7-1

Chapter 4a: Risk and Returns

• A Lesson From 1900

1

• The expected return of single asset

2 • The volatility of single asset

• Portfolio risk and return

3 • Beta and Market risk
 7-2

The lesson from 1900

 7-3

The lesson from 1900 (Cont.)

 7-4

Average Market Risk Premia (by country)

 7-5

0% or 25%?

A B
➢ Suppose you buy a particular ➢ If we calculate the
stock for $100. Unfortunately, returns year-by-year, we see
the first year you own it, it
falls to $50. The second year that you lost 50 % the first
you own it, it rises back to year (you lost half of your
$100, leaving you where you money).
started (no dividends were
➢ The second year, you made
paid).
100 % (you doubled your
➢ Common sense seems to say
that your average return must money).
be exactly zero because you ➢ Your average return over the
started with $100 and ended two years was (–50 % + 100
with $100
%)/2 = 25 %!
 Geometric Average Return Vs 7-6

Arithmetic Average Return

Geometric Average Return Arithmetic Average Return
(0%) (25%)
➢ “What was your ➢ “What was your return in an
average compound return average year over a particular
per year over a particular period?”
period?”
➢ What you earned in a typical
➢ What you actually earned
per year on average, year and is an unbiased
compounded annually estimate of the true mean of
➢ Useful in describing the the distribution
actual historical investment ➢ Useful in making estimates of
experience the future
Geometric Average Return Vs 7-7

Arithmetic Average Return

A stock has had returns of 34
%, 18 %, 29 %, –6 %, 16 %,
and –48 % over the last six
years. What are the arithmetic
and geometric returns for the
stock?
 7-8

Measuring Risk
Standard Deviation - A
measure of volatility.
– A popular statistical
measure that quantifies the
dispersion around the
expected value
– Used to calculate degree of
risk
Variance - Average value of
squared deviations from mean.
A measure of volatility.
 7-9

Measuring Risk
Coin Toss Game-calculating variance and standard deviation
 Normal Distribution and Its 7-10

Implication for Standard Deviation

Computing the Risk of a Single 7-11

Asset
 7-12

Standard Deviation Exercise

➢Let's assume that you
invest in Company XYZ
stock, which has returned
an average 10% per year
for the last 10 years. How
risky is this stock
compared to Company
ABC stock?
 7-13

Graphing The Returns

XYZ Returns ABC Returns

 7-14

Standard Deviation of XYZ

Standard déviation = √(3,850/9) = √427.78

= 0.2068
 7-15

Standard Deviation of ABC

 Calculating Returns and 7-16

Variability Exercise
Using the following
returns, calculate the
average returns, the
variances, and the
standard deviations
for X and Y
7-17
 7-18

Why it Matters
• Standard deviation is a measure of
1 risk that an investment will not meet
the expected return in a given period

• Smaller standard deviation →less

2 volatile and less risky

• Standard deviation is only one of

3 many measures of risk
Computing the Expected Return for 7-19

a Portfolio of Assets

• A portfolio is a collection of
1 assets

• Portfolios can include real estate,

2 stocks, gold, bonds, etc.

• The portfolio return is simply a

3 weighted average, so the first
step is to determine the weights
 7-20

Portfolio Weights
➢How to compute the asset weights for your
portfolio
– Portfolio weights
• The amount invested in asset i divided by the total
amount invested in the portfolio
 7-21

Computing Portfolio Weights

 7-22

Computing Expected Return

➢Computing expected return with unequal
amounts invested in multiple securities
 7-23

Computing Expected Return

 7-24

Equity Market Risk (by country)

Average Risk (1900-2008)
Standard Deviation of Annual Returns, %

40
35
30
25
20
33.93 34.3
15 28.32 29.57
23.98 24.09 25.28
20.16 21.83 22.05 22.99 23.23 23.42 23.51
10 17.02
18.45 19.22

5
0
Ireland
Switzerland
Australia

Netherlands
Denmark
Spain

Germany
Italy
South Africa

Japan
Norway
Canada

Belgium
U.S.

Sweden

France
U.K.
 7-25

Measuring Risk

Diversification - Strategy designed to reduce risk

by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
 7-26

Measuring Risk
Diversification
• Strategy designed to reduce risk by spreading the
portfolio across many investments

Market Risk
• Economy-wide sources of risk that affect the overall
stock market.
• Also called “systematic risk.”

Unique Risk
• Risk factors affecting only that firm.
• Also called “unsystematic risk.”
 7-27

Single Risk and Portfolio Return

Standard deviations for selected
U.S. common stocks, January The value of a portfolio evenly
2004– December 2008 divided between Dell and Starbucks
 7-28

Diversification Effects
• Average risk (standard
deviation) of portfolios
containing different
numbers of stocks.
• The stocks were
selected randomly from
stocks traded on the
New York Exchange
from 2002 through
2007.
• Notice that
diversification reduces
risk rapidly at first,
then more slowly
 7-29

Measuring Risk
Portfolio standard deviation

Unique
risk

Market risk
0
5 10 15
Number of Securities
 7-30

Portfolio Risk

The variance of a two stock portfolio is the sum of these

four boxes
➢ Covariance between stocks 1 and 2:
➢ P12 is correlation between returns on stocks 1 and 2
Another Way to Calculate 7-31

Covariance
 7-32

Portfolio Risk & Return

Example
Suppose you invest 60% of your portfolio in
Campbell Soup and 40% in Boeing. The expected
dollar return on your Campbell Soup stock is 3.1%
and on Boeing is 9.5%. The expected return on
your portfolio is:

Expected Return = (.60  3.1) + (.40  9.5) = 5.7%

 7-33

Portfolio Risk & Return (Cont.)

Example
Suppose you invest 60% of your portfolio in Campbell Soup and 40% in
Boeing. The expected dollar return on your Campbell Soup stock is 3.1%
and on Boeing is 9.5%. The standard deviation of their annualized daily
returns are 15.8% and 23.7%, respectively. Assume a correlation
coefficient between 2 stock is 1.0. Calculate the portfolio variance.
 7-34

Portfolio Risk & Return

Correlation
=+1

Correlation
=+0.18

Correlation
=-1
 7-35

Diversification Check
In which of the following situations would
you get the largest reduction in risk by
spreading your investment across two
stocks?
a. The two shares are perfectly correlated.
b. There is no correlation.
c. There is modest negative correlation.
d. There is perfect negative correlation
 7-36

Portfolio Risk & Return Exercise 1

Ms. Lan invests 60% of her funds in ACB

stock and the balance in BIDV stock. The
standard deviation of returns on ACB is
10%, and on BIDV it is 20%. Calculate the
variance of portfolio returns, assuming:
a. The correlation between the returns is 1.0.
b. The correlation is .5.
c. The correlation is 0
 7-37

Portfolio Risk & Return Exercise 2