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

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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

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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 1925 until the
beginning of 2012:
– Standard & Poor’s 500 (S&P 500)
– Small Stocks
– World Portfolio
– Corporate Bonds
– Treasury Bills

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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

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Table 11.1 Realized Returns, in Percent (%) for Small
Stocks, the S&P 500, Corporate Bonds, and Treasury
Bills, Year-End 1925–1935

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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

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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?

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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.

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Example 11.1 Realized Return

Execute:
• Using Eq. 11.1, the return from Nov 1, 2004 until Nov 15,
2004 is equal to

Divt 1  Pt 1  Pt 3.08  (27.39  28.08)

Rt 1    0.0851, or 8.51%
Pt 28.08

• This 8.51% can be broken down into the dividend yield and
the capital gain yield:

Divt 1 3.08
Dividend Yield =   .1097, or 10.97%
Pt 28.08
Pt 1  Pt  27.39  28.08 
Capital Gain Yield =   0.0246, or  2.46%
Pt 28.08

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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 return
—ignoring either one would give a very misleading
impression of Microsoft’s performance.

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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?

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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.

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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:

Divt 1 10.00
Dividend Yield    0.4919, or 49.19%
Pt 20.33
Pt 1  Pt 10.29  20.33
Capital GainYield    0.4939, or  49.39%
Pt 20.33

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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 HMA’s performance.

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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?

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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.

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Example 11.1b Realized Return

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

Divt 1  Pt 1  Pt 3.00  30.16  29.35

Rt 1    0.1298, or 0.12.98%
Pt 29.35

• This 12.98% can be broken down into the dividend yield and
the capital gain yield:

Divt 1 3.00
Dividend Yield    0.1022, or10.22%
Pt 29.35
Pt 1  Pt 30.16  29.35
Capital GainYield    0.0276, or 2.76%
Pt 29.35

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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 LTD’s performance.

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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)

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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?

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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:

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Example 11.2 Compounding Realized
Returns

Plan:

• 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.

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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

Divt 1  Pt 1  Pt 0.08  (25.93  27.39)

Rt 1    0.0504, or  5.04%
Pt 27.39

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Example 11.2 Compounding Realized
Returns

Execute:
• The table below includes the realized return at each period.

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Example 11.2 Compounding Realized
Returns

Execute:
• 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%

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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.

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Example 11.2a Compounding
Realized Returns

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

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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:

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Example 11.2a Compounding
Realized Returns
Plan:
Date Price Dividend
16-Mar-06 21.15
10-May-06 20.70 0.06
9-Aug-06 20.62 0.06
8-Nov-06 19.39 0.06
15-Feb-07 20.33
2-Mar-07 10.29 10.00
15-Mar-07 11.07

• 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.

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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

Div t 1  Pt 1  Pt 0.06  19.39  20.62

R t 1    0.0567, or  5.67%
Pt 20.62

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Example 11.2a Compounding
Realized Returns

Execute:
• 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 4.85%
2-Mar-07 10.29 10.00 -0.20%
15-Mar-07 11.07 7.58%

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Example 11.2a Compounding
Realized Returns

Execute:
• 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 %

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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.

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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?

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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:

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Example 11.2b Compounding
Realized Returns

Plan:
Date Price Dividend
3-Dec-12 $19.54
1-Mar-13 $21.03 $ 0.225
1-Jun-13 $24.28 $ 0.225
1-Sep-12 $21.98 $ 0.225
1-Dec-13 $23.84 $ 0.225
2-Dec-13 $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.

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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

Divt 1  Pt 1  Pt 0.225  (21.03  19.54)

Rt 1    0.0878, or 8.78%
Pt 19.54

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Example 11.2b Compounding
Realized Returns

Execute:
• The table below includes the realized return at each period.

Date Price Dividend Return

3-Dec-12 $19.54
1-Mar-13 $21.03 $ 0.225 8.78%
1-Jun-13 $24.28 $ 0.225 16.52%
1-Sep-12 $21.98 $ 0.225 -8.55%
1-Dec-13 $23.84 $ 0.225 9.49%
2-Dec-13 $23.70 -0.59%

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Example 11.2b Compounding
Realized Returns

Execute:
• 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%

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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.

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11.2 Historical Risks and Returns of
Stocks

• Average Annual Returns

– Average Annual Return of a Security

1
R  ( R1  R2  ...  RT ) (Eq. 11.3)
T

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Figure 11.2 The Distribution of Annual Returns for U.S. Large
Company Stocks (S&P 500), Small Stocks, Corporate Bonds, and
Treasury Bills, 1926–2012

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Figure 11.3 Average Annual Returns in the U.S. for
Small Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2012

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11.2 Historical Risks and Returns of
Stocks

• The Variance and Volatility of Returns:

– Variance

1
Var  R  
T 1
 ( R1  R )2  ( R2  R )2  ...  ( RT  R ) 2  (Eq. 11.4)

– Standard Deviation

SD( R)  Var  R  (Eq. 11.5)

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Example 11.3 Computing Historical
Volatility

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

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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.
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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:

1
Var ( R)  ( R1  R ) 2  ( R2  R ) 2  ...  ( RT  R ) 2 
T 1
1
 (.049  .031)2  (.158  .031)2  (.055  .031)2   0.370  .0312  .265  .0312 
5 1  
 .058

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Example 11.3 Computing Historical
Volatility

Execute:
• 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%

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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%.

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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 2006 2007 2008 2009

Small Stocks’ Return 5.69% 16.17% -5.22% -36.72% 28.09%

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Example 11.3a Computing Historical
Volatility
Solution:
Plan:

Year 2005 2006 2007 2008 2009

Small Stocks’ Return 5.69% 16.71% -5.22% -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.

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Example 11.3a Computing Historical
Volatility

Execute:
• Using Eq. 11.3, the average annual return for small stocks
during this period is:
1
R  (.0569  .1671  .0522  .3672+.2809)  .0171
5
• We now have all of the necessary inputs for the variance
calculation:
• Applying Eq. 11.4, we have:

1
Var ( R)  ( R1  R )2  ( R2  R )2  ...  ( RT  R )2 
T 1
1
 (.0569  .0171)2  (.1671  .0171)2  (.0522  0171)2   .3672  .01712  .2809  .01712 
5 1  
 .0615

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Example 11.3a Computing Historical
Volatility

Execute:
• Alternatively, we can break the calculation of this equation
out as follows:
2005 2006 2007 2008 2009
Return 0.0569 0.1671 -0.0522 -0.3672 0.2809
Average 0.0171 0.0171 0.0171 0.0171 0.0171
Difference 0.0398 0.15 -0.0693 -0.3843 0.2638
Squared 0.0016 0.0225 0.0048 0.1477 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%

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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%.

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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 2008 2009 2010 2011 2012

Large Stocks' Return -37.0% 26.5% 15.1% 2.1% 16.0%

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Example 11.3b Computing Historical
Volatility

Solution:
Plan:

Year 2008 2009 2010 2011 2012

Large Stocks' Return -37.0% 26.5% 15.1% 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.

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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:

1
Var ( R)  ( R1  R )2  ( R2  R )2  ...  ( RT  R )2 
T 1
1
 (0.370  .045)2  (.265  .045)2  (.151  .045)2   0.021  .0452  .160  .0452 
5 1  
 .0615

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Example 11.3b Computing Historical
Volatility

Execute:
• Alternatively, we can break the calculation of this equation
out as follows:
Year 2008 2009 2010 2011 2012
Return -0.370 0.265 0.151 0.021 0.160
Average 0.045 0.045 0.045 0.045 0.045
Difference -0.415 0.220 0.106 -0.024 0.115
Squared 0.173 0.048 0.011 0.001 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%

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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%.

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Figure 11.4 Volatility (Standard Deviation) of U.S.
Small Stocks, Large Stocks (S&P 500), Corporate
Bonds, and Treasury Bills, 1926–2012

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11.2 Historical Risks and Returns of
Stocks

• The Normal Distribution

– About two-thirds of all possible outcomes fall
within one standard deviation above or below
the average
– 95% of all possible outcomes fall with two
standard deviations above or below the average
• 95% Prediction Interval

Average  (2 x standard deviation)

(Eq. 11.6)
R  (2 x SD  R  )

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Figure 11.5 Normal Distribution

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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 2010’s return?

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Example 11.4 Confidence Intervals

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

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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%.

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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 2010’s return, the best we can say is that it will
lie between –45.1% and +51.3%.

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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 2010’s return?

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Example 11.4a Confidence Intervals

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

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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% to 50.77%

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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 2010’s return, the best we can say is that it will lie
between -47.89% and +51.31%.

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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 2010’s return?

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Example 11.4b Confidence Intervals

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

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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%

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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 2010’s return, the best we can say is that it will
lie between -7.59% and +20.57%.

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Table 11.2 Summary of Tools for
Working with Historical Returns

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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

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Figure 11.6 The Historical Tradeoff Between
Risk and Return in Large Portfolios, 1926–2011

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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
doesn’t explain the size of its average return
– All individual stocks have lower returns and/or
higher risk than the portfolios in Figure 11.6

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11.4 Common Versus Independent
Risk

• Theft Versus Earthquake Insurance

• Types of Risk
– Common Risk
– Independent Risk
– Diversification

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Table 11.3 Summary of Types of Risk

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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 friend’s $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?

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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.

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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
don’t 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!

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Example 11.5 Diversification

Execute:
• 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.

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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.

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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 friend’s $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?

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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.

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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 don’t 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 0.50 100, which is
far less than even 0.0001%). If it happens, you should take a
very careful look at the dice!

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Example 11.5a Diversification

Execute:
• 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.

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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.

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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

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Figure 11.7 Volatility of Portfolios of
Type S and U Stocks

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Figure 11.8 The Effect of Diversification
on Portfolio Volatility

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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

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Table 11.4 Systematic Risk Versus
Unsystematic Risk

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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

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11.5 Diversification in Stock
Portfolios

• The Importance of Systematic Risk

– There is no relationship between volatility and
average returns for individual securities

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Table 11.5 The Expected Return of
Type S and Type U Firms, Assuming the Risk-Free
Rate Is 5%

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Chapter 11 Quiz

1. 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?
2. For what purpose do we use the average and
standard deviation of historical stock returns?
3. What is the relation between risk and return for
large portfolios? How are individual stocks
different?
4. What is the difference between common and
independent risk?
5. Does systematic or unsystematic risk require a
risk premium? Why?

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