The Returns and Risks

From Investing
Chapter 6

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

6-1
Asset Valuation
 Value is a function of risk and return
◦ At the center of security analysis
 Historical risk-return relationships useful
indicators
◦ No guarantee future will be like past
◦ No reason to assume future relative
relationships will differ significantly from past
◦ Historical relationships especially useful in
the long-run

6-2
Return Components
 Return consist of two elements:
◦ Yield
 Periodic cash flows such as interest or dividends

◦ Capital gain (loss)

 The change in price of the asset

 Total Return = Yield + Price Change

 Investors sometimes focus only on one
component

6-3
Measuring Returns
 Return measures allow investors to
compare performance over time and across
securities
 Total return (R) is a percentage relating all
cash flows to the start of period price, PB
 For a single period:
CFt  (PE  PB )
R
PB

6-4
Measuring Returns
 Returns can be either positive or negative
◦ When cumulating or compounding, negative
returns are problematic

 A return relative (RR) solves this problem

because it is always positive

CFt  PE
RR   1 R
PB

6-5
Measuring Returns
 To convert returns to wealth and compound
over time, use the cumulative wealth index

 Cumulative wealth index, CWIn, over n

periods =

WI ( 1  R )( 1  R )...( 1  R )
0 1 2 n

◦ WI0 = Starting wealth

6-6
Measuring International Returns
  

6-7
Measures for a Return Series
 How do you summarize returns over several
time periods?
 Arithmetic mean, or simply mean,

6-8
Arithmetic versus Geometric
 Geometric mean captures compound growth
rate over time
◦ Reflects realized change in wealth over multiple
periods
◦ Reflects compound, cumulative returns over more
than one period
◦ Reflects true average compound growth rate over
multiple periods
 Arithmetic mean reflects typical return in a
single period

6-9
Geometric Mean

 Defined as the n-th root of the product of n

return relatives (1+R) minus one,
or G =

( 1  R1 )( 1  R2 )...( 1  Rn )
1 /n
1

6-10
Adjusting Returns for Inflation
 Return measures are nominal, i.e., are not
adjusted for inflation
◦ Purchasing power of investment may change
over time
◦ Nominal return (R) = [1+ real return (Rr)] ×
[1+ expected inflation rate (Ir)] - 1
 

 Consumer Price Index (CPI) is a possible

measure of inflation

6-11
Risk
 Risk and return are opposite sides of the
same coin
 Risk is the chance that a security’s actual
return will differ from its expected return
 Investors willing to assume large risks may
gain large returns, but they may also lose
money

6-12
 Interest Rate Risk  Financial Risk
◦ Market rates change ◦ Tied to debt financing
 Market Risk  Liquidity Risk
◦ Recession, war, etc. ◦ Marketability of
security
 Inflation Risk
◦ Purchasing power  Currency Risk
variability ◦ Exchange Rate Risk
 Business Risk  Country Risk
◦ Risk inherent in ◦ Political stability
business

6-13
Measuring Risk
 Risk arises from variability of outcomes
 Variance and standard deviation measure
variability
 Standard deviation is simply the square root
of the variance



  
X X  2 1/ 2


 n 1 
 
6-14
Returns for Major Asset Classes
200

Spread in Returns for Major Asset Classes, 1962-2014

-60

Inflation Treasury Corporate Treasury S&P 500 Small

bills bonds bonds stocks
6-15
Risk Premiums
 Premium is additional return earned or
expected for additional risk
◦ Calculated for any two asset classes
 Equity risk premium - difference between
stock return and risk-free return
◦ Stocks versus Treasury bills
◦ Stocks versus Treasury bonds

6-16
The Risk-Return Record
 From 1926 - 2010, geometric average
annual return was 9.6% for S&P 500
 Arithmetic mean was 11.4%
 Standard deviation was 19.9%
 Smaller common stocks showed greater
risks and returns than large common stocks
 T-bills showed lowest risk and return

6-17
Cumulative Wealth Indexes
 Cumulative wealth index can be
decomposed into
◦ Dividend component: cumulative dividend
yield (CDY)
◦ Price change component: (CPC)

6-18
Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

6-19
Portfolio Theory
Chapter 7

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

7-20
Investment Decisions
 Involve uncertainty
 Focus on expected returns
◦ Estimates of future returns need to consider and
manage risk
◦ Investors often overly optimistic about expected
returns
 Goal is to reduce risk without affecting returns
◦ Accomplished by building a portfolio
◦ Diversification is key

7-21
Risk and Return Measures
  

7-22
Risk and Return Measures
Ex ante Calculations
 
 Expected return:
 Variance of returns (σ2):
 

 Where, Ps equals probability of state s and Rs equals

return in state s.

7-23
Dealing With Uncertainty
 Risk that an expected return will not be
realized
 Investors must think about return distributions
 Probabilities weight outcomes
◦ Assigned to each possible outcome to create a
distribution
◦ History provides guide but must be modified for
expected future changes
◦ Distributions can be discrete or continuous

7-24
Calculating Expected Return
 Expected return for asset “i” E(Ri)
◦ Weighted average of all possible returns (R i,s)
included in the probability distribution
 Each outcome weighted by probability of
occurrence (Ps)

◦ Referred to as expected return

 

7-25
Calculating Risk
 Variance and standard deviation used to
quantify and measure risk
◦ Measure spread (dispersion) around the mean
◦ Variance of returns is in percent squared
◦ Standard deviation of returns (σ) is the square
root of variance and is measured in percent

7-26
Modern Portfolio Theory
 Framework for selection of portfolios based
on risk and expected return
 Used, to varying degrees, by financial
managers
 Quantifies benefits of diversification
 Security correlations are crucial in
determining portfolio risk
◦ An asset with high volatility may have low risk

7-6
Portfolio Expected Return
 Weighted average of the individual security
expected returns
◦ Each asset “i” has a weight, w, which
represents the asset’s value as a percent of
the portfolio value

n
E(R p )   w iE(R i )
i 1

7-28
Portfolio Risk
 Portfolio risk is measured by the variance
or standard deviation of portfolio returns
 Portfolio variance is impacted by two
characteristics:
1. The variance in returns for the
individual assets included in the portfolio
2. The co-movement of returns for the
individual assets included in the portfolio
Portfolio Risk
 Portfolio risk is “not” the weighted average of
individual security risks
n
   wi
2
p i
2

i1

 The risk of individual securities is “not” the

crucial consideration
 Diversification almost always lowers risk
 An asset with high σ may add little to portfolio
risk

7-30
Portfolio Risk
Variance of a Portfolio (p2):

p2 = wi2i2 + wiwjij

ij = covariance of asset i and asset j

Risk Reduction in Portfolios
 Assume security risk sources are independent
◦ This assumption is unrealistic when investing
◦ Market risk affects all firms, cannot be diversified
away
 The larger the number of securities, the
smaller the exposure to any particular risk
◦ “Insurance principle”
◦ Only issue is how many securities to hold

7-32
Risk Reduction in Portfolios
 Random (or naïve) diversification
◦ Diversifying without looking at how security
returns are related to each other
◦ Marginal risk reduction gets smaller as securities
are added
 Beneficial but not optimal
◦ Risk reduction kicks in as soon as additional
securities added
◦ Research suggests it takes a large number of
securities to eliminate majority of risk

7-33
Security Co-movement
 Correlation (ρij) and covariance (σij) measure
the tendency for security returns to move in
the same or opposite directions
 

7-34
Correlation (ij)
 -1 ij 

ij > 0 securities move together

ij < 0 securities move apart
ij = 0 no tendency one way or the
other
ij = -1 perfect negative correlation
ij = +1 perfect positive correlation
Correlation and Portfolio Risk

E(r)
 = -1
.j
 = 0.5
=1
.i


 90%
Returns to H-Tech
return
60%

30%

11 12 13 14 15

-30%
 90% Returns to Giffen
return
60%

30%

11 12 13 14 15

-30%
 90% Portfolio: 50% Giffen & 50% H-Tech
return
60%

30%

11 12 13 14 15

-30%
Correlation Coefficient
 When does diversification pay?
◦ With perfect positive correlation, risk is a weighted
average, therefore, no diversification benefit
◦ With perfect negative correlation, expected return can
be assured
◦ With zero correlation, significant risk reduction can be
achieved
 Cannot eliminate risk

 Negative correlation or low positive correlation

is ideal, but unlikely

7-40
Calculating Portfolio Risk
 Three inputs to calculate portfolio risk
1. Variance (risk) of each security

2. Covariance between each pair of securities

3. Portfolio weights for each security

 Goal: select weights to determine the

minimum variance combination for a given
level of expected return

7-41
Calculating Portfolio Risk
 Generalizations
◦ The lower the correlation between securities,
the better
◦ As the number of securities increases:
 Number of covariances grows quickly
 The importance of covariance relationships
increases
 The importance of each individual security’s risk
decreases

7-42
Simplifying Markowitz Calculations
 Markowitz full-covariance model
◦ Requires a covariance between the returns of
all securities in order to calculate portfolio
variance
◦ [n x (n-1)]/2 set of unique covariances for n
securities
 Markowitz suggests using an index to which
all securities are related to simplify

7-43
Copyright 2016 John Wiley & Sons, Inc.

All rights reserved. Reproduction or translation of

this work beyond that permitted in section 117 of
the 1976 United States Copyright Act without
express permission of the copyright owner is
unlawful. Request for further information should be
addressed to the Permissions Department, John
Wiley & Sons, Inc. The purchaser may make back-
up copies for his/her own use only and not for
distribution or resale. The Publisher assumes no
responsibility for errors, omissions, or damages
caused by the use of these programs or from the
use of the information herein.

7-44