Chapter 8: Risk & Return

Sumbal Waqas
Learning Objectives
 How to calculate the historical single period investment
return for a security or portfolio of securities
 The different methods for calculating returns
 What is meant by efficient portfolio
 expected return and risk of a portfolio of assets
 Difference between systematic and unsystematic risk
 Impact of diversification on total risk
Risk and Return
 Goal of investment; maximize returns and minimize risk
 High return investor will have to bear high risk
 Low return investor will bear low risk
 Investing in single securities you compromise on either;
 If investing in fixed income- low return and low risk
 If investing in stocks- high return and high risk
 A portfolio of securities maximizes returns and
diversifies/minimizes risk
Risk and Return
 Value of Financial Asset= PV of cash flows expected
 Two steps:
 Estimating the cash flows
 Determining the appropriate interest rate
 Interest rate depends on the minimum interest rate plus risk
premium
 The amount of risk premium depends on risk associated with
realizing the cash flows
 Determining the appropriate risk premium is done through
the relationship between expected return and risk
Measuring Investment Return
 Return on an investors portfolio=
 Rp= (V1 –Vo + D)/ Vo
 V1= portfolio market value at the end of the interval
 Vo= portfolio market value at the beginning of the interval
 D= the cash distributions to the investor during the interval
 V1 reflects any interest income or dividends received are
reinvested if not distributed
 Assumptions:
 Distribution occurs at the end of the interval
 No capital inflows during the interval
Example:
 XYZ mutual fund contained market value of $100million at
the end of June
 Interest payment of $5million made at the end of July
 End of July market value of $103 million
 Rp= (V1 –Vo + D)/ Vo
 Rp = (103,000,000 – 100,000,000 +
5,000,000)/100,000,000 = 0.08
 Rp for the month is 8%
Measuring Investment Return
 Returns can be calculated for any interval of time, e.g: 1
month or 10 years
 Problems:
 Calculations made for more than a few months not reliable as
assumption states all payments and inflows made and received at
the end of the period
 Comparison: cannot compare return on 1 month investment
with that of 10 years portfolio
Measuring Investment Return
 The problems are fixed by;
 Arithmetic Average Rate of Return
 Time-Weighted Rate of Return
Arithmetic Average Rate of Return
 Ra= (Rp1 + Rp2 + ….+Rpn)/n
 Ra= the arithmetic average return
 Rpk= the portfolio returns in interval k
 K= 1….N
 N= the number of intervals
 E.g: the portfolio return were -10%. 20% and 5% in July,
August and September
 Ra= (-10% +20% +5%)/3= 5%
Time-Weighted Rate of Return
 Aka geometric rate of return
 Rt= [(1+Rp1)(1+Rp2)….(1+Rpn)] 1/N – 1
 Measures the compounded rate of growth of the initial
portfolio
 Assumes that cash distributions are reinvested in portfolio
 Example:
 The portfolio returns were -10%. 20% and 5% in July,
August and September
 [(1-0.10)(1+0.2)(1+0,05)] 1/3 – 1= 0.43
 It means that the return is 4.3% per month. $1invested in the
portfolio at the end of June would have grown at a rate 4.3%
per month during the 3 month period
Arithmetic mean vs Geometric mean
 Assume that we have a 6-year sequence of investment returns
as follows:
 {40%, -30%, 40%, -30%, 40%, -30%}
 AM=(0.4 – 0.3 + 0.4 – 0.3 + 0.4 – 0.3 + 0.4 – 0.3)/6 =
0.05 or 5%
 GM:
 Therefore, our geometric mean return = (1.4 * 0.7 * 1.4 *
0.7 * 1.4 * 0.7 * 1.4 * 0.7)1/6 – 1 = -0.01 or -1%
 Considering the above example, a fund manager will most
likely quote the 5% return. Unfortunately, this is not the real
return! The actual return is -1% (a loss).
 Suppose you invested in an emerging mutual fund and earned
100% in the first year followed by a 50% loss in the second
year. The arithmetic mean return will be 25% i.e. (100 –
50)/2.
 Applying the geometric mean return formula outlined above
will give you a mean return of zero! If you start with $1,000,
you will have $2,000 at the end of year 1 which will be
reduced to $1,000 by the end of year 2. Thus, you earn a
return of zero over the 2-year period.
 The inaccuracy is caused by two factors:
 The compounding of returns
 The fluctuation, volatility, in the percentage return earned
from year to year
Portfolio Theory
 “Efficient portfolios” are investments that maximize the
expected return for some level of risk investors are willing to
accept
 Assumptions: investors are risk averse
 Given a choice of efficient portfolios investor will select the
optimal portfolio
 PORTFOLIO THEORY
 Portfolio theory works out the ‘best combination’ of
stocks to hold in your portfolio of risky assets.

 You like return but dislike ‘risk’

 We assume the investor is trying to ‘mix’ or combine

stocks to get the best return relative to the overall
riskiness of the chosen portfolio.

14 Copyright K. Cuthbertson and D. Nitzsche

Risky Asset vs Risk-free asset
 Risky asset is one which the return realized will be uncertain
 E.g. stocks, bonds, government securities
 Risk-free asset; return realized for the future is known for
sure today
 E.g: short term government securities
Expected Portfolio return
 Expected return is the weighted average of possible
outcomes
E(Rp) = P1R1 +P2R2+…+RnPn
E(Rp)= ∑PR
Example
Outcome Possible Return Probability
1 50% 0.1
2 30 0.2
3 10 0.4
4 -10 0.2
5 -30 0.1

E(Rp)= 0.1(50%)+ 0.2(30) + 0.4(10) + 0.2(-10) + 0.1(-30) = 10%

Risk
 Chance of achieving less returns than expected
 Measure risk by the dispersion of possible returns below
expected value
 Variance and standard deviation
Var (Rp)= P1[R1- E(Rp)]2 + P2[R2- E(Rp)]2 +….+ Pn[Rn-
E(Rp)]2
Var (Rp) = 0.1(50%-10%)2 +0.2(30-10)2 + 0.4(10-10)2 +
0.2(-10-10)2 + 0.1 (-30-10)2 = 480%
SD= 22%
Diversification
 Systematic risk is the market related risk: undiversifiable risk
 If returns of securities are less than perfectly correlated
diversification of portfolio risk occurs
 Diversification occurs with increasing number of holdings,
the SD declines but average returns is unrelated to the
number of holdings
 At a portfolio size of about 20 randomly selected common
stocks the level of total portfolio risk is reduced such that
what is left is systematic risk
 For individual stocks the ratio of systematic risk to total risk
is bout 30%
Systematic and unsystematic portfolio
risk
Financial Jargon
Optimal Portfolio
Risk averse
Risk free or riskless asset
Standard deviation
Systematic risk
Expected return
Practice Questions
 Calculate the historical rate of return for the months of Jan
and Feb for MN Corp:
Price on Jan 1: $20
Cash dividends in Jan= $0
Price on Feb 1: $21
Cash dividends in Feb= $2
Price on March 1: $24
Practice Questions
 Suppose monthly return for two investors is as follows:
Month Investor 1 Investor 2
1 9% 25%
2 13% 13%
3 22% 22%
4 -18% -24%
a) What is the arithmetic average monthly rate of return for 2
investors?
b) What is the time-weighted average monthly rate of return
for two investors?
c) Why does the AM diverge more from the GM for investor
2 than investor 1?
Practice Questions
 The probability distribution for the one-period return of
some asset is as follows:
Return Probability
0.20 0.10
0.15 0.20
0.10 0.30
0.03 0.25
-0.06 0.15

 What is the assets expected one-period return ?

 What is the assets variance and SD for the one period return?