CHAPTER 5: RISK AND RETURN

RISK
Definition:
 Risk is defined as the deviation of realized return from its expectation.
Mathematical Representation:
 If returns follow a normal distribution, risk can be proxied by the standard deviation, denoted as:

EXAMPLE:
YEAR RETURN % Deviation Squared Deviation
1 10 6 36
2 -2 -6 36
3 0 -4 16
4 5 1 1
5 7 3 9
SUM 20 98
AVERAGE 4 24.5
STD DEV 4.95

TO CALCULATE:
1. Find average return (Mean Return): Sum of Return% ÷ number of years.
2. Find Deviation: Return – Mean Turn
3. Find Squared Deviation
4. Sum of Squared deviation ÷ Number of years to find Average.
5. Lastly Find Std Dev: Under root Average Squared deviation.

INTERPRETATION:
Based on the calculation above, we can say that this investment on average provides a return of 4% per annum.
However, none of the past five years’ returns meet the expected return. In years 1, 4 and 5, the realised returns
are higher than expected (upside risk).

Whereas in years 2 and 3, returns are lower than expected (downside risk). This kind of deviation from the mean
(expectation) constitutes the concept of risk in financial management. As long as (i) the returns of an investment
follow the normal distribution and (ii) investors have no preference toward the upside and downside risks,
standard deviation will be a neat measurement of risk for this type of investment.

EXAMPLE:
a. In Example 5.1, what is the probability that an investor will receive a return of 10% from the investment?
The probability of an outcome from a normal distribution can be expressed as:
 where μ is the mean,
σ is the standard deviation
x is the outcome of the function.
Given that in Example 5.1 that we have x = 10%, m = 4% and s = 4.95, we have:

b. What is the probability that an investor will not suffer a loss in the investment?
The probability for an investor not suffering from a loss is equal to the probability that the return is equal
to or larger than 0%.
Given that a normal distribution curve is symmetrical at the mean value, we can easily see that the
probability of returns equal to and larger than 4% would be 50%.
So, what is the probability that a return is between 0% and 4%?
To answer this, we first define the z-value as:

In this example, z = (0 – 4)/4.95 = 0.808.

 This corresponds to finding the area under the standard normal distribution curve between Z = -
0.808 and Z = 0 (the mean).
 The table indicates that the probability for Z = -0.808 is approximately 0.291.
Calculating Overall Probability for No Loss:
 Since the distribution is symmetrical around the mean in a standard normal distribution, the
probability of a return being equal to or larger than 4% is 0.5 (50%).
 Adding the probabilities for returns between 0% and 4% (0.291) and returns equal to or larger than
4% (0.5) gives the total probability of not suffering a loss: 0.5 + 0.291 = 0.791.

Conditions for Using Standard Deviation as a Proxy for Risk:

1. Normal Distribution: Returns must follow a normal distribution.
2. Equal Preference: Investors should have equal preference for upside and downside deviations.
3. Non-Diversified Portfolio: Applicable when investors are not holding well-diversified portfolios.

RISK DIVERSIFICATION:
Two asset portfolios
Suppose that you are considering an investment portfolio with two stocks, Rose Plc and Thorn Plc. The returns
of these two stocks for the last five years are in columns 1 and 2 of the table below.
 YEAR ROSE, Rx THORN, Ry Rx – E(Rx) [Rx – E(Rx)]2 Ry – E(Ry) [Ry – E(Ry)]2 [Rx – E(Rx)] [Ry – E(Ry)]
1 4 2 0 0 -1 1 0
2 11 -2 7 49 -5 25 -35
3 13 6 9 81 3 9 27
4 -8 -1 -12 144 -4 16 48
5 0 10 -4 16 7 49 -28
SUM 20 15 290 100 12
MEAN 4 3 Variance: 72.5 Variance: 25 Covariance: 3
STD DEV 8.5 5
Coefficient of 0.07
correlation

Note that the variance and covariance are calculated using the following formulas:

ROSE: 290 ÷ (5-1) = 72.5

THORN
100 ÷ (5-1) = 25

COVARIANCE 12 ÷ (5-1) = 3

Now we calculate return on portfolio:

Rp = Wx. E(Rx) + Wy. E(Ry)
(ASSUMED)
To calculate weight of X we: Investment in X ÷ Total Investment = 0.8
To calculate weight of Y we: Investment in Y ÷ Total Investment = 0.2
Rp= (0.8x4%) + (0.2x3%) = 3.8%

σp=7%
To see the diversification effect, we first calculate the standard deviation of the two companies and their
covariance. Covariance measures the co-movement of the two stocks. At first glance, Rose and Thorn are not
moving in the same direction all the time, suggesting that they are not perfectly correlated. To see the extent of
their co-movement, we compute the covariance and coefficient of correlation.
 THEORETICAL PART

Risk:
Risk, in financial terms, refers to the uncertainty or variability associated with the potential outcome of an
investment. It is the chance that the actual return on an investment may differ from the expected return. In other
words, risk involves the possibility of losing some or all of the invested capital or not achieving the anticipated
financial goals.
 Sources of Risk:
 Market Risk: Arises from changes in overall market conditions.
 Credit Risk: The risk of loss due to a borrower's failure to repay a loan or meet contractual
obligations.
 Liquidity Risk: The risk that an investment cannot be quickly bought or sold without a significant
price change.
 Operational Risk: Associated with the internal processes, systems, and people within an
organization.
 Risk and Return Trade-off:
 Generally, higher potential returns are associated with higher levels of risk.
 Investors often seek a balance between risk and return that aligns with their risk tolerance and
financial objectives.

Return:
Return, in financial terms, is the gain or loss made on an investment relative to the amount invested. It is a
measure of the financial success of an investment and is expressed as a percentage. Returns can come from
various sources, including capital appreciation, interest, dividends, and other income generated by the investment.
 Types of Returns:
 Capital Gains: Profits made from the increase in the value of an asset.
 Dividend Income: Payments made by a corporation to its shareholders.
 Interest Income: Earnings from interest-bearing securities like bonds or savings accounts.
 Risk and Return Relationship:
 There is a positive correlation between risk and return. Generally, investments with higher potential
returns also come with higher levels of risk.
 Investors must assess their risk tolerance, investment goals, and time horizon to determine an
appropriate balance between risk and return.
 Risk-Return Trade-off:
 Investors aim to maximize returns while minimizing risk, striking a balance that aligns with their
financial objectives.
 Different investments offer varying risk-return profiles, allowing investors to tailor their portfolios to
match their risk preferences.
 Return Calculation:
 The return on a single security can be calculated using the following formula:
 Return = ((Ending Price − Beginning Price + Dividends) /Beginning Price) × 10
 Where:
o Ending Price is the current price of the security.
o Beginning Price is the initial price of the security.
o Dividends represent any income received from the security.
Example:
Let's say you have the following historical prices for a stock over a period:
 Beginning Price: $100
 Ending Price: $120
 Dividends: $2 per share
 Historical Returns: 5%, 2%, -3%, 8%, 1%

Return Calculation:
Return = [(120−100+2)/100] × 100 = 22%

Risk Calculation:
Calculate the average return:
 Rˉ= (5+2−3+8+1)/5=2.6%
Calculate the standard deviation:
 σ= (1/5-1) ((5−2.6)2+(2−2.6)2+(−3−2.6)2+(8−2.6)2+(1−2.6)2)
 σ≈ (1/5-1) (2.52+(−0.6)2+(−5.6)2+(5.4)2+(−1.6)2)
 σ≈ (1/5-1) (6.25+0.36+31.36+29.16+2.56)
 σ≈ (1/5-1) (69.69)
 σ≈ 17.4225
 σ≈ 4.17%

Concept of Risk Reduction/Diversification:

Risk reduction or diversification is a strategy employed by investors to manage and mitigate risk in their
investment portfolios. The basic idea is to spread investments across different assets or asset classes to reduce the
impact of poor performance in any single investment on the overall portfolio. Diversification aims to achieve a
balance between risk and return by minimizing the concentration of risk in a particular investment.
Key Principles of Diversification:
1. Asset Allocation:
 Diversification involves spreading investments across different asset classes, such as stocks, bonds,
real estate, and cash equivalents.
 Each asset class has its own risk-return profile, and their performance may not be perfectly
correlated.
2. Geographic Diversification:
 Investors can diversify by investing in different regions and countries.
 This helps reduce exposure to regional economic downturns or geopolitical risks.
3. Industry and Sector Diversification:
 Within a stock portfolio, diversification can be achieved by investing in different industries and
sectors.
 This guards against poor performance in a specific sector affecting the entire portfolio.
4. Company-Specific Diversification:
 Investors can diversify within an asset class by holding shares in different companies.
 This minimizes the impact of poor performance or financial troubles in one company.
5. Time Diversification:
 Spreading investments across different time horizons helps mitigate the impact of market volatility.
 Dollar-cost averaging is an example of a time-based diversification strategy.

Relation to Portfolio Management:

1. Risk Management:
 Diversification is a fundamental risk management tool in portfolio construction.
 By holding a mix of assets with different risk factors, the overall portfolio risk is reduced.
2. Return Enhancement:
 While diversification aims to reduce risk, it also seeks to enhance overall portfolio returns.
 This is achieved by combining assets that have the potential for returns at different points in the
market cycle.
3. Volatility Reduction:
 Diversification helps smooth out the volatility of a portfolio.
 While some assets may experience losses, others may provide gains, resulting in a more stable
overall performance.
4. Optimal Risk-Return Trade-off:
 Portfolio managers aim to find the optimal mix of assets that provides the desired level of return for
a given level of risk.
 Diversification plays a crucial role in achieving this balance.
5. Minimizing Idiosyncratic Risk:
 Diversification reduces exposure to company-specific risks (idiosyncratic risk) by spreading
investments across various securities.
6. Aligning with Investor Goals and Risk Tolerance:
 Portfolio managers consider the investor's goals, time horizon, and risk tolerance when constructing
diversified portfolios.
 This ensures that the portfolio aligns with the investor's financial objectives.