The Trade-off Between

Risk and Return

Chapter 6

2009 Cengage Learning/SouthWestern

The Trade-off Between Risk

and Return

The Trade-off Between Risk

and Return
The return earned on investments
represents the marginal benefit of investing.
Risk represents the marginal cost of
investing.
A trade-off always arises between expected
risk and expected return.
3

The Trade-off Between Risk

and Return
Valuing risky assets is a task fundamental to
financial management
Three-step procedure for valuing a risky asset
1. Determine the assets expected cash flows
2. Choose discount rate that reflects assets
risk
3. Calculate present value (PV cash inflows PV outflows)
This three-step procedure is called
discounted cash flow (DCF) analysis.
4

Understanding Returns
Total return: the total gain or loss
experienced on an investment over a given
period of time
Component
s of the
total
return

Income stream from the

investment
Capital gain or loss due to
changes in asset prices

Total return can be expressed either in dollar

terms or in percentage terms.
5

Dollar Returns
Total dollar return = income + capital gain or
loss
Terrell bought 100
shares of MicroOrb stock for $25
A year later:
Dividend =
$1/share
Sold for $30/share
Owen bought 50
shares of Garcia
Inc. stock for $15
A year later:
No dividends paid
Sold for $25/share

Dollar return
= (100 shares) x ($1 + $5)
= $600

Dollar return
= (150 shares) x ($15)
= $500
6

Percentage Returns
Terrells dollar return exceeded Owens by $100. Can
we say that Terrell was better off?

No, because Terrell and Owens initial investments

were different: Terrell spent $2,500 in initial
investment, while Owen spent $750.

totaldollarreturn
Total percentagereturn
initial investment

Percentage Returns
100 $1 $5
Terrell' s percentage return
0.24 24%
$2,500
50 $10
Owen' s percentage return
0.67 67%
$750
In percentage terms, Owens investment
performed better than Terrells did.
8

The History of Returns: Nominal Returns

The Value of $1 Invested in Stocks, Treasury Bonds,
and Bills

The History of Returns: Real Returns

The Real Value of $1 Invested in Stocks, Treasury Bonds,
and Bills

10

The Risk Dimension

Percentage Returns on Bills, Bonds, and Stocks, 1900 - 2006

11

Risk premium: the additional return that an

investment must offer, relative to some
alternative, because it is more risky than the
alternative.

Percentage Returns on Bills, Bonds,

and Stocks, 19002006

12

Percentage
Returns on
Stocks,
Treasury Bonds
and Bills,
1900 - 2006

13

Table 6.2 Risk Premiums for Stocks,

Bonds, and Bills, 19002006

14

Volatility and Risk

Average Returns and Standard Deviation for Equities, Bonds,
and Bills, 1900 - 2006

Asset classes with greater volatility pay

higher average returns.
Average return on stocks is more than double the
average return on bonds, but stocks are 2.5 times
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more volatile.

The Distribution of Historical Stock

Returns
1900 - 2006

16

We can approximate the unknown probability distribution for

future stock returns by assuming a normal distribution.

The Variability of Stock

Returns

Normal distribution can be described by

its mean and its variance.

Variance (2) a measure of volatility in units of

percent
squared
N

Variance
2

2
(
R

R
)
t
t 1

N 1

Standard deviation a measure of volatility in

percentage
terms

Standard deviation Variance

17

Table 6.3 Estimating the Variance of

Stock Returns from 19942006

18

Table 6.4 Average Returns and Standard

Deviation for Equities, Bonds, and Bills,
(19002006)

19

Fig. 6.6 The Relationship Between Average

(Nominal) Return and Standard Deviation for Stocks,
Treasury Bonds, and Bills, 1900 - 2006

Investors who want higher returns have to take more risk.

The incremental reward from accepting more risk is constant.
20

The Power of Diversification

Average Returns and Standard Deviations for 11

Stocks, 1994-2006

From 1994 2006, the standard deviation of the typical stock

in the U.S. was abut 60% per year, while the standard
deviation of the entire stock market was only 19.8%! 21

The Power of Diversification

Most individual stock prices show higher volatility
than the price volatility of a portfolio of all common
stocks.
How can the standard deviation for individual stocks
be higher than the standard deviation of the portfolio?

Diversification: The act of investing in many

different assets rather than just a few, so as to
reduce volatility.
The ups and downs of individual stocks partially
cancel each other out.
22

Annual Returns on
Coca-Cola and Wendys International

The two stocks did not always move in sync.

The net effect is that the portfolio is less volatile than either
stock held in isolation.
23

Average Returns and Standard

Deviations of Portfolios of Stocks and
Bonds, 1972 - 2006

24

The Relationship Between Portfolio Standard

Deviation and the Number of Stocks in the
Portfolio

The risk that diversification eliminates is called unsystematic risk.

The risk that remains, even in a diversified portfolio, is called
systematic risk.
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Systematic and
Unsystematic Risk

Diversification reduces portfolio volatility, but

only up to a point. Portfolio of all stocks still
has a volatility of 19.8%.
Systematic risk: the volatility of the portfolio
that cannot be eliminated through
diversification.
Unsystematic risk: the proportion of risk of
individual assets that can be eliminated
through diversification
What really matters is systematic risk.
how a group of assets move together.
26

Risk and Return Revisited

For the various asset classes, a trade-off
arises between risk and return.
Does this trade-off hold for
individual securities?

27

Average Returns and Standard

Deviations
for 11 Stocks, 1994-2006

No obvious pattern here!

28

Risk and Return Revisited

Anheuser-Busch had a higher average return than
Archer Daniels Midland, and with smaller volatility.
American Airlines had a much smaller average
return than Wal-Mart, with similar volatility.
The tradeoff between standard deviation and
average returns that holds for asset classes does
not hold for individual stocks!
Standard deviation contains both systematic and
unsystematic risk.
Because investors can eliminate unsystematic risk
through diversification, market rewards only
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systematic risk.

Risk Premiums Around the

World

30

The Trade-off Between Risk

and Return
Investment performance is measured by
total return.
Trade-off between risk and return for
assets: historically, stocks have higher
returns and volatility than bonds and bills.
One measure of volatility: standard
deviation
Systematic risk: risk that cannot be
eliminated through diversification
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