Return

By Yousuf Zahid yousuf.zahid@live.com

Risk &

Sunday, January 8, 2011

Understanding: Risk and Return

Statistics Refresher Standard Deviation Dispersion Average difference of observations from their mean value Variance Square root of SD Measure of relative dispersion and used to check consistency Correlation Inter-relationship between two variables Positive, negative or zero relationship Covariance Correlation (+/-) times SD of each of the two variables

The Way of the Return Example 1 1 year ago, Stock A was $10 per share Current trading at $9.50 per share Shareholders receive dividend of $1 What return was earned over the past year?

$1.00 + ($9.50 - $10.00 ) $10.00 = 5%

The Way of the Return Example 2 What is the return on an investment that costs $1,000 and is sold after 1 year for $1,100? Dollar return $ Received - $ Invested $1,100 - $1,000 Percentage return $ Return / $ Invested $100 / $1,000

= $100

= 10%

The Way of the Return Example 3 1 year ago, 100 shares of Wal-Mart bought at $4,500 Over last year, $27 received in dividends (or 27 cents per share) At year end, stock sells for $4,800 How did you do?

$27 + ($4,800 - $4,500) = $327 Dollar gain $327 with percentage gain at 7.3%

Not at all recommended

Mark Twain suggested otherwise Warren Buffet strongly disagrees

Simply put, diversify

Uncertainty of an outcome

Risk

Return

Expected to be realized

The Trade-off

Variability Inversely related

Investor Genre

Risk Avoider or Averse

Risk Seeker

Shares, Securities, Assets

Government treasuries e.g. T-Bills

Mutual funds

Including properties

Including precious metals & commodities

How to Measure Risk

Behavioral

Quantitative

Sensitivity

Probability

Standard Deviation

Coefficient of Variation

Single investment

Sensitivity Analysis Variability of outcomes sensed through a range And through economic conditions

Probability Distribution What percent chance is there? Probability assigned to return rate

Risk Measurement
Standard Deviation of Return Observing risk on dispersion of returns Absolute so misleading Coefficient of Variation Converts SD of expected into relative values Best for portfolio

All about portfolios

Why a Portfolio?

The obvious is inevitable

Holding stocks in isolation

Holding portfolio in several stocks

Individual stock s risk diversified

Portfolio investment is diversification

Portfolio Risk
Standard deviation Relative importance Interaction between two assets

Portfolio Return
Aggregation of returns Expected rate of return Relative share in the portfolio

Correlation Effect
+
Negatively correlated assets tend to move in opposite directions

Perfect Negative
Risk removed

Perfect Positive
Trade-off
Positively correlated assets tend to move up and down together

Zero

Portfolio Asset Returns

Contribution of an asset to overall risk Risk judged at portfolio level only PNC Highly risky asset may act as portfolio risk stabilizer

Risks to Portfolio Systematic Risk Overall market risk that cannot be diversified away E.g. interest rate policy, tax rates, deficit financing, inflation & forex Non-systematic Risk Firm specific and avoidable by diversification E.g. Strike, R&D expert resigns, competitor & weak supply-chain