Resume

chapter 12 – part 5
“Risk and return”
Chentia Aisya Oktarina – 242221055 – Magister Manajemen
01 RETURNS

02 THE HISTORICAL
RECORD

03 AVERAGE RETURNS: THE

FIRST LESSON
04 THE VARIABILITY OF RETURNS: THE
SECOND LESSON
05 MORE ABOUT AVERAGE
RETURNS

06 CAPITAL MARKET
EFFICIENCY

07 SUMMARY AND
CONCLUSIONS

08 MINICASE
01.
RETUR
NS

DOLLAR RETURNS
Your gain (or loss) from that investment is
called the return on your investment.
Two components of return:
1. You may receive some cash directly
while you own the investment (income
component).
2. The value of the asset you purchase will
often change (capital gain or capital
loss)
rETURNS
PERCENTAGE RETURNS
It’s more convenient to summarize
information about returns in percentage
terms, rather than dollar terms.
Two components of percentage return:
1. Dividend yield (percentage of the
beginning stock price results)
2. Capital gains yield (the change in the
price during the year)
02.
THE
HISTORICAL
RECORD
 The historical record
Roger Ibbotson and Rex Sinquefield presented year-to-year
historical rates of return on five important types of financial
investments.
 Financial investments

03
Long-term corporate
01
bonds
Large-company stocks
This is based on high-quality bonds with 20
This common stock portfolio is based on the years to maturity.
Standard & Poor’s (S&P) 500 index, which
contains 500 of the largest companies in the
United States. 04
LONG-TERM U.S.
GOVERNMENT BONDS
02
This is based on U.S. government bonds with
Small-company stocks 20 years to maturity.

This is a portfolio composed of the stock

corresponding to the smallest 20 percent of 05
the companies listed on the New York Stock U.s. treasury bills
Exchange.
This is based on Treasury Bills (T-bills for
short) with a one month maturity.
 Roger ibbotson on capital market history

• Risky securities, such as stocks, have higher average returns than riskless
securities such as Treasury bills.
• Stocks of small companies have higher average returns than those of larger
companies.
• More liquid stocks have higher valuations, but lower returns than less liquid
stocks.
• The cost of capital for a company, project, or division can be estimated using
data from the markets.
03.
AVERAGE
RETURNS: THE
FIRST LESSON
 AVERAGE RETURNS: THE FIRST
LESSON

01 calculating
average returns
03
Risk premiums

The excess return required from an investment

in a risky asset over that required from a risk-
free investment.
02
Average returns: the
historical record
04.
THE
VARIABILITY
OF RETURNS:
THE SECOND
LESSON
 THE VARIABILITY OF RETURNS: THE
SECOND LESSON

The historical
Frequency variance and
distributions standard Normal
and variability deviation distribution

To count up the number of • Variance is the average (or bell curve) is a

times the annual return on squared difference symmetric, bell-shaped
the common stock of between the actual frequency distribution that
portfolio falls. return and the average is completely defined by its
return. mean and standard
• Standard deviation is the deviation.
positive square root of
the variance.
05.
MORE ABOUT
AVERAGE
RETURNS
 You buy a particular stock for $100.
Unfortunately, the first year you own it, it falls
to $50. The second year you own it, it rises back
to $100.

What was your average return on this investment?

 MORE ABOUT AVERAGE RETURNS

Your average return must be exactly zero because you started with $100 and ended
with $100. But if we calculate the returns year-by-year, we see that you lost 50
percent the first year. The second year, you made 100 percent. Your 25average
return over the two years was thus (-50% + 100%)/2 = 25%!

So, which is correct, 0 percent or 25 percent? Both are correct. The 0 percent is
called the geometric average return. The 25 percent is called the arithmetic
average return.
 MORE ABOUT AVERAGE
RETURNS

Geometric average arithmetic average

RETURNS RETURNS

The average compound return earned per The return earned in an average year over a
year over a multiyear period. multiyear period.
06.
CAPITAL
MARKET
EFFICIENCY
 CAPITAL MARKET EFFICIENCY

• Capital market history suggests that the market values of stocks and bonds can
fluctuate widely from year to year.
• Efficient capital market is a market in which security prices reflect available
information
• The efficient markets hypothesis (EMH) is the hypothesis that actual capital
markets, such as the NYSE, are efficient.
 Three forms of market efficiency

Strong form semiStrong weak form

efficient form efficient efficient

If the market is strong form If a market is semistrong If a market is weak form

efficient, then all form efficient, then all efficient, it suggests that, at
information of every kind public information is a minimum, the current
is reflected in stock prices. reflected in the stock price. price of a stock reflects the
stock’s own past prices.
07.
SUMMARY
AND
CONCLUSIONS
 SUMMARY AND CONCLUSIONS

• Risky assets, on average, earn a risk premium. There is a reward for bearing
risk.
• The greater the potential reward from a risky investment, the greater is the
risk.
MINICAS
E
 Question & answer

01 What advantages do the mutual funds offer compared to the company

stock?

The main advantage of mutual funds over company stock is diversification. As a company employee,
the 401(k) holder is already risking his or her entire compensation stream (frequently one's largest
source of income) on the fortunes of the company. By investing in the company's stock, the employee
is risking two losses, his or her wages and retirement income, by investing in a single company. This
company stock presents a further hazard; because the company is privately-held, its stock is not
readily marketable. Therefore, if the company runs into trouble, the employee could not easily
liquidate the stock.
 02. Assume that you invest 5 percent of your
salary and receive the full 5 percent match from
S&S Air. What EAR do you earn from the
match? What conclusions do you draw about
matching plans?
In this case, 5% of salary is invested an 5 % full amount match is received
from S&S. The EAR will be 100% as the amount invested is received back
in full
 Question & answer

03. Assume you decide you should invest at least part of your money in large-
capitalization stocks of companies based in the United States. What are the
advantages and disadvantages of choosing the Bledsoe Large-Company Stock
Fund compared to the Bledsoe S&P 500 Index Fund?

Investing in the Bledsoe large-company stocks allows me to respond swiftly to market volatility
because the fund manager makes appropriate market trend driven investment decisions on my behalf
and helps choose the most profitable portfolios. The manager also protects my investment in case of
sudden market fluctuations. On the other hand, the fund manager is not liable for investment
decisions made in the S&P 500 Index Fund. But, the disadvantages are Bledsoe Financial Service
charges a higher percentage on mutual fund expenses at 1.50% for large company stocks compared to
0.15% of assets per year in the S&P 500.
 Question & answer

04. The returns on the Bledsoe small-cap fund are the most volatile of all the mutual
funds offered in the 401 (k) plan. Why would you ever want to invest in this fund?
When you examine the expenses of the mutual funds, you will notice that this fund
also has the highest expenses. Does this affect your decision to invest in this fund?

Yes, the higher expenses do influence my decision. As an investor, I believe the Bledsoe Small-Cap
can work well for an individual with a high risk tolerance, unlike me. Even so, I can consider
investing in the Small-Cap Fund because the higher risk corresponds to the higher return of
investment.
 Question & answer

05. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The
Sharpe ratio is calculated as the risk premium of an asset divided by its standard
deviation. The standard deviation and return of the funds over the past 10 years listed
in the following table. Calculate the sharpe ratio for each of these funds. Assume that
the expected return and standard deviation of the company stock will be 18 percent
and 70 percent, respectively. Calculate the Sharpe ratio for the company stock. How
appropriate is the Sharpe ratio for these assets? When would you use the Sharpe ratio?
 Question & answer

Sharpe ratio is the measure of the excess return per unit of risk in an investment asset or trading
strategy. To calculate the Sharpe of the following annual return using the formula:

From the given information, the risk-free rate wasn’t

given, so let’s assume that the risk-free rate is 3.2%
 Question & answer

Bledsoe S&P 500 Index Fund

= 0.5233

Bledsoe Small-Cap Fund

= 0.6863
 Question & answer

Bledsoe Large-Company Stock Fund

= 0.4404

Bledsoe Bond Fund

= 0.5974
 Question & answer

As showed in the slide before, the Small-Cap Fund has the highest return per unit of risk, and Large-
Company Stock Fund has the lowest return per unit of risk. The whole risk is reflected by the
Sharpe Ratio, which is believed to be completely diversified, and systemic risk is reduced. It is good
for other stock funds since the overall risk is crucial for small investors. It is also acceptable to
invest in Bond Fund. We would use the Sharpe Ratio when comparing various assets with differing
risk and when we are concerned about any type of volatility.
 Question & answer

06. What portfolio allocation would you choose? Why? Explain your thinking
carefully.

If I were going to develop a portfolio out of the fund choices above, I would use a combination of the
Bledsoe Small-Cap Fund, Bledsoe S&P 500 and Bledsoe Bond. I choose this combination to help
diversify my portfolio. I choose the Small-Cap Fund as because of its relatively high returns, the S&P
500 Fund because on its moderate returns and low expenses, and The Bond Fund to reduce portfolio
volatility and higher Sharpe ratio. I won’t invest in the Bledsoe Large-Cap Fund because of its
similarity to the Bledsoe S&P 500, and because Bledsoe Large-Cap charges an expense of 1.50%
while S&P 500 Fund charges only 0.15%.
THANK YOU