The Risk-Return Trade-Off

• investors like returns and they dislike risk.

• a fundamental trade-off between risk and return: to entice investors to take on more risk, you
must provide them with higher expected returns.

Risk is defined by Webster’s Dictionary as “a hazard; a peril; exposure to loss or injury.” Thus, risk refers
to the chance that some unfavourable event will occur. If you engage in skydiving, you are taking a
chance with your life—skydiving is risky. If you bet on the horses, you are risking your money.

An asset’s risk can be analysed in two ways:

(1) on a stand-alone basis, where the asset is considered by itself

(2) on a portfolio basis, where the asset is held as one of several assets in a portfolio.

the risk of an asset is different when the asset is held by itself versus when it is held as a part of a group,
or portfolio, of assets

Stand-Alone Risk is the risk an investor would face if he or she held only this one asset.

No investment should be undertaken unless the expected rate of return is high enough to compensate
for the perceived risk.
STATISTICAL MEASURES OF STAND-ALONE RISK

1. Probability distributions: Listings of possible outcomes or events with a probability (chance of

occurrence) assigned to each outcome

2. Expected rates of return, r ⁄ (“r hat”): The rate of return expected to be realized from an investment;
the weighted average of the probability distribution of possible results,

the tighter the probability distribution, the lower the risk.

3. Historical, or past realized, rates of return, r (“r bar”):

because past results are often repeated in the future, the historical “s” (Standard Deviation ) is often
used as an estimate of future risk.

Using a longer historical time series has the benefit of giving more information, but some of that
information may be misleading if you believe that the level of risk in the future is likely to be very
different from the level of risk in the past.

4. Standard deviation, s (sigma):

The standard deviation, s, is a measure of how far the actual return is likely to deviate from the
expected return

We can use the standard deviation (s, pronounced “sigma”) to quantify the tightness of the probability
distribution. The smaller the standard deviation, the tighter the probability distribution and, accordingly,
the lower the risk

how do we choose between two investments if one has the higher expected return but the other has
the lower standard deviation?

5. Coefficient of variation (CV): analysts often use other measures of risk. One measure, the coefficient
of variation (CV), is the standard deviation divided by the expected return.

The coefficient of variation shows the risk per unit of return, and it provides a more meaningful risk
measure when the expected returns on two alternatives are not the same.
6. Sharpe ratio: weighs the return on an investment against its volatility.

An investment with a higher Sharpe ratio means it’s a

stable stock compared to one with a lower ratio even
though the latter may have higher expected returns.

Depending on the circumstances, an analyst may

calculate the Sharpe ratio using historical returns and
standard deviation, or they may base their calculations
on forward-looking estimates of expected returns. In
either case, excess returns measure the amount that
investment returns are above the risk-free rate— so
investments with returns equal to the risk-free rate
will have a zero Sharpe ratio.
RISK AVERSION AND REQUIRED RETURNS

Risk-averse
investors dislike
risk and require
higher rates of
return as an
inducement to
buy riskier
securities.

Risk Premium
(RP) The difference between the expected rate of return on a given risky asset and that on a less risky
asset

In a market dominated by risk-averse investors, riskier securities compared to less risky securities must
have higher expected returns as estimated by the marginal investor. If this situation does not exist,
buying and selling will occur until it does exist.

Risk in a Portfolio Context: The CAPM

the risk of stocks when they are held in portfolios rather than as stand-alone assets. Our discussion is
based on an extremely important theory, the capital asset pricing model, or CAPM

when a stock is held in portfolio one particular stock’s price increases or decreases is not important-
what is important is the return on the portfolio and the portfolio’s risk. Logically, then, the risk and
return of an individual stock should be analysed in terms of how the security affects the risk and return
of the portfolio in which it is held.

EXPECTED PORTFOLIO RETURNS

The weighted average of the expected returns on the assets held in the portfolio.
PORTFOLIO RISK

Although the expected return on a portfolio is simply the weighted average of the expected returns on
its individual stocks, the portfolio’s risk, sP , is not the weighted average of the individual stocks’
standard deviations. The portfolio’s risk is generally smaller than the average of the stocks’ sS because
diversification lowers the portfolio’s risk

The tendency of two variables to move together is called correlation,

the correlation coefficient, r (pronounced “rho”), measures this tendency.

Negative correlation reduces risk

Perfectly negatively correlated r=-1

Positive correlation: a portfolio consisting of these stocks would be exactly as risky as the individual
stocks.

Thus, diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly
positively correlated.

Perfectly positively correlated, r = +1

0 indicates no relation between stocks

As a rule, on average, portfolio risk declines as the number of stocks in a portfolio increase

The portfolio’s total risk can be divided into two parts

1. diversifiable risk: That part of a security’s risk associated with random events; it can be
eliminated by proper diversification. This risk is also known as company specific, or unsystematic
risk
Diversifiable risk is caused by such random, unsystematic events as lawsuits, strikes, successful
and unsuccessful marketing and R&D programs, the winning or losing of a major contract, and
other events that are unique to the particular firm. Because these events are random, their
effects on a portfolio can be eliminated by diversification—bad events for one firm will be offset
by good events for another.
2. market risk: The risk that remains in a portfolio after diversification has eliminated all company-
specific risk. This risk is also known as nondiversifiable or systematic or beta risk.

Market risk stems from factors that systematically affect most firms: war, inflation, recessions, high
interest rates, and other macro factors. Because most stocks are affected by macro factors, market
risk cannot be eliminated by diversification.
 If we carefully selected the stocks included in the portfolio rather than adding them randomly, the
graph would change. If we chose stocks with low correlations with one another and with low stand-
alone risk, the portfolio’s risk would decline faster than if random stocks were added. The reverse
would hold if we added stocks with high correlations and high ss.

Market Portfolio

A portfolio consisting of all stocks. for many investors an ideal strategy is to hold a large diversified
market portfolio that has low transactions costs and fees.

How then should we measure a stock’s risk in a world where most

people hold portfolios?
THE BETA COEFFICIENT
all risk except that related to broad market movements can and will be
diversified away by most investors—rational investors will hold enough
stocks to move down the risk curve to the point where only market risk
remains in their portfolios.
Relevant Risk The risk that remains once a stock is in a diversified portfolio is its contribution to the
portfolio’s market risk. It is measured by the extent to which the stock moves up or down with the
market
The tendency of a stock to move with the market is measured by its beta coefficient, b.

Beta Coefficient, b A metric that shows the extent to which a given stock’s returns move up and down
with the stock market. Beta measures market risk.

Ideally, when estimating a stock’s beta, we would like to have a crystal ball that tells us how the stock is
going to move relative to the overall stock market in the future. But because we can’t look into the
future, we often use historical data and assume that the stock’s historical beta will give us a reasonable
estimate of how the stock will move relative to the market in the future.

A plot of the data shows that the three stocks moved up or down with the market, but that H was twice
as volatile as the market, A was exactly as volatile as the market, and L had only half the market’s
volatility. It is apparent that the steeper the line, the greater the stock’s volatility and thus the larger its
loss in a down market. The slopes of the lines are the stocks’ beta coefficients
an average stock’s beta, bA = 1.0

A large portfolio of such b= 1.0 stocks would

(1) have all its diversifiable risk removed

(2) still move up and down with the broad market averages and thus have a degree of risk.

Stock H, which has b = 2.0, is twice as volatile as an average stock, which means that it is twice as risky.
The value of a portfolio consisting of b = 2.0 stocks could double—or halve—in a short time, and if you
held such a portfolio, you could quickly go from being a millionaire to being a pauper.

Stock L, on the other hand, with b = 0.5, is only half as volatile as the average stock, and a portfolio of
such stocks would rise and fall only half as rapidly as the market. Thus, its risk would be half that of an
average-risk portfolio with b = 1.0

If a stock whose beta is greater than 1.0 (say, 1.5) is added to a bp = 1.0 portfolio, the portfolio’s beta
and consequently its risk will increase.

Conversely, if a stock whose beta is less than 1.0 is added to a bp = 1.0 portfolio, the portfolio’s beta
and risk will decline.

Thus, because a stock’s beta reflects its contribution to the riskiness of a portfolio, beta is the
theoretically correct measure of the stock’s riskiness.

A stock’s risk has two components,

1. diversifiable risk: can be eliminated, and most investors do eliminate it, either by holding very
large portfolios or by buying shares in a mutual fund
2. market risk: which is caused by general movements in the stock market and reflects the fact
that most stocks are systematically affected by events such as wars, recessions, and inflation.
Market risk is the only risk that should matter to a rational, diversified investor.

Investors must be compensated for bearing risk—the greater the risk of a stock, the higher its required
return.

However, compensation is required only for risk that cannot be eliminated by diversification.

If risk premiums existed on a stock due to its diversifiable risk, that stock would be a bargain to well-
diversified investors. They would start buying it and bid up its price, and the stock’s final (equilibrium)
price would be consistent with an expected return that reflected only its market risk.

The market risk of a stock is measured by its beta coefficient, which is an index of the stock’s relative
volatility.

b = 0.5: Stock is only half as volatile, or risky, as an average stock.

b = 1.0: Stock is of average risk.

b = 2.0: Stock is twice as risky as an average stock

To illustrate, if an investor holds a $100,000 portfolio consisting of $33,333.33 invested in each of three
stocks and if each of the stocks has a beta of 0.70, the portfolio’s beta will be bp = 0.70

Such a portfolio would be less risky than the market, so it should experience relatively narrow price
swings and have relatively small rate-of-return fluctuations.

The Relationship between Risk and Rates of Return

The next issue is this: For a given level of risk as measured by beta, what rate of return is required to
compensate investors for bearing that risk?

The market risk premium, RPM, shows the premium that investors require for bearing the risk of an
average stock. The size of this premium depends on how risky investors think the stock market is and on
their degree of risk aversion.
The risk premium on individual stocks varies in a systematic manner from the market risk premium. For
example, if one stock is twice as risky as another stock as measured by their beta coefficients, its risk
premium should be twice as high.

Therefore, if we know the market risk premium, RPM, and the stock’s beta, bi , we can find its risk
premium as the product (RPM)bi

the required return for any stock can be found as follows:

Here the risk-free return includes a premium for expected inflation.

if we assume that the stocks under consideration have similar maturities and liquidity, the required return on Stock L can be

found using the security market line (SML) equation:

Security Market Line (SML): An equation that shows the relationship between risk as measured by beta and the required rates

of return on individual securities.

1.Required rates of return are shown on the vertical

axis, and risk as measured by beta is shown on the

horizontal axis

2.Riskless securities have bi = 0—so the return on the

riskless asset, rRF = 3%, is shown as the vertical axis

intercept in Figure 8.8.

3.The slope of the SML in Figure 8.8 can be found using

the rise-over-run procedure. When beta goes from 0 to

1.0, the required return goes from 3% to 8%, or 5%—

so the slope is 5%/1.0 5 5%. Thus, a 1-unit increase in

beta causes a 5% increase in the required rate of

return.
4. The slope of the SML reflects the degree of risk aversion in the economy— the greater the average investor’s risk

aversion,

(a) the steeper the slope of the line

(b) the greater the risk premium for all stocks—hence, the higher the required rate of return on all stocks.

The SML shows the required returns for a given level of risk. Investments outperform the market when they earn

realized returns that are greater than these required returns—doing so is often referred to as generating positive

alpha. Similarly, investments with realized returns below their required returns have negative alphas.

Graphically, positive alpha investments end up above the SML, whereas negative alpha investments end up below the

SML