eq 11.1 to calculate the realized return. We need the
purchase price ($20.33), the selling price ($10.29), and the dividend
($10.00) and we are ready to proceed.

Example 11.1a Realized Return

Execute:
Using Eq. 11.1, the return from February 15, 2007 until March 2, 2007
is equal to
Div t 1 Pt 1 Pt 10.00 10.29 20.33
R t 1

0.002, or 0.2%
Pt
20.33
This -0.2% can be broken down into the dividend yield and the capital
gain yield:
Dividend Yield

Divt 1 10.00

0.4919, or 49.19%
Pt
20.33

Capital GainYield

Pt 1 Pt 10.29 20.33

0.4939, or 49.39%
Pt
20.33

Example 11.1a Realized Return

Evaluate:
These returns include both the capital gain (or in this case a capital
loss) and the return generated from receiving dividends. Both
dividends and capital gains contribute to the total realized return
ignoring either one would give a very misleading impression of
HMAs performance.

Example 11.1b Realized Return

Problem:
Limited Brands paid a one-time special dividend of $3.00 on
December 21, 2010. Suppose you bought LTD stock for $29.35 on
October 18, 2010 and sold it immediately after the dividend was paid
for $30.16. What was your realized return from holding the stock?

Example 11.1b Realized Return

Solution:
Plan:
We can use Eq 11.1 to calculate the realized return. We need the
purchase price ($29.35), the selling price ($30.16), and the dividend
($3.00) and we are ready to proceed.

Example 11.1b Realized Return

Execute:
Using Eq. 11.1, the return from October 18, 2010 until December 21,
2010 is equal to
Rt 1

Divt 1 Pt 1 Pt 3.00 30.16 29.35

0.1298, or 0.12.98%
Pt
29.35

This 12.98% can be broken down into the dividend yield and the
capital gainDiv
yield: 3.00

Dividend Yield

t 1

Pt

Capital GainYield

29.35

0.1022, or10.22%

Pt 1 Pt 30.16 29.35

0.0276, or 2.76%
Pt
29.35

Example 11.1b Realized Return

Evaluate:
These returns include both the capital gain (or in this case a capital
loss) and the return generated from receiving dividends. Both
dividends and capital gains contribute to the total realized return
ignoring either one would give a very misleading impression of LTDs
performance.

11.2 Historical Risks and Returns

of Stocks
Computing Historical Returns
Individual Investment Realized Returns
For quarterly returns (or any four compounding
periods that make up an entire year) the annual
realized return, Rannual, is found by compounding:

1 Rannual (1 R1 )(1 R2 )(1 R3 )(1 R4 )

(Eq. 11.2)

Example 11.2 Compounding

Realized Returns
Problem:
Suppose you purchased Microsoft stock (MSFT) on Nov 1, 2004 and
held it for one year, selling on Oct 31, 2005. What was your annual
realized return?

Example 11.2 Compounding

Realized Returns
Solution:
Plan:
We need to analyze the cash flows from holding MSFT stock for each
quarter. In order to get the cash flows, we must look up MSFT stock
price data at the purchase date and selling date, as well as at any
dividend dates. From the data we can construct the following table to
fill out our cash flow timeline:

Example 11.2 Compounding

Realized Returns
Plan (contd):

Next, compute the realized return between each set of dates using Eq.
11.1. Then determine the annual realized return similarly to Eq. 11.2
by compounding the returns for all of the periods in the year.

Example 11.2 Compounding

Realized Returns
Execute:
In Example 11.1, we already computed the realized return for Nov 1,
2004 to Nov 15, 2004 as 8.51%. We continue as in that example, using
Eq. 11.1 for each period until we have a series of realized returns. For
example, from Nov 15, 2004 to Feb 15, 2005, the realized return is

Rt 1

Divt 1 Pt 1 Pt 0.08 (25.93 27.39)

0.0504, or 5.04%
Pt
27.39

Example 11.2 Compounding

Realized Returns
Execute (contd):
The table below includes the realized return at each period.

Example 11.2 Compounding

Realized Returns
Execute (contd):
We then determine the one-year return by compounding.

1 Rannual (1 R1 )(1 R2 )(1 R3 )(1 R4 ) 1 R5

1 Rannual (1.0851)(0.9496)(0.9861)(1.0675)(0.9473) 1.0275
Rannual 1.0275 1 .0275 or 2.75%

Example 11.2 Compounding

Realized Returns
Evaluate:
By repeating these steps, we have successfully computed the realized
annual returns for an investor holding MSFT stock over this one-year
period. From this exercise we can see that returns are risky. MSFT
fluctuated up and down over the year and ended-up only slightly
(2.75%) at the end.

Example 11.2a Compounding

Realized Returns
Problem:
Suppose you purchased Health Management Associates stock (HMA)
on March 16, 2006 and held it for one year, selling on March 15, 2007.
What was your realized return?

Example 11.2a Compounding

Realized Returns
Solution:
Plan:
We need to analyze the cash flows from holding HMA stock for each
period. In order to get the cash flows, we must look up HMA stock
price data at the start and end of both years, as well as at any dividend
dates. From the data we can construct the following table to fill out
our cash flow timeline:

Example 11.2a Compounding

Realized Returns
Date (contd):Price
Plan
16-Mar-06
10-May-06
9-Aug-06
8-Nov-06
15-Feb-07
2-Mar-07
15-Mar-07

Dividend
21.15
20.70
20.62
19.39
20.33
10.29
11.07

0.06
0.06
0.06
10.00

Next, compute the realized return between each set of dates using Eq.
11.1. Then determine the annual realized return similarly to Eq. 11.2
by compounding the returns for all of the periods in the year.

Example 11.2a Compounding

Realized Returns
Execute:
In Example 11.1a, we already computed the realized return for
February 15, 2007 to March 2, 2007 as -.2%. We continue as in that
example, using Eq. 11.1 for each period until we have a series of
realized returns. For example, from August 9, 2006 to November 8,
2006, the realized return is

R t 1

Div t 1 Pt 1 Pt 0.06 19.39 20.62

0.0567, or 5.67%
Pt
20.62

Example 11.2a Compounding

Realized Returns
Execute (contd):
The table below includes the realized return at each period.
Date

Price

Dividend

Return

16-Mar-06

21.15

10-May-06

20.70

0.06

-1.84%

9-Aug-06

20.62

0.06

-0.10%

8-Nov-06

19.39

0.06

-5.67%

15-Feb-07

20.33

2-Mar-07

10.29

15-Mar-07

11.07

4.85%
10.00

-0.20%
7.58%

Example 11.2a Compounding

Realized Returns
Execute (contd):
We then determine the one-year return by compounding.

1 Rannual (1 R1 )(1 R2 )1 R3 (1 R4 )(1 R5 )(1 R6 )

1 Rannual (0.982)(0.999)0.943(1.048)(0.998)(1.076)
Rannual 1.0411 1 .0411or 4.11%

Example 11.2a Compounding

Realized Returns
Evaluate:
By repeating these steps, we have successfully computed the realized
annual returns for an investor holding HMA stock over this one-year
period. From this exercise we can see that returns are risky. HMA
fluctuated up and down over the year and yielded a return of only
4.11% at the end.

Example 11.2b Compounding

Realized Returns
Problem:
Suppose you purchased Intel stock (INTC) on December 3, 2012 and
held it for one year, selling on December 2, 2013. What was your
annual realized return?

Example 11.2b Compounding

Realized Returns
Solution:
Plan:
We need to analyze the cash flows from holding INTC stock for each
quarter. In order to get the cash flows, we must look up INTC stock
price data at the purchase date and selling date, as well as at any
dividend dates. From the data we can construct the following table to
fill out our cash flow timeline:

Example 11.2b Compounding

Realized Returns
Plan (contd):

Date
3-Dec-12
1-Mar-13
1-Jun-13
1-Sep-12
1-Dec-13
2-Dec-13

Price
Dividend
$19.54
$21.03 $ 0.225
$24.28 $ 0.225
$21.98 $ 0.225
$23.84 $ 0.225
$23.70

Next, compute the realized return between each set of dates using Eq.
11.1. Then determine the annual realized return similarly to Eq. 11.2
by compounding the returns for all of the periods in the year.

Example 11.2b Compounding

Realized Returns
Execute:
We use Eq. 11.1 for each period until we have a series of realized
returns. For example, from December 3, 2012 to March 1, 2013, the
realized return is

Rt 1

Divt 1 Pt 1 Pt 0.225 (21.03 19.54)

0.0878, or 8.78%
Pt
19.54

Example 11.2b Compounding

Realized Returns
Execute (contd):
The table below includes the realized return at each period.
Date
3-Dec-12
1-Mar-13
1-Jun-13
1-Sep-12
1-Dec-13
2-Dec-13

Price
Dividend Return
$19.54
$21.03 $ 0.225 8.78%
$24.28 $ 0.225 16.52%
$21.98 $ 0.225 -8.55%
$23.84 $ 0.225 9.49%
$23.70
-0.59%

Example 11.2b Compounding

Realized Returns
Execute (contd):
We then determine the one-year return by compounding.

1 Rannual (1 R1 )(1 R2 )(1 R3 )(1 R4 ) 1 R5

1 Rannual (1.0878)(1.1652)(0.9145)(1.0949)(0.9941) 1.2617
Rannual 1.2617 1 .2617 or 26.17%

Example 11.2b Compounding

Realized Returns
Evaluate:
We have successfully computed the realized annual returns for an
investor holding INTC stock over this one-year period. From this
exercise we can see that returns are risky. INTC fluctuated up and
down over the year but ended-up returning 26.17% for the year.

11.2 Historical Risks and Returns

of Stocks
Average Annual Returns
Average Annual Return of a Security
1

R ( R1 R2 ... RT )
T

(Eq. 11.3)

Figure 11.2 The Distribution of Annual Returns for U.S. Large Company
Stocks (S&P 500), Small Stocks, Corporate Bonds, and Treasury Bills,
19262012

Figure 11.3 Average Annual Returns in the U.S. for Small

Stocks, Large Stocks (S&P 500), Corporate Bonds, and
Treasury Bills, 19262012

11.2 Historical Risks and Returns

of Stocks
The Variance and Volatility of Returns:
Variance
1

Var R

(R R)

T 1
1

( R2 R )2 ... ( RT R ) 2

Standard Deviation
SD( R) Var R

(Eq. 11.4)

(Eq. 11.5)

Example 11.3 Computing

Historical Volatility
Problem:
Using the data below, what is the standard deviation of the S&P 500s
returns for the years 2005-2009?

Example 11.3 Computing

Historical Volatility
Solution:
Plan:

With the five returns, compute the average return using Eq.
11.3 because it is an input to the variance equation. Next,
compute the variance using Eq. 11.4 and then take its
square root to determine the standard deviation, as shown
in Eq. 11.5.

Example 11.3 Computing

Historical Volatility
Execute:
In the previous section we already computed the average annual return
of the S&P 500 during this period as 3.1%, so we have all of the
necessary inputs for the variance calculation:
Applying Eq. 11.4, we have:
Var ( R)

1
( R1 R ) 2 ( R2 R ) 2 ... ( RT R ) 2
T 1
(.049 .031)2 (.158 .031)2 (.055 .031)2 0.370 .0312 .265 .0312

5 1
1

.058

Example 11.3 Computing

Historical Volatility
Execute (cont'd):
Alternatively, we can break the calculation of this equation out as
follows:

Summing the squared differences in the last row, we get 0.233.

Finally, dividing by (5-1=4) gives us 0.233/4 =0.058
The standard deviation is therefore:

SD( R) Var ( R) .058 0.241,or 24.1%

Example 11.3 Computing

Historical Volatility
Evaluate:
Our best estimate of the expected return for the S&P 500 is its average
return, 3.1%, but it is risky, with a standard deviation of 24.1%.

Example 11.3a Computing

Historical Volatility
Problem:
Using the data below, what is the standard deviation of small stocks
returns for the years 2005-2009?
Year

2005

Small Stocks Return 5.69%

2006

2007

16.17% -5.22%

2008

2009

-36.72%

28.09%

Example 11.3a Computing

Historical Volatility
Year

Solution:
Plan:

2005

Small Stocks Return 5.69%

2006

2007

16.17% -5.22%

2008

2009

-36.72%

28.09%

With the five returns, compute the average return using Eq. 11.3
because it is an input to the variance equation. Next, compute the
variance using Eq. 11.4 and then take its square root to determine the
standard deviation, as shown in Eq. 11.5.

Example 11.3a Computing

Historical Volatility
Execute:
Using Eq. 11.3, the average annual return1for small stocks during this
R (.0569 .1671 .0522 .3672+.2809) .0171
period is:
5

We now have all of the necessary inputs for the variance calculation:
Applying Eq. 11.4, we have:
Var ( R)

1
( R1 R )2 ( R2 R ) 2 ... ( RT R ) 2
T 1
(.0569 .0171)2 (.1671 .0171)2 (.0522 0171)2 .3672 .01712 .2809 .01712

5 1
1

.0615

Example 11.3a Computing

Historical Volatility
Execute (cont'd):
Alternatively, we can break the calculation of this equation out as
2005
2006
2007
2008
2009
follows:
Return
Average
Difference
Squared

0.0569
0.0171
0.0398
0.0016

0.1671
0.0171
0.15
0.0225

-0.0522
0.0171
-0.0693
0.0048

-0.3672
0.0171
-0.3843
0.1477

0.2809
0.0171
0.2638
0.0696

Summing the squared differences in the last row, we get 0.2462.

Finally, dividing by (5-1=4) gives us 0.2462/4 =0.0615
The standard deviation is therefore:

SD( R) Var ( R) 0.0615 0.2480, or 24.80%

Example 11.3a Computing

Historical Volatility
Evaluate:
Our best estimate of the expected return for small stocks is its average
return, 1.71%, and they are risky, with a standard deviation of 24.80%.

Example 11.3b Computing

Historical Volatility
Problem:
Using the data below, what is the standard deviation of the Large
Stock returns for the years 2008-2012?

Year
Large Stocks' Return

2008
2009 2010
-37.0% 26.5% 15.1%

2011
2012
2.1% 16.0%

Example 11.3b Computing

Historical Volatility
Solution:
Plan:
Year
Large Stocks' Return

2008
2009 2010
-37.0% 26.5% 15.1%

2011
2012
2.1% 16.0%

With the five returns, compute the average return using Eq. 11.3
because it is an input to the variance equation. Next, compute the
variance using Eq. 11.4 and then take its square root to determine the
standard deviation, as shown in Eq. 11.5.

Example 11.3b Computing

Historical Volatility
Execute:
The average annual return for Large Stocks during this period is 4.5%,
so we have all of the necessary inputs for the variance calculation:
Applying Eq. 11.4, we have:

Var ( R)

1
( R1 R ) 2 ( R2 R ) 2 ... ( RT R ) 2
T 1
(0.370 .045)2 (.265 .045)2 (.151 .045)2 0.021 .0452 .160 .0452

5 1
1

.0615

Example 11.3b Computing

Historical Volatility
Execute (cont'd):
Year
Alternatively, we
can break
the calculation
of this equation
out as
2008
2009
2010
2011
2012
Return follows:
-0.370
0.265
0.151
0.021
0.160
Average
Difference
Squared

0.045
-0.415
0.173

0.045
0.220
0.048

0.045
0.106
0.011

0.045
-0.024
0.001

0.045
0.115
0.013

Summing the squared differences in the last row, we get 0.246.

Finally, dividing by (5-1=4) gives us 0.246/4 =0.0615
The standard deviation is therefore:

SD( R) Var ( R) .0615 0.248,or 24.8%

Example 11.3b Computing

Historical Volatility
Evaluate:
Our best estimate of the expected return for Large Stocks is the
average return, 4.5%, but it is risky, with a standard deviation of
24.8%.

Figure 11.4 Volatility (Standard Deviation) of U.S. Small

Stocks, Large Stocks (S&P 500), Corporate Bonds, and
Treasury Bills, 19262012

11.2 Historical Risks and Returns

of Stocks
The Normal Distribution
95% Prediction Interval
Average (2 x standard deviation)

(Eq. 11.6)

R (2 x SD R )
About two-thirds of all possible outcomes fall
within one standard deviation above or below the
average

Figure 11.5 Normal Distribution

Example 11.4 Confidence

Intervals
Problem:
In Example 11.3 we found the average return for the S&P 500 from
2005-2009 to be 3.1% with a standard deviation of 24.1%. What is a
95% confidence interval for 2010s return?

Example 11.4 Confidence

Intervals
Solution:
Plan:
We can use Eq. 11.6 to compute the confidence interval.

Example 11.4 Confidence

Intervals
Execute:
Using Eq. 11.6, we have:
Average (2 standard deviation) = 3.1% (2 24.1%) to 3.1% + (2
24.1% )
= 45.1% to 51.3%.

Example 11.4 Confidence

Intervals
Evaluate:
Even though the average return from 2005 to 2009 was 3.1%, the S&P
500 was volatile, so if we want to be 95% confident of 2010s return,
the best we can say is that it will lie between
45.1% and
+51.3%.

Example 11.4a Confidence

Intervals
Problem:
The average return for small stocks from 2005-2009 was 1.71% with a
standard deviation of 24.8%. What is a 95% confidence interval for
2010s return?

Example 11.4a Confidence

Intervals
Solution:
Plan:
We can use Eq. 11.6 to calculate the confidence interval.

Example 11.4a Confidence

Intervals
Execute:
Using Eq. 11.6, we have:

Average 2 standard deviation 1.71% (2 24.8%) to1.71% (2 24.8%)

47.89% to50.77%

Example 11.4a Confidence

Intervals
Evaluate:
Even though the average return from 2005-2009 was 1.71%, small
stocks were volatile, so if we want to be 95% confident of 2010s
return, the best we can say is that it will lie between -47.89% and
+50.77%.

Example 11.4b Confidence

Intervals
Problem:
The average return for corporate bonds from 2005-2009 was 6.49%
with a standard deviation of 7.04%. What is a 95% confidence interval
for 2010s return?

Example 11.4b Confidence

Intervals
Solution:
Plan:
We can use Eq. 11.6 to calculate the confidence interval.

Example 11.4b Confidence

Intervals
Execute:
Using Eq. 11.6, we have:

Average 2 standard deviation 6.49% (2 7.04%) to 6.49% (2 7.04%)

7.59% to 20.57%

Example 11.4b Confidence

Intervals
Evaluate:
Even though the average return from 2005-2009 was 6.49%, corporate
bonds were volatile, so if we want to be 95% confident of 2010s
return, the best we can say is that it will lie between -7.59% and
+20.57%.

Table 11.2 Summary of Tools for

Working with Historical Returns

11.3 Historical Tradeoff between

Risk and Return
The Returns of Large Portfolios
Investments with higher volatility, as measured
by standard deviation, tend to have higher
average returns

Figure 11.6 The Historical Tradeoff Between Risk

and Return in Large Portfolios, 19262011

11.3 Historical Tradeoff between

Risk and Return
The Returns of Individual Stocks
Larger stocks have lower volatility overall
Even the largest stocks are typically more
volatile than a portfolio of large stocks
The standard deviation of an individual security
doesnt explain the size of its average return
All individual stocks have lower returns and/or
higher risk than the portfolios in Figure 11.6

11.4 Common Versus

Independent Risk
Theft Versus Earthquake Insurance
Types of Risk
Common Risk
Independent Risk
Diversification

Table 11.3 Summary of Types of

Risk

Example 11.5 Diversification

Problem:
You are playing a very simple gambling game with your friend: a $1
bet based on a coin flip. That is, you each bet $1 and flip a coin: heads
you win your friends $1, tails you lose and your friend takes your
dollar. How is your risk different if you play this game 100 times in a
row versus just betting $100 (instead of $1) on a single coin flip?

Example 11.5 Diversification

Solution:
Plan:
The risk of losing one coin flip is independent of the risk of losing the
next one: each time you have a 50% chance of losing, and one coin flip
does not affect any other coin flip. We can compute the expected
outcome of any flip as a weighted average by weighting your possible
winnings (+$1) by 50% and your possible losses (-$1) by 50%. We can
then compute the probability of losing all $100 under either scenario.

Example 11.5 Diversification

Execute:
If you play the game 100 times, you should lose about 50 times and
win 50 times, so your expected outcome is 50 (+$1) + 50 (-$1) =
$0. You should break-even. Even if you dont win exactly half of the
time, the probability that you would lose all 100 coin flips (and thus
lose $100) is exceedingly small (in fact, it is 0.50100, which is far less
than even 0.0001%). If it happens, you should take a very careful look
at the coin!

Example 11.5 Diversification

Execute (contd):
If instead, you make a single $100 bet on the outcome of one coin flip,
you have a 50% chance of winning $100 and a 50% chance of losing
$100, so your expected outcome will be the same: break-even.
However, there is a 50% chance you will lose $100, so your risk is far
greater than it would be for 100 one dollar bets.

Example 11.5 Diversification

Evaluate:
In each case, you put $100 at risk, but by spreading-out that risk across
100 different bets, you have diversified much of your risk away
compared to placing a single $100 bet.

Example 11.5a Diversification

Problem:
You are playing a very simple gambling game with your friend: a $1
bet based on a roll of two six-sided dice. That is, you each bet $1 and
roll the dice: if the outcome is even you win your friends $1, if the
outcome is odd you lose and your friend takes your dollar. How is
your risk different if you play this game 100 times in a row versus just
betting $100 (instead of $1) on a roll of the dice?

Example 11.5a Diversification

Solution:
Plan:
The risk of losing one dice roll is independent of the risk of losing the
next one: each time you have a 50% chance of losing, and one roll of
the dice does not affect any other roll. We can compute the expected
outcome of any roll as a weighted average by weighting your possible
winnings (+$1) by 50% and your possible losses (-$1) by 50%. We can
then compute the probability of losing all $100 under either scenario.

Example 11.5a Diversification

Execute:
If you play the game 100 times, you should lose about 50% of the time
and win 50% of the time, so your expected outcome is 50 (+$1) + 50
(-$1) = $0. You should break-even. Even if you dont win exactly
half of the time, the probability that you would lose all 100 dice rolls
(and thus lose $100) is exceedingly small (in fact, it is 0.50100, which
is far less than even 0.0001%). If it happens, you should take a very
careful look at the dice!

Example 11.5a Diversification

Execute (contd):
If instead, you make a single $100 bet on the outcome of one roll of
the dice, you have a 50% chance of winning $100 and a 50% chance of
losing $100, so your expected outcome will be the same: break-even.
However, there is a 50% chance you will lose $100, so your risk is far
greater than it would be for 100 one dollar bets.

Example 11.5a Diversification

Evaluate:
In each case, you put $100 at risk, but by spreading-out that risk across
100 different bets, you have diversified much of your risk away
compared to placing a single $100 bet.

11.5 Diversification in Stock

Portfolios
Unsystematic Versus Systematic Risk
Stock prices are impacted by two types of
news:
1. Company or Industry-Specific News
2. Market-Wide News

Unsystematic Risk
Systematic Risk

Figure 11.7 Volatility of

Portfolios of Type S and U Stocks

Figure 11.8 The Effect of

Diversification on Portfolio
Volatility

11.5 Diversification in Stock

Portfolios
Diversifiable Risk and the Risk Premium
The risk premium for diversifiable risk is zero
Investors are not compensated for holding
unsystematic risk

Table 11.4 Systematic Risk

Versus Unsystematic Risk

11.5 Diversification in Stock

Portfolios
The Importance of Systematic Risk
The risk premium of a security is determined
by its systematic risk and does not depend on
its diversifiable risk

11.5 Diversification in Stock

Portfolios
The Importance of Systematic Risk
There is no relationship between volatility and
average returns for individual securities

Table 11.5 The Expected Return of

Type S and Type U Firms, Assuming the Risk-Free Rate Is 5%

Chapter 11 Quiz
1.
2.
3.
4.
5.

Historically, which types of investments have had the

highest average returns and which have been the most
volatile from year to year? Is there a relation?
For what purpose do we use the average and standard
deviation of historical stock returns?
What is the relation between risk and return for large
portfolios? How are individual stocks different?
What is the difference between common and independent
risk?
Does systematic or unsystematic risk require a risk
premium? Why?