RISK & RETURN (272 – 303)

Part 1: The Risk-Return Trade-Off (272 & 273)

 Investors like returns and they dislike risk.
 There is a fundamental trade-off between risk and return: to entice investors to take on more risk, you have
to provide them with higher expected returns.
 The slope of the risk-return line indicates how much additional return an individual investor requires in order
to take on a higher level of risk.
 A steeper line suggests that an investor is very averse to taking on risk. (Reluctance to take on risks = risk
averse)
 A flatter line would suggest that the investor is more comfortable bearing risk.
 Investors who are less comfortable bearing risk tend to gravitate toward lower-risk investments.
 While investors with a greater-risk appetite tend to put more of their money into higher-risk, higher-return
investments.
 The average investor’s willingness to take on risk also varies over time.
 For example, before the recent financial crisis, an increasing number of investors were putting their money
into riskier investments that included high-growth stocks, junk bonds, and emerging market funds.
 After the crisis, there was a tremendous “flight to quality” where investors rapidly moved away from riskier
investments and instead flocked toward safer investments such as Treasury securities and money market
funds.
 At any point in time, an investor’s goal should be to earn returns that are more than sufficient to compensate
for the perceived risk of the investment.
 In other words, getting above the risk-return tradeoff line.
 The trade-off between risk and return is also an important concept for companies trying to create value for
their shareholders.
 If a company is investing in riskier projects, it must offer its investors (both bondholders and stockholders)
higher expected returns.
 Higher-risk companies must pay higher yields on their bonds to compensate bondholders for the additional
default risk.
 Riskier companies trying to increase their stock price must generate higher returns to compensate their
stockholders for the additional risk.
 It is important to understand that the returns that companies have to pay their investors represent the
companies’ costs of obtaining capital.
 From a company’s perspective, the risk-return line represents its cost of obtaining capital, and the slope of
the risk-return line reflects the average investor’s current willingness to take on risk.
 Companies create value by investing in projects where the returns on the investments exceed their costs of
capital.

Part 2a: Stand-Alone Risk (274 -276)

 Risk is defined as a hazard; a peril; exposure to loss or injury.
 Risk refers to the chance that some unfavourable event will occur.
 Individuals and firms invest funds today with the expectation of receiving additional funds in the future.
 Bonds offer relatively low returns, but with relatively little risk— particularly Treasury and high-grade
corporate bonds.
 Stocks offer the chance of higher returns, but stocks are riskier than bonds.
 If you invest in speculative stocks, you are taking a significant risk in the hope of making an appreciable
return.
 An asset’s risk can be analysed in two ways: On a stand-alone basis, where the asset is considered by itself or
on a portfolio basis, where the asset is held as one of a number of assets in a portfolio.
 An asset’s stand-alone risk is the risk an investor would face if he or she held only this one asset.
 Most financial assets, and stocks in particular, are held in portfolios, but it is necessary to understand stand-
alone risk to understand risk in a portfolio context.
 If an investor buys $100,000 of short-term Treasury bills with an expected return of 5%.
 In this case, the investment’s return, 5%, can be estimated quite precisely, and the investment is defined as
being as almost risk-free.
 This same investor could also invest the $100,000 in the stock of a company just being organized to prospect
for oil.
 In the worst case, the company would go bankrupt, and the investor would lose all of his or her money, in
which case the return would be -100%.
 In the best-case, the company would discover huge amounts of oil, and the investor would receive a 1,000%
return.
 When evaluating this investment, the investor might analyse the situation and conclude that the expected
rate of return, in a statistical sense, is 20%.
 However, the actual rate of return could range from 1,000% to -100%.
 Since there is a significant danger of earning much less than the expected return, such a stock would be
relatively risky.
 No investment should be undertaken unless the expected rate of return is high enough to compensate for
the perceived risk.
 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.
 The table shows probability distributions for Martin Products, which makes engines, and for U.S. Water,
which supplies water and thus has very stable sales and profits.
 Three possible states of the economy are shown in column 1 and and the probabilities of these outcomes,
expressed as decimals in column 2.
 There is a 30% chance of a strong economy, a 40% probability of normal demand, and a 30% probability of
weak demand.
 Columns 3 and 6 show the returns for the two companies under each state of the economy.
 Returns are relatively high when demand is strong and low when demand is weak.
 Martin’s rate of return varies far more widely than U.S. Water’s.
 There is a fairly high probability that Martin’s stock will suffer a -60% loss, though at worst, U.S. Water should
have a 5% return.
 Columns 4 and 7 show the products of the probabilities times the returns under the different demand levels.
 When we sum these products, we obtain the expected rate of return, r (“r-hat”), for each stock. Both stocks
have an expected return of 10%.
 Expected Rate of Return, r is the rate of return expected to be realized from an investment, the weighted
average of the probability distribution of possible results.
 When graphed the range of possible returns for Martin is from -60% to 80%, and the expected return is 10%.
 The expected return for U.S. Water is also 10%, but its possible range (and thus maximum loss) is much
narrower.
 Before we assumed that only three economic states could occur.
 Actually, the economy can range from a deep depression to a fantastic boom, with an unlimited number of
possibilities in between.
 We would have a similar table except that it would have many more demand levels.
  This table could be used to calculate expected rates of return as shown previously, and the probabilities and
outcomes could be represented by continuous curves.
 The tighter (or more peaked) the probability distributions, the more likely the actual outcome will be close to
the expected value and, consequently, the less likely the actual return will end up far below the expected
return.
 Thus, the tighter the probability distribution, the lower the risk.
 U.S. Water has a relatively tight distribution, its actual return is likely to be closer to its 10% expected return
than is true for Martin, and so U.S. Water is less risky.

Part 2b: MEASURING STAND-ALONE RISK: THE STANDARD DEVIATION (277 – 279)

 It is useful to measure risk for comparative purposes, but risk can be defined and measured in several ways.
 The tighter the probability distribution of expected future returns, the smaller the risk of a given investment.
 According to this definition, U.S. Water is less risky than Martin Products because there is a smaller chance that
the actual return of U.S. Water will end up far below its expected return.
 We use the standard deviation to quantify the tightness of the probability distribution.
 The smaller the standard deviation, the tighter the probability distribution and, accordingly, the lower the risk.
 Columns 1, 2, and 3 remain the same.
 Then in column 4, we find the deviation of the return in each demand state from the expected return: Actual
return - Expected 10% return.
 The deviations are squared and shown in column 5.
 Each squared deviation is then multiplied by the relevant probability and shown in column 6.
 The sum of the products in column 6 is the variance of the distribution.
 Finally, we find the square root of the variance—this is the standard deviation.
 The standard deviation, s, is a measure of how far the actual return is likely to deviate from the expected return.
 Standard Deviation, s is a statistical measure of the variability of a set of observations.
 Martin’s standard deviation is 54.22%, so its actual return is likely to be quite different from the expected 10%.
 U.S. Water’s standard deviation is 3.87%, so its actual return should be much closer to the expected return of
10%.
 The average publicly traded firm’s s has been in the range of 20% to 30% in recent years, so Martin is riskier than
most stocks, and U.S. Water is less risky.

 Till now we found the mean and standard deviation based on a subjective probability distribution.
 Since past results are often repeated in the future, the historical standard deviation s is often used as an estimate
of future risk.
 A key question that arises when historical data is used to forecast the future is how far back in time we should go.
 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.
 The 4 years of historical data are considered to be a “sample” of the full (but unknown) set of data, and the
procedure used to find the standard deviation is different from the one used for probabilistic data.
 If we had actual historical data instead, the standard deviation of returns could be found by the equation for
sample data.
 Here rt (“r bar t”) denotes the past realized rate of return in period t.
 ravg is the average annual return earned over the last N years.
 The average return for the past period (10.3% in our example) may also be used as an estimate of future returns,
but this is problematic because the average historical return varies widely depending on the period examined.
 In our example, if we went from 2015 to 2017 instead of 2015-2018, we would get a different average from the
10.3%.
 The average historical return stabilizes with more years of data, but that brings into question whether data from
many years ago are still relevant today.
Part 2c: Measures of Stand-Alone Risk: The Coefficient of Variation & The Sharpe Ratio (280
– 282)
 If a choice has to be made between two investments that have the same expected returns but different standard
deviations, most people will choose the one with the lower standard deviation and therefore the lower risk.
 Similarly, given a choice between two investments with the same risk (standard deviation) but different expected
returns, investors would generally prefer the investment with the higher expected return.
 To most people —return is “good”, and risk is “bad”; consequently, investors want as much return and as little
risk as possible.
 How do we choose between two investments if one has the higher expected return but the other has the lower
standard deviation? We use coefficient of variation (CV).
 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.
 In this example, the firm with the larger standard deviation, Martin, must also have the larger coefficient of
variation.
 In fact, the coefficient of variation for Martin is 54.22/10 = 5.42, and the coefficient of variation for U.S. Water is
3.87/10 = 0.39.
 Thus, Martin is about 14 times riskier than U.S. Water on the basis of this criterion.
 Coefficient of Variation (CV) is the standardized measure of the risk per unit of return; calculated as the standard
deviation divided by the expected return.

 Another alternative risk measure is the Sharpe ratio.

 The Sharpe ratio compares the asset’s realized excess return to its standard deviation over a specified period:
Sharpe ratio = (Return – Risk free rate)/s
 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.
 Over a given time period, investments with higher Sharpe ratios performed better, because they generated
higher excess returns per unit of risk.
 For example, if we calculate the Sharpe ratio on a forward-looking basis for U.S. Water and Martin Products and
assume that the risk-free rate is 4%.
 U.S. Water will have a Sharpe ratio of ((10% - 4%)/3.87%) = 1.55, while Martin will have a Sharpe ratio of ((10% -
4%)/54.22%) = 0.11.
 Once again we see on a risk-adjusted basis that U.S. Water is expected to perform better, because it has the same
expected excess return as Martin Products but with considerably less risk.
 Sharpe Ratio is measure of stand-alone risk that compares the asset’s realized excess return to its standard
deviation over a specified period.
 An investment with a higher ratio has performed better than one with a lower ratio.

 Those assets have the highest average returns also had the highest standard deviations and the widest ranges of
returns.
 For example, small-cap stocks had the highest average annual return, 16.6%, but the standard deviation of their
returns, 31.9%, was also the highest.
 By contrast, U.S. Treasury bills had the lowest standard deviation, 3.1%, but they also had the lowest average
return, 3.4%.
 You plan to invest $1 million and then retire on the income.
 You can buy a 5% U.S. Treasury bill, and you will be sure of earning $50,000 interest.
 Alternatively, you buy stock in R&D Enterprises. If R&D’s programs are successful, your stock will increase to $2.1
million. However, if the research is a failure, the value of your stock will be zero.
 You regard R&D’s chances of success or failure as 50–50, so the expected value of the stock a year from now is
0.5($0) + 0.5($2,100,000) = $1,050,000.

 Subtracting the $1 million cost leaves an expected $50,000 profit and a 5% rate of return, the same as for the T-
bill.
 Given the choice of the sure $50,000 profit and 5% rate of return and the risky expected $50,000 profit and 5%
return which would you pick. If you select less risky investment, you are risk averse. Most investors are risk
averse.
 Risk-averse investors dislike risk and require higher rates of return as an inducement to buy riskier securities.
 The implications of risk aversion on security prices and rates of return are that other things held constant, the
higher a security’s risk, the higher its required return, and if this situation does not hold, prices will change to
bring about the required condition.
 Both the U.S. Water and Martin Products stocks sells for $100 per share and each has an expected rate of return
of 10%.
 Investors are averse to risk; therefore, under those conditions, there would be a general preference for U.S.
Water.
 People with money to invest would bid for U.S. Water, and Martin’s stockholders would want to sell and use the
money to buy U.S. Water.
 Buying pressure would quickly drive U.S. Water’s stock price up and selling pressure would simultaneously cause
Martin’s price to fall.
 These price changes would change the expected returns of the two securities.
 For example, U.S. Water’s stock price was bid up from $100 to $125 and Martin’s stock price declined from $100
to $77.
 These price changes would cause U.S. Water’s expected return to fall to 8% and Martin’s return to rise to 13%.
 The difference in returns, 13% – 8% = 5%, would be a risk premium (RP), which represents the additional
compensation investors require for bearing Martin’s higher risk.
 Risk Premium (RP) is 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.

Part 3: Risk in a Portfolio Context: The CAPM (283)

 An extremely important theory the capital asset pricing model (CAPM) was developed in the 1960s.
 CAPM explains how risk should be considered in a world where stocks and other assets are held in portfolios
rather than stand-alone assets.
 Capital Asset Pricing Model (CAPM) is based on the proposition that any stock’s required rate of return is equal to
the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.
 The risk of a stock held in a portfolio is typically lower than the stock’s risk when it is held alone.
 Because investors dislike risk and because risk can be reduced by holding portfolios most stocks are held in
portfolios.
 Banks, pension funds, insurance companies, mutual funds are required by law to hold diversified portfolios.
 Most individual investors—at least those whose security holdings constitute a significant part of their total
wealth—also hold portfolios.
 Therefor the fact that 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.
 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.
 Pay Up’s stock is not very liquid and its earnings have experienced sharp fluctuations in the past.
 This suggests that Pay Up is risky and that its required rate of return, r, should be relatively high.
 However, Pay Up’s required return over the years was quite low in comparison to other companies.
 This indicates that investors think Pay Up is a low-risk company in spite of its uncertain profits.
 This counterintuitive finding has to do with diversification and its effect on risk.
 Pay Up’s earnings rise during recessions, whereas most other companies’ earnings decline when the economy
slumps.
 Thus, Pay Up’s stock is like insurance—it pays off when other investments go bad—so adding Pay Up to a
portfolio of “regular” stocks stabilizes the portfolio’s returns and makes it less risky.
Part 3a: EXPECTED PORTFOLIO RETURNS, rp (284)
 The expected return on a portfolio, rp is the weighted average of the expected returns of individual assets in the
portfolio.
 The weights are percentage of the total portfolio invested in each asset.
 Expected Return on a Portfolio rp is the weighted average of the expected returns on the assets held in the
portfolio.

 Ri is the expected return on the ith stock. Wi are the stocks’ weights, or the percentage of the total value of the
portfolio invested in each stock. N is the number of stocks in the portfolio.
 You had $100,000 and you planned to invest $25,000, or 25% of the total, in each stock.
 An analyst estimated returns on the four stocks shown in column 1.
 You could multiply each stock’s percentage weight in column 4 by its expected return to obtain the product in
column 5.
 The sum of column 5 is used to calculate the expected portfolio return, 7.875%.
 If you added a fifth stock with a higher expected return, the portfolio’s expected return would increase, and vice
versa if you added a stock with a lower expected return.
 The key point to remember is that the expected return on a portfolio is a weighted average of expected returns
on the stocks in the portfolio.

 The expected returns in column 2 would be based on a study, but they would still be essentially subjective and
judgmental because different analysts could look at the same data and reach different conclusions.
 If we added companies such as U.S. Steel Corp. and GM, which are generally considered to be relatively risky,
their expected returns as estimated by the marginal investor would be relatively high; otherwise, investors would
sell them, drive down their prices, and force the expected returns above the returns on safer stocks.
 After a year, the actual realized rates of return, “r-bar,” values on the individual stock would certainly be different
from the initial expected values r-cap.
 That would cause the portfolio’s actual return, r-bar to differ from the expected return, r-cap = 7.875%.
 Realized Rates of Return, r-bar are returns that were actually earned during some past period.
 Actual returns r-bar usually turn out to be different from expected returns r-cap except for riskless assets.
Part 3b: 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, S.D is not the weighted average of the individual stocks’ standard deviations.
 The portfolio’s risk is generally smaller than the average of the stocks’ S.D because diversification lowers the
portfolio’s risk.
 Investor has invested 50% on each stock W and M.
 The left graph plots the data in a time series format, and it shows that the returns on the individual stocks vary
widely from year to year. Therefore, the individual stocks are risky.
 However, the portfolio’s returns are constant at 15%, indicating that it is not risky at all.
 The probability distribution graphs to the right show the same thing—the two stocks would be quite risky if they
were held in isolation, but when they are combined to form Portfolio WM, they have no risk whatsoever.

 If you invested all of your money in Stock W, you would have an expected return of 15%, but you would face a
great deal of risk. The same thing would hold if you invested entirely in Stock M.
 However, if you invested 50% in each stock, you would have the same expected return of 15%, but with no risk
whatsoever.
 Being rational and averse to risk, you and all other rational investors would choose to hold the portfolio, not the
stocks individually.
Correlation
 Stocks W and M can be combined to form a riskless portfolio because their returns move countercyclically to
each other—when W’s fall, M’s rise, and vice versa.
 The tendency of two variables to move together is called correlation, and the correlation coefficient, rho
measures this tendency.
 In statistical terms, we say that the returns on Stocks W and M are perfectly negatively correlated, with rho= –1.
 The opposite of perfect negative correlation is perfect positive correlation, with rho = 1.
 If returns are not related to one another at all, they are said to be independent and rho = 0.
 Correlation is the tendency of two variables to move together.
 Correlation Coefficient, rho is a measure of the degree of relationship between two variables.
 The returns on two perfectly positively correlated stocks with the same expected return would move up and
down together, and a portfolio consisting of these stocks would be exactly as risky as the individual stocks.
 If we drew a graph, we would see just one line because the two stocks and the portfolio would have the same
return at each point in time.
 Thus, diversification is completely useless for reducing risk if the stocks in the portfolio are perfectly positively
correlated.
 When stocks are perfectly negatively correlated (rho =-1.0), all risk can be diversified away; however, when stocks
are perfectly positively correlated (rho =+1.0), diversification does no good.
 In reality, most stocks are positively correlated, but not perfectly so.
 Past studies have estimated that on average, the correlation coefficient between the returns of two randomly
selected stocks is about 0.30.
 Under this condition, combining stocks into portfolios reduces risk but does not completely eliminate it.