Return and Risk Analysis

Objective

1. To help students understand the relationship between risk and return of an investment

2. To equip students with tools for measuring risk and return.

Return

- It refers to income received from an investment plus any change in market price,
usually expressed as a percentage of the beginning market price of the investment.

For example buy for $100 a security that would pay $7 in cash to you and be worth
$106 one year later. The return would be:

= $7+$6)/100

= 13%

Risk

- Refers to variability of returns from those that are expected.

Probability Distribution to measure Risk

- For risky securities (Assets), the actual rate of return can be viewed as a random variable
subject to a probability distribution.

- The risk associated with an asset can be measured more accurately by the use of
probability distribution than the range analysis as the range is based on only two extreme
values. The probability of an event represents the chances of its occurrence. For instance,
if the chance of an event taking place is 3 out of 5, it can be said to have 60% chance or
0.60 probabilities.

Expected Return

- It is the weighted average of possible returns, with the weights being the probabilities
of occurrence

Where:
E (R) = is the expected Return

P n = Number of possible outcomes

Pi = Possibility associated with ith possible outcome.

Ri = Rate of return for the ith possible outcome.

Example

Suppose that an investor believed that the possible one year returns for investing in a
particular common stock were as shown Below

State of economy Probability (Pi) Possible Return Ri (%)

Excellent 0.25 10

Good 0.50 12

Poor 0.25 14

Expected Return = (0.25*10) + (0.50*12) + (0.25*14)

= 12%

State of Economy Probability Possible Return Expected Return = (Pi*Ri)

Excellent 0.25 10 2.50
Good 0.50 12 6.00
Poor 0.25 14 3.50
Total 12.00

Standard Deviation (σ):

Standard deviation is the most common quantitative measure of risk of an asset. Unlike the
range, it considers every possible event and weight equal to its probability is assigned to each
event. Standard deviation is a measure of dispersion around the expected or average mean
value.

In this method the deviations are squared making all values positive. Then the weighted
average of these figures is taken, using probabilities on weights. The result is termed as
variance. It is converted to the original units by taking the square root. The result is termed as
standard deviation. Symbolically,
Where:

σ= Standard deviation

n = Number of possible outcomes

Ri = Rate of return from the ith possible outcomes

E(R) = Expected return

Pi = Possibility associated with the ith possible outcome

Let us use the same example shown below and now you are required to find the risk of this
investment:

State of economy Probability (Pi) Possible Return Ri (%)

Excellent 0.25 10

Good 0.50 12

Poor 0.25 14

Solution:

Step 1:

Find Variance:

σ2= ∑Pi[E(R) –R]2

= [0.25*(12-10)2] + [0.50* (12-12)2] + [0.25 (12-14)2]

=2

Step 2

Find Standard Deviation

σ = √variance = √ σ2
 = √2

= 1.414

Accordingly, this investment has very low risk of 1.414% with expected return of 12%, an
investor can compare these factors with an alternative return

Coefficient of Variation

- The standard deviation can sometimes be misleading in comparing the risk, or

uncertainty, surrounding alternatives if they differ in size.

- Consider two investment opportunities, A and B, whose normal probability

distribution of one year have the following characteristics:

Investment A Investment B
Expected Return 8% 24%
E(R)
Standard Deviation 6% 8%
Coefficient of 0.75 0.33
Variation, CV

- From the data above it might appear investment B is riskier than investment A. We
need to qualify our assumption by measuring relative risk and thus Coefficient of
variation.
- The coefficient of variation (CV) is a statistical measure of the relative dispersion of
data points in a data series around the mean.
- In finance, the coefficient of variation allows investors to determine how much
volatility, or risk, is assumed in comparison to the amount of return expected from
investments.
- The lower the ratio of the standard deviation to mean return, the better risk-return
trade-off.
- The larger the CV, the larger the relative risk of the investment.

Coefficient of Variation (CV) = σ/E(R)

Investment A = 0.6/0.8 Investment B = 0.8/0.24

= 0.75 = 0.33

Using CV as our risk measure, Investment A with a return distribution CV of 0.75 is

viewed as being more riskier than investment B, whose CV equals only 0.33

Risk and Return Relationship

Return

SML
 1 σ

- The risk-return trade-off is an investment principle that indicates that the higher the
risk, the higher the potential reward.
- To calculate an appropriate risk-return trade-off, investors must consider many
factors, including overall risk tolerance, the potential to replace lost funds and more.

- Investors consider the risk-return trade-off on individual investments and across

portfolios when making investment decisions

Attitude towards risk

- Different people have different attitudes toward the risk-return tradeoff.

- People shy away from risks and prefer to have as much security and certainty as is
reasonably affordable in order to lower their discomfort level.

- They would be willing to pay extra to have the security of knowing that unpleasant
risks would be removed from their lives.

- The generally accepted view is that investors are, by and large, risk averse. This
implies that risky investments must offer higher expected returns than less risky
investments in order for people to buy and hold them.

- a risk seeker is someone who will enter into an endeavor (such as blackjack card
games or slot machine gambling) as long as a positive long run return on the money is
possible, however unlikely (much more like gambling).

- Risk neutral when its risk preference lies in between these two extremes (risk averse
and risk seeker). Risk neutral individuals will not pay extra to have the risk
transferred to someone else, nor will they pay to engage in a risky endeavor.

- The table below shows most likely attitude of risk in different life stages:

Life Cycle Stages Young Middle Years/ Retirement/ Spending

Person/Accumulation Consolidation Stage & Gifting
Stage
Return No need for Little need for current Stable current income
Investment income, income, total return to meet expenses not
inflation protection, desired, inflation met by social security
real returns protection. and pension, inflation
protection.
Risk High tolerance, can risk Still a high risk Little tolerance relative
 loss of principal. tolerance but less so. to principle.

Risk and return in a portfolio context

- A Portfolio is a combination of two or more assets/securities

Portfolio Return

- The returns on the portfolio are calculated as the weighted average of the returns on
all the assets held in the portfolio.

For example, if an asset constitutes 25% of the portfolio, its weight will be 0.25. Note that
sum of all the asset weights will be equal to 1, as it will represent 100% of the investment

Portfolio Risk

- Is the risk that is inherent in a combination of invested assets.

- It is calculated considering the relationship among the returns of the assets that make
up the portfolio

Risk Diversification

- Diversification is a strategy that mixes a wide variety of investments within a

portfolio in an effort to minimise risk.
- Portfolio holdings can be diversified across asset classes and within classes, and also
geographically—by investing in both domestic and foreign markets.
 - Diversification limits portfolio risk but can also mitigate performance, at least in the
short term.

Systematic Risk

- Systematic risk is risk associated with market returns. This is risk that can
be attributed to broad factors. It is risk to your investment portfolio that
cannot be attributed to the specific risk of individual investments.

- Sources of systematic risk could be macroeconomic factors such as inflation,

changes in interest rates, fluctuations in currencies, recessions, wars, etc.
Macro factors which influence the direction and volatility of the entire market
would be systematic risk. An individual company cannot control systematic
risk

- Systematic risk can be partially mitigated by asset allocation.

Unsystematic risk

- Unsystematic risk is company specific or industry specific risk. This is risk

attributable or specific to the individual investment or small group of investments. It
is uncorrelated with stock market returns. Other names used to describe unsystematic
risk are specific risk, diversifiable risk, idiosyncratic risk, and residual risk.

- Examples of risk that might be specific to individual companies or industries are

business risk, financing risk, credit risk, product risk, legal risk, liquidity risk, political
risk, operational risk, etc

- Proper diversification can nearly eliminate unsystematic risk.

Practice Questions:

Question Four (20 Marks)

1. The data in the table below relates to a portfolio of shares in Ltd and Dube Ltd.

Probability Forecast return Forecast return

 Magocha Ltd Synthia Ltd
% %
0.20 12 12
0.60 14 16
0.20 16 22

Required:
(i) Find expected return for each of the securities.
(ii) Find the risk of each of the securities.
(iii) Recommend the best security.
(iv) Find the Coefficient of Variation of the two stocks

2. i) Graphically explain the risk-return relationship.

ii) Define risk and state three measures of risk
iii) State the difference between Systematic and Unsystematic risks.
iv) What are the advantages of risk diversification?
v) Define coefficient of Variation (CV)
3. If investors were not risk-averse on average, but rather were either risk indifferent (neutral) or even
liked risk, would the risk-return concepts hold? Explain your answer.