CHAPTER 5

PORTFOLIO RISK AND RETURN: PART I

Presenter
Venue
Date

RETURN ON FINANCIAL ASSETS

Total Return

Periodic
Income

Capital Gain
or Loss

HOLDING PERIOD RETURN

A holding period return is the return from
holding an asset for a single specified period of
time.

Pt Pt 1 Dt Pt Pt 1 Dt
R

Pt 1
Pt 1
Pt 1
Capital gain Dividend yield

105 100
2
R

5% 2% 7 %
100
100

HOLDING PERIOD RETURNS

What is the 3-year holding period return if the
annual returns are 7%, 9%, and 5%?
R 1 R1 1 R2 1 R3 1

1 .07 (1 .09)(1 .05) 1 .1080 10.80%

AVERAGE RETURNS

Average
returns

Arithmetic
or mean
return

Geometric
mean return

Moneyweighted
return

ARITHMETIC OR MEAN RETURN

The arithmetic or mean return is the simple
average of all holding period returns.

Ri1 Ri 2 RiT 1 RiT 1 T

Ri
Rit
T
T t 1
50% 35% 27%
Ri
4%
3

GEOMETRIC MEAN RETURN

The geometric mean return accounts for the
compounding of returns.

RGi T 1 Ri1 1 Ri 2 1 RiT 1 1 RiT 1

T

T 1 Rit 1
t 1

RGi 3 (1 .50) (1 .35) (1 .27) 1 5.0%

MONEY-WEIGHTED RETURN

CF0
CF3
CF1
CF2

0
0
1
2
3
(1 IRR)
(1 IRR) (1 IRR)
(1 IRR)
- 100
- 950
350
1270

0
1
2
3
1
(1 IRR) (1 IRR)
(1 IRR)
IRR 26.11%

ANNUALIZED RETURN
rannual 1 rperiod 1
c

c : number of periods in a year

Weekly return of 0.20%:

rannual (1 0.002) 1 .1095 10.95%

52

18-month return of 20%:

2

rannual (1 0.20) 3 1 0.1292 12.92%

GROSS AND NET RETURNS

Gross returns

Expenses

Net returns

PRE-TAX AND AFTER-TAX NOMINAL

RETURN

Pre-tax nominal
return

Taxes

After-tax
nominal
return

NOMINAL RETURNS AND REAL RETURNS

(1 r ) 1 rrF (1 ) (1 RP ) (1 0.03) (1 0.02) (1 0.05)
r 10.313%

1 rreal 1 rrF (1 RP ) (1 0.03) (1 0.05)

rreal 8.15%

1 rreal (1 r ) (1 ) (1 0.10313) (1 0.02)

rreal 8.15%

VARIANCE AND STANDARD DEVIATION OF A

SINGLE ASSET

Population

R
t 1

Sample

R R
T

s2

t 1

s s2

T 1

VARIANCE OF A PORTFOLIO OF ASSETS

Variance can be determined for N securities in a portfolio
using the formulas below. Cov(Ri, Rj) is the covariance of
returns between security i and security j and can be
expressed as the product of the correlation between the
two returns (i,j) and the standard deviations of the two
assets, Cov(Ri, Rj) = i,j ij.
N

2
P Var RP Var wi Ri
i 1

w w Cov R , R
N

i , j 1
N

w Var Ri
i 1

2
i

w w Cov R , R
N

i , j 1, i j

EXAMPLE 5-4 RETURN AND RISK OF A TWOASSET PORTFOLIO

Assume that as a U.S. investor, you decide to hold a
portfolio with 80 percent invested in the S&P 500 U.S.
stock index and the remaining 20 percent in the MSCI
Emerging Markets index. The expected return is 9.93
percent for the S&P 500 and 18.20 percent for the
Emerging Markets index. The risk (standard deviation) is
16.21 percent for the S&P 500 and 33.11 percent for the
Emerging Markets index. What will be the portfolios
expected return and risk given that the covariance
between the S&P 500 and the Emerging Markets index is
0.0050?

EXAMPLE 5-4 RETURN AND RISK OF A TWOASSET PORTFOLIO (CONTINUED)

RP w1 R1 w2 R2 0.80 0.0993 0.20 0.1820
0.1158 11.58%

P2 w12 12 w22 22 2w1w2Cov R1 , R2

0.80 2 0.16212 0.20 2 0.33112 (2 0.80 0.20 0.0050)

0.02281

P w12 12 w22 22 2w1w2Cov R1 , R2

0.02281 0.1510 15.10%

EXAMPLE 5-4 RETURN AND RISK OF A TWOASSET PORTFOLIO (CONTINUED)

EXHIBIT 5-5 RISK AND RETURN FOR U.S. ASSET

CLASSES BY DECADE (%)

EXHIBIT 5-7 NOMINAL RETURNS, REAL RETURNS, AND

RISK PREMIUMS FOR ASSET CLASSES (19002008)

IMPORTANT ASSUMPTIONS OF MEANVARIANCE ANALYSIS

Mean-variance
analysis

Returns are normally

distributed

Markets are
informationally and
operationally efficient

EXHIBIT 5-9 HISTOGRAM OF U.S. LARGE

COMPANY STOCK RETURNS, 1926-2008

Violations of the
normality assumption:
skewness and
kurtosis.

UTILITY THEORY
Expected
return

Variance or
risk

1
2
U E (r ) A
2
Utility of an
investment

Measure of
risk
tolerance or
risk aversion

INDIFFERENCE CURVES
An indifference
curve plots the
combination of
risk-return pairs
that an investor
would accept to
maintain a given
level of utility.

PORTFOLIO EXPECTED RETURN AND

RISK ASSUMING A RISK-FREE ASSET
Assume a portfolio of two assets, a risk-free asset
and a risky asset. Expected return and risk for that
portfolio can be determined using the following
formulas:

E RP w1 R f 1 w1 E Ri

w 1 w1 2w1 1 w1 fi f i
2
P

2
1

2
f

2
i

1 w1 i2
2

P 1 w1 1 w1 i
2

2
i

THE CAPITAL ALLOCATION LINE (CAL)

E(Rp)

CAL

E(Ri)
Equation of the CAL :
E Ri R f
E RP R f
P
i

Rf

p
i

EXHIBIT 5-15 PORTFOLIO SELECTION FOR TWO

INVESTORS WITH VARIOUS LEVELS OF RISK AVERSION

CORRELATION AND PORTFOLIO RISK

Correlation
between assets
in the portfolio
Portfolio risk

EXHIBIT 5-16 RELATIONSHIP BETWEEN

RISK AND RETURN

EXHIBIT 5-17 RELATIONSHIP BETWEEN

RISK AND RETURN

AVENUES FOR DIVERSIFICATION

Diversify
with asset
classes
Buy
insurance

Evaluate
assets

Diversify
with index
funds

Diversify
among
countries

EXHIBIT 5-22 MINIMUM-VARIANCE

FRONTIER

EXHIBIT 5-23 CAPITAL ALLOCATION LINE

AND OPTIMAL RISKY PORTFOLIO
CAL(P) is
the optimal
capital
allocation
line and
portfolio P
is the
optimal
risky
portfolio.

THE TWO-FUND SEPARATION THEOREM

Investment
Decision

Optimal
Investor
Portfolio
Financing
Decision

EXHIBIT 5-25 OPTIMAL INVESTOR

PORTFOLIO
Given the
investors
indifference
curve,
portfolio C on
CAL(P) is the
optimal
portfolio.

SUMMARY
Different approaches for determining return
Risk measures for individual assets and portfolios
Market evidence on the risk-return tradeoff
Correlation and portfolio risk
The risk-free asset and the optimal risky portfolio
Utility theory and the optimal investor portfolio