Professional Documents
Culture Documents
Investment Risk,
Return, and
Performance
7721
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
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Table of Contents
Introduction ............................................................................ 1
Chapter 1: Risk ....................................................................... 3
Systematic (Nondiversifiable) Risk ..................................... 6
Unsystematic (Diversifiable) Risk ....................................... 9
Client Attitudes Toward Risk ............................................ 13
Chapter 1 Review ............................................................. 18
Chapter 2: The Risk/Return Relationship ........................... 20
Measuring Risk ................................................................. 20
Risk-Adjusted Returns ...................................................... 28
Chapter 2 Review ............................................................. 34
Summary ............................................................................... 58
Chapter Review Answers ...................................................... 59
Chapter 1 ........................................................................... 59
Chapter 2 ........................................................................... 61
Chapter 3 ........................................................................... 63
Chapter 4 ........................................................................... 64
References .............................................................................. 66
About the Author ................................................................... 67
Index ...................................................................................... 68
Introduction
T
he wealth management adviser takes a holistic approach to working with
their high net worth clients, and is often serving in a relationship
management role and may not be the hands-on investment professional
for the client. However, the wealth management adviser must still have a
fundamental understanding of the investment process, and this module considers
several concepts that constitute the very heart of that process. Investment risk is
defined, along with tools to categorize client attitudes toward risk. Systematic
and unsystematic risk are also defined. Betas are reviewed in terms of their ability
to measure risk, both at the individual security level and at the portfolio level. The
capital asset pricing model (CAPM) is introduced as a method of calculating risk-
adjusted return.
Risk
Introduction 1
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Upon completion of this module, you should understand fundamental
concepts of risk and performance measurement principles.
To enable you to reach the goal of this module, material is structured around the
following learning objectives:
2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.
Look for the boxed objectives throughout this module to guide your studies.
B
ridget and John Bishop have never set foot inside a brokerage firm—at
least, not until today. They have always thought of brokers as fast-lane
speculators. The total “investing” experience of the Bishops has taken
place within their community bank, where, for years, a customer service clerk has
provided them with information on current bank certificate of deposit (CD) rates.
Until now, their investment decisions have been confined to choices involving CDs
with maturities of six months, one year, two years, and three years.
Bridget and John have come to the brokerage firm because their bank’s CD rates
have dropped into the cellar. They know that they must obtain higher returns on
their funds if they intend to meet their long-term financial goals, and they appear
to be psychologically prepared, at least on the surface, to deal with the added
risks they associate with the brokerage office they have freely entered. But will
Bridget and John be able to live with the added risks of market investing? Will
they invest their funds if their new investment professional explains the facts
about risks and investment returns? Will they bolt at the first fluctuation in the
market value of their investments?
Helping clients like the Bishops to make the transition from cautious savers to
decisive investors is one of the greater challenges of the investment professional.
Success in that effort usually begins with a process of education about risk and
its relationship to return. Risk is often taken to mean the degree of uncertainty
associated with the return of an asset. The uncertainties of return that cause
investors to worry and to hesitate include the extent to which the price behavior
of a market security, such as a stock or bond, cannot be predicted, or the chance
that a bond issuer will default.
Chapter 1: Risk 3
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Another way of looking at risk is in terms of volatility. A stock whose price
fluctuates wildly up and down is considered riskier than another stock, whose
price stays on an even keel, even if the two stocks end up delivering the same
return after a number of years.
A third way to look at risk is what is the possibility of losing money in this
investment? This is the first way many clients view risk and such a view has
merit. For example, if a stock falls 50%, it takes a 100% return to get back to
even. If a stock falls 75% (like some stocks in 2008), it takes a return of 300% to
get back to even, which could take years. This is why it is critically important for
an investor to avoid large losses. Conservative clients are especially sensitive to
the possibility of loss. In these situations, bank CDs have great appeal because
they are fully insured (up to FDIC limits) by the government. Stocks, on the
other hand, have the real possibility of losing money for a client.
This, however, is not the total picture. CDs do have risk—purchasing power
risk—because their interest and the return of principal are paid in fixed dollar
amounts. In contrast, over time, stocks have provided an excellent counter to
inflation. Long-term studies of asset returns indicate U.S. large company stocks
returned a compound rate of return of about 10% during which inflation
increased slightly more than 3%. Two lessons from this are:
1. there is risk in every investment (even insured CDs have purchasing power
risk); and
In this sense, the time frame within which the investment will be held has a direct
relationship to risk.
The degree of risk in owning a security is often given little thought by investors;
they instead usually concentrate on the return of an investment. As an example,
in 2006 and 2007, investors bought collateralized debt obligations (CDOs) that
How do you deal with risk and the investment process? What can you tell a
couple like the Bishops about risks and the greater returns they hope to achieve?
Before we can explain anything to clients like the Bishops, we need to first
understand the two broad types of risk that exist in investing: systematic and
unsystematic risk. Together, systematic risk and unsystematic risk comprise total
risk, which is measured by standard deviation (which measures variability).
Systematic risk, as we will see later on, is measured by beta (which measures
volatility).
Total Risk
Standard Deviation (Variability)
Systematic Risk
Unsystematic Risk
Beta (Volatility)
Chapter 1: Risk 5
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Systematic (Nondiversifiable) Risk
Systematic risk is the uncertainty of return inherent in the “system” of which any
asset is a part. It exists anytime there is an unknown element in an investment.
For example, a share of Intel common is part of a larger system of events and
relationships that have an effect on Intel shares in spite of anything the
management of Intel Corporation may do. It is the risk of the investment
environment that exists outside of Intel. To varying degrees, systematic risk is
found in nearly all securities because comparable securities generally move
together in a systematic manner. For this reason, it is also called
“nondiversifiable” risk.
Systematic risk includes the following types, and can be remembered with the
acronym “PRIME”:
Reinvestment risk
Market risk
Purchasing power (inflation) risk. This risk is the risk of one’s purchasing
power decreasing as a result of an increase in inflation. At times, like in 2008
when the Consumer Price Index from December 2007 to December 2008
increased only 0.1%, inflation can be very subtle. However, even with a low
overall rate, in certain segments of the economy such as health care and higher
education, inflation can be much higher. Inflation has a corrosive effect on the
investor’s principal and return, robbing both of purchasing power. For example,
assuming an inflation rate of 3%, something costing $10,000 at the beginning of
the year1990 would cost $22,213 at by the beginning of year 2017. Inflation is
most devastating to bond prices since the interest and principal are usually fixed
in terms of dollar amounts. Just the hint or expectation of an increase in inflation
Reinvestment risk. Sometimes called reinvestment rate risk, this is the risk that
market interest rates have decreased at the time payments from an investment are
received. An investor is forced to reinvest his or her payment amount at a time
when rates are not as favorable as they may have been previously. Investors who
need a fixed amount of income should pay special attention to this risk. Another
investor who has significant exposure to this risk is the person who has a large
amount of bond principal coming due on one day. For example, a person with
$500,000 worth of bonds maturing at one time is taking the risk that interest rates
will be low when that newly paid out bond principal needs to be reinvested.
Interest rate risk. The market values of most securities, and fixed-income
securities in particular, move inversely with changes in interest rates. When
market interest rates go up, the value of outstanding bonds goes down. Even
stock prices can be hurt by rising interest rates as bond yields become more
attractive to investors and corporate earnings are reduced by higher borrowing
costs. Residential real estate values are likewise affected as higher mortgage rates
make home ownership less affordable. Again, interest rate risk is systematic;
even the most solid bond, such as U.S. Treasury securities, will drop in market
value when market interest rates rise. The safety of Treasury securities is in terms
of payments due (creditworthiness), not in terms of price while the bonds are
outstanding. In addition, buying several more bond issues (diversification) will
not eliminate interest rate risk, which is what makes it a systematic risk.
Market risk. “A rising tide lifts all boats” is a time-honored maxim of Wall
Street, and likely the converse is also true. Market risk stems from factors
independent of any particular security. These factors include political events,
broad economic and social changes, and the mood of the investing public. It is
“systematic” in the sense that the price of any security can rise or fall in reaction
to these larger events. Thus, if the stock market is seized by a temporary selling
panic, many securities will suffer short-term losses, regardless of each company’s
Chapter 1: Risk 7
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
financial condition. Market risk was clearly demonstrated on “Black Monday,”
October 19, 1987, when the Dow Jones Industrial Average fell over 500 points
(the DJIA was around 2,000 at that time) and again in 2008 when the S&P 500
stock index dropped approximately 37% that year.
Exchange rate risk (also called currency risk). When U.S. investors buy assets
denominated in foreign currencies, they face the risk of having both their
principal and their return diminished by changes in the relative values of U.S.
and foreign currencies. For example, the American purchaser of shares in a fund
of British bonds is subject to changes in the U.S. dollar/British pound exchange
rate. If this exchange rate changes in favor of the British pound—that is, if the
pound strengthens against the dollar—the investor will find his or her return
enhanced as he or she will receive more dollars after pounds are converted into
dollars. A weakening in the British currency relative to the dollar, however, will
have just the opposite effect.
Chapter 1: Risk 9
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
uncertainty are specific to an individual firm. Some of the most common forms
of unsystematic risk are described in the following.
Business risk. Every business has a set of income flows that are unique and
related to the nature of its operations and products. Depending upon the business,
these income flows can be steady or volatile. Steady and dependable income
flows mean greater certainty of returns—that is, less risk. Firms with highly volatile
income flows are viewed as risky because plunging income flows threaten a firm’s
ability to pursue its strategic plans, meet payrolls, or pay dividends.
On another level, business risk is associated with the unique nature of the firm’s
operations, management, and it’s the firm’s position in its industry. An
established company with competitive products and established customers has far
less business risk than does a start-up venture whose product has neither patents
nor customers and is still under development. This level of business risk, of
course, is mirrored in the patterns of income flows mentioned above.
Financial risk. Financial risk is the degree to which a company utilizes debt to
finance its operations. Assume EFG Corporation is entirely financed by equity—
that is, all of its assets are paid for, and it has no debts. XYZ Inc., on the other
hand, is a highly “leveraged” firm. For every dollar of assets it owns, 75 cents is
owed to creditors. Because a firm is under a legal obligation to repay the interest
and principal of its debts, high debt levels increase the risk that shareholders will
not receive dividends. Heavy debt obligations also increase the risk to
bondholders that the firm will not generate sufficient funds to meet its obligations to
repay either interest or principal—or both. The common stock price of a highly
leveraged company having difficulty meeting its debt service will likely decline.
Default risk. Default is a condition in which an entity cannot repay its debt
obligations. The best-known obligation of a bond issue is the obligation to make
payments of interest when due and principal at maturity. The U.S. government is
viewed as being free from default risk because of its ability to raise taxes and
print money, with which to pay its debts. State and municipal securities have no
abilities to print money, but (within limits) they can raise taxes to generate the
income needed to meet their obligations. The degree of a company’s or
Credit risk. This risk is closely related to default risk. A lowering or expected
lowering of the credit rating on an issuer’s debt can cause the market price of that
debt to fall. Often these price declines occur before credit agencies actually
downgrade issues as bond investors recognize deteriorating financial conditions
and therefore anticipate the downgrading. The prices of all corporate or
municipal debt issues can also be affected if the risk premium demanded by
investors for a given credit rating changes.
Liquidity risk. Every investment has some amount of “liquidity risk.” This is
related to the ability to transform the investment into cash in a short period of
time with little or no change in price. A share of a blue-chip company trading on
the NYSE, for example, has little liquidity risk because there are always plenty of
buyers and sellers, a situation that keeps bid and ask prices fairly close together.
A partnership interest in a local shopping mall, on the other extreme, has a great
deal of liquidity risk. The sale of the shopping mall partnership interest could
take months to consummate unless a substantial price concession is made to
facilitate a quick sale. For an investment to be considered liquid, there must also
be an active market for the investment.
Event risk. Event risk is the possibility that a bond or stock holder will be
negatively affected by an unanticipated and damaging event. The event may take
the form of a major tax or regulatory change; a change in a company’s capital
structure due to a merger or buyout; disclosure of fraud or other significant
misdeeds; negative media attention to a particular product; or some other major,
unexpected event. Municipal bonds can experience event risk as well. For
example, in July of 2013 the city of Detroit defaulted on $600 million of general
obligation municipal bonds, and in 1993 and 1994 the treasurer of Orange
County, California invested in derivative securities, which eventually caused
large, unexpected losses. This, in turn, caused a large selloff of the county’s
bonds due to serious questions about the county’s ability to make bond payments
Chapter 1: Risk 11
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(the county declared bankruptcy on December 6, 1994, due to $1.7 billion of
losses from these derivatives).
Yet another example is the April 2010 oil leak in the Gulf of Mexico from a well
owned by BP, the large British oil company. Certainly this was an unexpected
event that had a huge effect on BP, as it had to spend billions of dollars to cover
the damage caused by the leak. The total cost of this event is still unknown, and
could be billions of dollars more than already calculated. This can have a major
impact on BP’s corporate reputation. In the two months after the oil leak, BP stock
price fell 50%, along with a dividend suspension, as the cost of this event climbed.
Call risk. Call risk is the possibility that a debt security will be called in by its
issuer prior to maturity. This option is a feature of most municipal and corporate
bond issues, making it possible for the issuers to pay off existing high-coupon
bond issues with new ones that have lower coupon rates. Therefore, calling a
bond is advantageous for the issuer but disadvantageous for the bondholder. Call
risk increases when interest rates decline. When investors receive their principal
from called bonds, they find that they are able to reinvest the funds only at a
lower rate (thereby encountering reinvestment risk). Call dates indicate the first
and successive dates on which bonds may be called, and call premium is the
amount above par value to be paid if the issue is called.
Political risk and country risk. Political risk captures the risk of a nation-state
defaulting on its commercial debt obligations due to potential government
In nations with both high country and high political risk, there are risks caused
by less available public information about the issuers of securities, less stringent
regulatory standards, and lack of uniform accounting, auditing, and financial
reporting standards. A security or portfolio of securities from emerging market
countries would, of course, have more political risk and country risk than securities
from developed countries. The United States is considered to be the most stable
country in the world for investment. When uncertainty exists in the world,
investment funds tend to flow into the United States as a safe haven for wealth.
Clients, however, do not lose sleep worrying about the “risk” of an asset
producing an increase in a given year; on the other hand, they worry considerably
about a loss. In an article on the attitude of individual investors to risk, Owen M.
Quattlebaum remarked that, “there is something in the human mind that so
abhors a loss that giving up a quantity of money is rarely fully offset by an
equivalent gain.” Other studies in the field of behavioral finance have confirmed
Chapter 1: Risk 13
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
this statement. Said another way, people dislike losing money more than they like
making the same amount.
The Barnewall study. The field of investments is abundant with research studies
on market performance, price behaviors of various instruments, and other
quantitative measures. Much less attention has been given to the human
behaviors that underlie the investment process. Fortunately, Marilyn MacGruder-
Barnewall conducted a very comprehensive study that contributes greatly to our
understanding of clients and risk.
Barnewall conducted focus group interviews with 2,000 affluent individuals over
a 13-year period ending in the mid-1980s. Her goal, which remains relevant
today, was to determine the extent to which individuals in the different
occupation/professional groups targeted by financial services firms were either
active or passive investors and, by extension, the risk tolerance of these same
individuals. The individuals studied by Barnewall are categorized by
occupation/profession in Table 1.
entrepreneurs
Barnewall described these groups as active investors, who, in her definition, are
“... those individuals who have earned their own wealth in their lifetimes. They
have been actively involved in wealth creation and they have risked their own
capital in achieving their wealth objectives.”
Chapter 1: Risk 15
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
local residential apartment building by this same investor and two or three other
local businesspeople would be perceived as less risky.
The difference here is the investor’s access to information and decision making—
that is, to control. As Barnewall put it, “By their involvement and control, they
feel they reduce the risk to an acceptable level.” In general, their investments are
70% in the risky category and only 30% in the secure products favored by
passive investors.
1. Active clients are candidates for your firm’s more complex and risky
investment opportunities, but they will demand information and may end up
knowing more about the particular investment than you do. They have
tremendous confidence in their own judgment and are unlikely to defer to
yours.
2. Passive investors are poor candidates for your firm’s more complex and risky
investment opportunities—at least not until they have reached a stage in life
that their lifestyle requirements are very secure. They are generally better
candidates for managed investments and are more likely to defer to your
recommendations.
A word of caution: Even with this study as evidence, do not be too quick to
classify an individual until you get to know him or her well.
And more than a few investment professionals have encountered the elderly
person who invested his or her life savings in U.S. Treasury bonds because they
were “government guaranteed,” only to see their market value plunge to 75 cents
on the dollar due to rising interest rates. And, as mentioned before, even
government-insured certificates of deposit, which do not fluctuate in value, have
purchasing power risk.
Chapter 1: Risk 17
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 1 Review
1. Define risk in terms of investing.
Go to answer.
c. reinvestment risk
Go to answer.
b. financial risk
Go to answer.
c. default risk
Go to answer.
Go to answer.
e. liquidity risk
Go to answer.
f. event risk
Go to answer.
g. call risk
Go to answer.
h. political risk
Go to answer.
Chapter 1: Risk 19
© 1996, 2002–2018, College for Financial Planning, all rights reserved.
Chapter 2: The Risk/Return
Relationship
A
ssume you have the option of choosing one of two investments.
Investment A has an expected return of 12% while Investment B has an
expected return of 9%. Which investment would your clients choose?
Of course, every client would select Investment A. However, let’s add some
more information. Investment A is stock in foreign gold mines and Investment B
is U.S. Treasury bonds. Would this change the selection of your clients? Very
likely it would, because instead of just return, the element of risk has been
introduced. And a 3% difference in expected return would not be enough to
compensate an investor for the additional risk taken. This example illustrates the
importance of considering both the risk and the expected return, and not just
simply the return, of an investment.
Most people with any level of experience intuitively understand that investments
touted as being “high profit, no risk” are generally too good to be true—and
invariably they turn out to be not true. Yet many ignore their intuition when
faced with the promise of a very high return and, unfortunately, end up losing
money, sometimes all they have. In fact, fraudulent investment sales are based upon
exaggerated returns promised to investors. The essence of investing is balancing risk
and return. Both subjects will be addressed in this course, starting with risk.
Measuring Risk
This chapter examines risk with greater precision, and offers quantitative tools
you can use in the course of serving your customers. After completing this
chapter, you will be able to:
Sarah Wilson purchased QRS stock in January 2007. Over a holding period of 10
years, her stock produced an average annual return of 12%.
Average
QRS Stock
Annual
Return
12%
Year 1 2 3 4 5 6 7 8 9 10
Year 1 2 3 4 5 6 7 8 9 10
The data points represent the variability, or dispersion, of stock returns from the
average return for each stock. For QRS, the data points indicate that yearly
returns did not vary a great deal from the average for the 10-year period. For
TUV, however, annual returns varied greatly over the period. Both stocks may
have had the same total return over 10 years, but did they have the same level of
risk? QRS exhibited a low level of variability relative to its average return; TUV,
by contrast, had a relatively high level of variability.
So, who cares? If one investment has the same long-term return as another, but
its value fluctuates dramatically, does it matter? Ask your clients. If the client did
In the case of QRS and TUV stocks, above, the lower variability of annual returns
of QRS would result in a lower standard deviation of returns than that of TUV. In
other words, QRS has lower risk than TUV. This can be thought of in simple,
common sense terms. If, over the past 10 years, investment A had returns between
3.0% and 5.0% and investment B had returns that ranged from -20% to +25%, it
would be much easier to reasonably predict the return of investment A than of
investment B. Saying this a different way, there is less uncertainty in the returns of
investment A than of B. And the uncertainty of returns is one definition of risk.
Knowing the standard deviation calculations is not enough, however. You also
need to know how to interpret standard deviation. Statisticians have found that in
a “normal distribution” (where 50% of returns fall above the mean and 50% fall
below the mean return,) 68% of returns will fall within one standard deviation on
either side of the mean. Likewise, 95% of returns will fall within two standard
deviations, and 99% within three standard deviations. With this knowledge, the
probability of expected returns can be assessed. Figure 3 shows how this can be
accomplished. The value of one standard deviation is added to, and subtracted
from, the mean to determine the interval within which the returns can be
To illustrate this, assume the following investment of stock S that has a mean
return of 7% and a standard deviation of 6.42%.
68%
95%
99%
3σ 2σ 1σ X 1σ 2σ 3σ
Stock: -12.26 -5.84 0.58 7.00 13.42 19.84 26.26
According to this data, the following can be said about the stock (S):
In the investment world, investments with higher standard deviations have higher
variability (risk). As we will see in the next module, the standard deviation of
returns for various asset classes has been calculated, providing us with a sense of
how variable the returns of these assets have been over time. For example, the
compound annual growth rate of large company stocks was about 10.1% between
1926 and 2013. That figure tells us how much an investment in common stocks
would have grown on a compounded basis over that long period. It fails, however,
to tell us anything about the ups and downs of stock investing during those years.
For that, we need to consider the standard deviation, which was 20.2% for the same
period of time. By comparison, the standard deviation of long-term U.S.
government bonds was only about 9.8%—less than half as variable.
It has long been observed that some stocks outpace the general stock market
during bull markets, and that these same stocks fall further than the general stock
market during bear markets. Other stocks lag behind market upswings but do not
lose value as rapidly as most stocks when the market declines. Thus, individual
stocks, over time, have demonstrated a price movement relationship to the overall
stock market.
The computation of beta requires calculating the standard deviations of both the
individual security and the market (appropriate benchmark). It also requires
calculating the correlation coefficient between the security and the
market/benchmark. The formula is as follows:
σi
β= × Rim
σm
Example. Assume that the standard deviation of a stock is 22, the standard
deviation of the market index is 16, and that the correlation coefficient between
the stock and the market is .66. What is the beta of the stock?
σi
β= × Rim
σm
22
β= × .66 = .91
16
Betas for many individual issues are readily available from a variety of
investment research sources. The stock market as a whole has a beta of 1.0, and
individual issues have betas either equal to, or higher or lower than, that figure. If
a stock has a beta of 1.0, it is expected to move in the same proportion as the
market; that is, if the market drops 10%, that stock should drop 10%. If a stock
has a beta of 1.2, and the market rises 10%, the stock should rise 12% (10% ×
1.2) and can be viewed as being 20% more volatile than the market. A stock with
a beta less than 1.0, say 0.9, would be expected to rise only 9% if the overall
market rose by 10% (10% × 0.9).
You can also use your financial calculator to arrive at the answer. Here are the
keystrokes for the HP10bII+:
1.10, INPUT
20, ∑+
1.15, INPUT
20, ∑+
1.25, INPUT
Caveat on the use of betas. Betas are determined by a statistical process called
simple linear regression. This process looks at price movements of a stock and
the market for a number of periods in the past. Thus, the use of betas is a
projection of past price behaviors into the present and future—a practice that
contains certain perils. Scholars have made two important observations about the
behavior of betas over time:
1. Betas for individual stocks change over time, but betas for portfolios are
fairly stable and the larger the number of stocks in the portfolio, the more
stable the beta will be.
2. As time passes, portfolio betas tend to “regress to the mean”—that is, betas
tend to approach the market beta of 1.0 over time (Reilly and Brown 2006).
Thus, while the services that compute and publish stock betas keep them up to
date, the investment professional should be cautious with the tactical use of betas
when applied to single stocks and to portfolios of just a few issues. You also
should know that the same stock might have different betas, depending upon who
is measuring it and over what period of time. This difference results from the
various measurement methodologies employed by the data services. The
differences, however, tend to be minor.
We are not taking a deep dive into the coefficient of determination (r-squared) in
this course. However, it is still important to point out that for beta to be
considered reliable in either a Jensen’s alpha or a Treynor calculation that we
will cover later, the r-squared should be .70 or higher.
Risk-Adjusted Returns
Reading the following material should enable you to:
2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.
Nowhere is the relationship between risk and return more clearly seen than in the
investment world, where the returns on risky assets, such as common stocks,
provide higher total returns over time than do low-risk assets like T-bills and
commercial paper. Modern financial markets are fairly efficient in adjusting rates
of return in response to risk.
Rate of
Return %
Rf=3%
0
Risk (Standard Deviation)
Moving up this sloped line of increasingly risky but potentially higher return
assets, we might progressively encounter the various assets shown in Figure 5.
Return %
20 International Small
Large Stocks Stocks
Stocks
15 Intermediate-term
Bonds
Gold
10
Long-Term
Bonds
5 Short-term Bonds
Treasury Bills
0
0 5 10 15 20 25
Risk (Standard Deviation)
The capital asset pricing model (CAPM). The logic of the capital market line
can be applied to an individual stock or to a portfolio. This application is known
as the security market line (SML) and incorporates beta, rather than standard
deviation, as the measure of risk. Since unsystematic risk can be diversified
away, what is left is systematic risk, which is measured by beta. The formula
used to plot the expected return for various levels of risk (beta) along the SML is
known as the capital asset pricing model (CAPM), which calculates the required
return for an individual stock or portfolio. Symbolically, the CAPM is
Rs = Rf + (Rm – Rf) βs
where
Rs = the required return of the individual stock
Rf = the risk-free rate, generally the current T-bill rate
βs = the stock’s beta
Rm = the stock market return
(Rm – Rf) = the “market risk premium”—the extra rate of return that
stock market investors obtain over investors in T-bills
Notice in this calculation first we subtract .01 from .08 to get .07. This amount in
the parentheses is known as the “market risk premium” and represents the
amount above the risk-free rate that the market rewards those willing to risk their
capital in the market. Then we multiply .07 (market risk premium) by 1.10 (beta
of the individual security) to get .077. Finally we add .077 to .01 (the risk-free
rate) to get .087 or 8.7%, the return an investor should require if they are to
invest in this security.
Here, we have demonstrated the application of the CAPM to estimating the risk-
adjusted return of a single stock. The model can be extended, with little extra
work, to estimating the return of an entire portfolio (Rp). The only element that
changes is the beta. Instead of using the beta of a single stock, as in the example
just given, we use the weighted-average beta, or portfolio beta (Bp), whose
calculation was described earlier. The equation would then be as follows:
Rp = Rf + (Rm – Rf) βp
The concept of risk-adjusted returns will be covered in greater detail later when
measuring investment performance.
The investment pyramid. “Okay,” you say, “we’ve got our betas covered;
figuring the weighted-average beta of a portfolio is straightforward. But most of
my clients would start looking at their smartphones if I started explaining this to
them. And that business about Rs = Rf + (Rm – Rf) βs just would lose them
altogether.”
The arrow rising up the left side of the pyramid indicates that there is an
increasing risk of loss of principal as one moves up from the conservative base
toward the top; but there is an increasing potential for capital appreciation as
well. Conversely, the arrow pointing downward along the right side of the
pyramid indicates increasing safety of principal, but with an increasing risk of
purchasing power loss.
The investment pyramid can be used to good effect with clients in explaining
many issues of risk and return treated earlier in this module. Keep in mind that
the pyramid reflects generalizations, so there may be exceptions to these
rankings when considering specific securities. Many misinterpret this diagram to
clients, however, suggesting that the larger “base” indicates that a larger
proportion of the client’s funds should be invested in the lower-tier financial
instruments, and that other investment instruments should be funded in
increasingly smaller proportions. While this may be ideal for some clients, one
size does not fit all. The choice of investment assets and their proportion in a
client’s portfolio should instead depend on suitability and the client’s stated
objectives, circumstances, and preferences. (Note: New HH bonds are no longer
being issued after August 2004, and many HH bonds still outstanding have stopped
earning interest.)
Futures
contracts
Speculative Gold
common &
stocks & bonds collectibles
Go to answer.
Go to answer.
Go to answer.
5. The risk-free rate is 1.25%, the market rate of return is 9%, and the beta of
ABC stock is .80. Given this information, and using the capital asset pricing
model, what is the expected return of ABC stock?
Go to answer.
N
ow that we understand the important concepts of risk and required
returns, we can proceed to the active business of managing risk in client
portfolios, perhaps the greatest value-added service the investment
professional can render.
From time to time, diversification seems like an old fashioned concept, especially
during strong bull markets. If stocks provide much higher returns, for example,
why invest in bonds or other asset classes at all? Certainly this reasoning existed
at the beginning of the year 2000. At that time, a suggestion to cut back on stocks
and reinvest elsewhere would have seemed like a foolish idea. However, three
years later, the logic of a diversified portfolio became apparent as stocks fell
significantly and high quality bonds increased in price. In other words, in the
short run diversification can seem like a way to lower a portfolio’s return, but
long-term, it provides a smoother path toward investment goals.
This can be further illustrated by looking at the performance of bonds and stocks
over the 10-year period ending in 2010. This period is an important example
because it includes a strong bull stock market and two strong bear stock markets.
Using the Barclays Capital Aggregate Bond index as a proxy for bonds and the
S&P 500 stock index for stocks, we can see the following returns through
December 31, 2010:
These returns illustrate that strong bear markets can have a significant negative
impact on returns as the 10-year returns incorporate the bear markets of 2000–
2002 and 2007–2009. Although not shown, the returns for stocks through 2007
were 5.49% (1 year), 8.62% (3 years), 12.83% (5 years), and 5.91% (10 years).
These returns, compared to the returns through 2010, show the devastating
effects of a major bear market.
As seen here, there are periods when bonds can significantly outperform stocks.
The recent 10-year period shown above was one of the worst in history for
stocks; it was unusual, yet it did happen. As mentioned, bonds, and in particular
high-quality bonds, can smooth out a portfolio’s returns, which means at certain
times they can hold back a portfolio’s performance (as in 1999 when the
Barclays Aggregate index was down 0.82% while the S&P 500 was up 21.04%)
and at other times enhance it (as in 2008 when the Barclays Aggregate index was
up 5.24% while the S&P 500 index was down 37.00%). When reviewing these
returns, keep in mind that high-yield bonds often act more like stocks than bonds
because their risk of default increases during weak economic periods.
Diversification and asset allocation, then, are critically important in constructing
a portfolio in line with a client’s investment objectives.
Note: Should you or your clients ever need a reminder of the importance of asset
allocation, you can refer to The Callan Periodic Table of Investment Returns
(https://www.callan.com/research/periodic/) for the 20-year rolling asset class
returns. Alternatively, J.P. Morgan Asset Management provides a similar
analysis in the Asset Class Returns segment of their Guide to the Markets
publication, which can be found at https://am.jpmorgan.com/us/en/asset-
management/gim/adv/insights/guide-to-the-markets.
Consider Figure 7, which displays total risk on the vertical axis and (referring
specifically to large company stocks) the number of stocks in the portfolio or the
degree of diversification along the horizontal axis. As more stocks are added to
the portfolio, the total risk decreases marginally, so as the number of stocks
approaches 10 to 15 different issues (and in different industries), eventually
almost all unsystematic risk can be eliminated, and only systematic risk remains.
Standard
Deviation
(σ)
Total
Risk
Unsystematic
Risk
σm
Systematic
Risk
The reduction in unsystematic risk occurs only if the stocks being added to the
portfolio are less than perfectly positively correlated. As illustrated in Figure 8
below, the further the correlation is from +1.0, the more diversification is
provided.
-1 0 +1
That is, a stock with a correlation of .90 adds a small amount of diversification,
but a stock with a correlation of .20 adds much more diversification. Likewise,
additional diversification occurs if the correlation is ‒.20; and even more if the
correlation is ‒.80 (in practice, assets with large negative correlations are very
rare).
Stocks within a specific industry tend to have high correlations so if, for
example, you start with the stock of a semiconductor manufacturer and add the
stock of two more semiconductor manufacturers, the diversification effect is
likely to be very minimal. For purposes of discussion here, you will diversify
away unsystematic risk as you add stocks having low correlations from different
industries to the portfolio.
Return
Stock B
Stock A
Time
Corp.
U.S High
Large Yield Muni Comm-
Cap EAFE EME Bonds Bonds Bonds REITs odities
U.S. Large 1.00
Cap
EAFE 0.89 1.00
EME 0.79 0.90 1.00
Bonds -0.29 -0.14 -0.04 1.00
Corp High 0.75 0.79 .86 -0.05 1.00
Yield Bonds
Muni Bonds -0.12 0.00 0.08 0.81 0.12 1.00
REITs 0.77 0.67 0.55 0.02 0.67 0.09 1.00
Commodities 0.53 0.61 0.68 –0.10 0.66 –0.09 0.40 1.00
Source: J.P. Morgan Asset Management Guide to the Markets, Q1 2017.
Looked at another way, if you do not diversify, you are taking additional risk
without additional return.
Diversification within asset classes. The effects of this method have already
been explained. But assuming that the stocks added to a portfolio are not in the
same industry or subject to the same business forces, how many stocks are
needed to eliminate most of the unsystematic risk? For this course, the general
rule of thumb is that 10 to 15 large company U.S. stocks (in different industries)
Perhaps the most important part of the client assessment that precedes any
investment action is determining the client’s time horizon. Is the client investing
to accumulate college funds needed 15 years from today? Are the funds
represented by the account needed in three years to repay a loan? Are the client’s
funds needed in six months to purchase a house?
Harvard University has an endowment of about $38 billion. It has its own
asset management department to invest this sum in real assets, stocks, bonds,
and alternative investments such as hedge funds, venture capital situations,
private equity, commodities, and LBO funds. Although it draws millions of
dollars each year from the earnings of its endowment to support operations,
financial aid, and facilities expansion, Harvard is a long-term investor. Its
endowment is viewed as a “permanent fund” and is invested, for the most
part, with more concern for high, long-term returns than for short-term
fluctuations in asset values. The investment managers at Harvard know that
in general the risk of investing in volatile assets like stocks decreases as
one’s time horizon increases. This is the common definition of time
diversification. (Of course, this assumes high-quality investments are purchased;
owning financially weak, highly speculative securities can lead to large losses
over time as demonstrated by the savings and loan debacle of the mid-’80s.)
Bill Walters has accumulated $50,000 for the education of his two children,
the first of whom will begin college in just one year. His concern is for the
value of his portfolio at those moments when he must withdraw funds for
scheduled tuition payments.
Return
Stocks
Bonds
Time
Stocks grow to materially greater values over time in this illustration (as they have
done historically), but with much greater volatility. Obviously, a client such as
Harvard, which views its funds as “permanent,” can live through the ups and downs
of stock fluctuations; Bill Walters, however, cannot risk the possibility that the
stock market will be in a slump one year from now. CDs or one-year notes may be
the better approach for him.
40% in T-bills
The church withdraws a small amount of its funds each year to meet current
obligations, but members of its investment committee view the endowment as
permanent funds. When asked by their investment adviser if they would consider
shifting the portfolio to contain 50% to 70% stocks, they reply: “Oh, no. That
would be too risky. We cannot afford to lose this money.” Of course, the real
risks are (1) risk of paper losses if they shift more into stocks, and (2) purchasing
power risk if they pursue their current investment policy. In other words, there is the
risk of having to sell stocks at a loss and the risk of being too conservative and not
being in investments that can earn a return above the inflation rate over time.
Sometimes the opposite situation can occur when a strong bull market over a
period of time makes it seem that investing in stocks is low in risk. For example,
during 1998 and 1999, when the S&P 500 and NASDAQ composite stock
indexes reached record levels, day trading became popular. Making money by
trading stocks based on very short time frames, sometimes just hours or even
minutes, seemed so easy that many people became involved in day trading. Not
everyone was successful, as certain tragic stories reported in the news
demonstrated. For some of these people expecting to become wealthy in a short
period of time, the risk of investing in stocks to achieve their short-term goal
became all too clear in very short order as they watched investment portfolios
plummet.
The time horizon for a goal, then, has a direct bearing on what investments are
appropriate for achieving that goal. In general, if the time horizon is more than
five years, common stocks are appropriate since there should be sufficient time to
make up for any down markets during that period. After the “credit crisis” of
2008–2009 and current economic and market conditions, some planners have
Educating clients to understand the relationship between risk and return, and the
part played by their own investment time horizons, is extremely important.
Client assessment. Any actions taken on behalf of the client must always be
preceded by a “client assessment.” The manner of making this assessment was
discussed in Module 1 under the subjects of data gathering, information
analysis, building a relationship, and helping the client to establish specific
and reasonable goals. The object of client assessment is to determine the
following:
3. How long or short is the client’s time horizon for each goal?
4. Does the client have investment income or liquidity needs (for emergencies,
college funding, and so forth) that should be considered?
5. What is the client’s risk tolerance? Does this risk tolerance match up with the
client’s expectations of investment returns?
Answers to these questions will determine the parameters within which risk-
adjusted portfolios can be developed. The client assessment process also assures
that we are meeting the “know your customer” requirement of professional
practice.
Chapter 3 Review
1. How does correlation relate to risk reduction?
Return to question.
W
hether we are training for a marathon race, developing new on-the-
job skills, or managing investments, we need some measurement
device to know how well we are doing or progressing toward our
goal. For investment professionals, investment performance is
receiving more attention as investors become more sophisticated. This chapter
includes a number of practical performance measures.
How are we doing? How have we done? Why did we get the performance we
did? Was the investment manager lucky or skillful? As you will see at the end of
the chapter, there are performance measurements that the client will favor and
performance measurements that the investment manager will prefer. Therefore,
these questions are important as you monitor the performance of client accounts
and as you discuss results with your clients. Some investment institutions are
officially obliged to calculate their performance on a regular basis. Mutual fund
and pension fund managers must make this calculation for shareholders and
pension sponsors, respectively. For managers dealing with listed securities, these
calculations are straightforward, as beginning and ending values and the total of
distributions are easily obtainable. For the investment professional, it becomes
more difficult when clients hold securities whose market value is not listed.
Excess Return
One common measure of portfolio performance is “excess return.” This figure is
defined and calculated as follows:
Rp = R f + ( Rm − R f ) βp
Here, if we assembled a portfolio whose beta was slightly larger than that of the
overall market, say 1.10, at a time when the risk-free rate was 1% and the actual
market return was 7%, that portfolio’s required rate of return could be calculated
as shown below:
If our client’s portfolio returned less than 7.6%, then somehow we would not
have achieved the required returns, given the level of risk that we took. Perhaps
our selection of securities was faulty; perhaps the current betas of our stocks
were different than their published betas. On the other hand, if the client’s return
is greater than 7.6%, we have returned more than what was required for the level
of risk taken. To illustrate the possibilities of either underperforming (point B,
which is below the security market line) or outperforming (point A) the required
rate of return, based on the risk taken as measured by beta, we need to return to
the security market line (Figure 11).
Expected
Return %
Security
Market
Line
Portfolio A Portfolio B
Earlier in this module, we saw the risk and return relationship of the assets
classes as demonstrated by the Capital Market Line (CML). The CML graphed
the risk premium as we moved from the risk-free asset through the riskiest of
asset classes, using standard deviation as the risk measurement. The Security
Market Line (SML) is a similar-looking risk-return graph that focuses on the
systematic risk using beta. The SML can be used for both efficient portfolios (as
per Figure 11) or for individual assets. In Figure 11, the point where the Security
Market Line intercepts the “Required Return %” axis is the risk-free rate (Rf).
The condition described as alpha is the difference between the return that was
realized and the required rate of return, given the level of risk that was taken. The
goal is to have a positive alpha, such as reflected by Portfolio A. The alpha for
the security market line is zero in that it always delivers exactly what is expected.
Portfolio A has generated returns above the SML by the amount alpha (α); thus,
the alpha for this portfolio is positive. Portfolio B, on the other hand, has a
negative alpha. A negative alpha does not necessarily mean the portfolio had a
negative return but instead indicates that the portfolio achieved a lower return
than we would expect/require for the risk taken (as measured by CAPM using
beta). Alpha is a stand-alone performance measurement tool, meaning it can be
used by itself as an indication of a portfolio manager’s performance. That is, a
positive alpha indicates the manager performed better than expected given the
risk he or she took, while a negative alpha indicates that the manager performed
worse than expected given the risk he or she took. The greater the positive
(negative) alpha, the better (worse) the portfolio manager performed on a risk-
adjusted basis. The Jensen model uses this formula:
αp = Rp − Rf + (Rm − Rf ) βp
where
Rp = the portfolio’s actual return
Rf = the risk-free rate
βp = the portfolio’s beta
Rm = the stock market’s return
For example, assume a mutual fund, with a beta of 1.1, had a return of 14%, the
stock market returned 10% in that same period, and the risk-free return was 4%.
Using the above formula, we would get:
Excess return
Ti =
Portfolio beta
Another way of putting it would be:
.125 − .03
TA = = 0.117
0.81
The Sharpe performance index is similar to the Treynor index but uses the
portfolio standard deviation instead of the portfolio beta. Therefore, using the
Sharpe index is appropriate whenever you have a portfolio that is not fully
diversified (as standard deviation is a measure of total risk). The Sharpe index
formula is as follows:
Total portfolio return − Risk-free rate
Si =
Portfolio standard deviation
Thus, if the manager of Portfolio A earned a total return of 12% when the risk-
free return was 3% and the standard deviation of the portfolio was .25, the
manager’s Sharpe index would be:
.12 − .03
SA = = .36
.25
If the manager of Portfolio B earned a total return of 10% during the same
period, but his portfolio standard deviation was .15, his Sharpe index would be as
follows:
.10 − .03
SB = = .47
.15
Therefore, although the manager of Portfolio A earned a higher return, the
manager of Portfolio B had a better risk-adjusted return based on the Sharpe
performance index.
Performance Benchmarks
Table 5 identifies some of the more popular stock and bond benchmarks used by
investment professionals.
Benchmark Synopsis
S&P 500 Tracks performances of 500 of the largest companies listed on
the NYSE, the AMEX, and the NASDAQ system, accounting for
approximately 64% of the market value of stocks listed on the
exchanges
S&P Mid-Cap 400 Tracks performances of stocks listed on the NYSE that have a
market capitalization between $1.4 billion and $5.9 billion
Russell 2000 Tracks performances of the smallest 2,000 stocks in the Russell
3000 index and includes a market capitalization up to $6 billion
2. be sure to add back all dividends or other distributions taken. The indexes all
assume that dividends and distributions are reinvested.
Time-Weighted Returns
Time-weighted returns are most applicable when determining the performance of
an investment manager. For a fund manager, the benefit of time-weighted returns is
that they negate the effects of contributions and withdrawals made by investors
Dollar-Weighted Returns
We have established that time-weighted returns are the preferred method to
compare the performances of two different portfolio managers or funds, but a
method is still needed to determine the rate of return actually received by the
client on the total funds he or she has invested. The answer to that problem is
found by calculating the compound returns of all funds in the portfolio for the
period of investment. The time-weighted method does not recognize the impact
of cash flows and, therefore, is not an accurate representation of how the client
fared. For this reason, a client’s investment performance in, say, XYZ Fund will
very rarely be the same as XYZ Fund’s performance.
For example, assume Fund A had the following annual returns for the past five
years: 10%, 12%, –8%, 15%, and 9%. If a client invested $1,000 in Fund A five
years ago and still held the investment today, the client would have earned a
compound annual return of 7.3% (this is the time-weighted return). If the client
makes an additional investment of $500 at the end of the second year, the
portfolio return would change dramatically. This new $500 investment would
have missed out on the good returns of years one and two and then would have
been exposed to the poor return in year three. The overall effect would be a
reduction in the rate of return to about 6.8% (this is the dollar-weighted return).
Chapter 4 Review
1. Describe how the Jensen performance index can be used.
Go to answer.
T
his module has examined in detail one of the most important sets of
concepts in the investment business—risk, returns, and managing risk
through diversified and risk-adjusted portfolios.
Having read the material in this module, you should be able to:
2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.
a. market risk
Stems from factors that are independent of any particular security;
factors include political events, broad economic and social
changes, and the mood of the investing public.
Return to question.
c. reinvestment risk
The risk that an investor will be reinvesting his or her payment
amount from a fixed income instrument at a time when rates are
lower than they had been previously. This risk is sometimes called
reinvestment rate risk.
Return to question.
b. financial risk
This is the degree to which a company utilizes debt to finance
operations. Leverage can increase return on equity (ROE) but it
can also magnify losses.
Return to question.
c. default risk
The risk that an entity cannot make good on its obligations (such
as bonds paying their required payments of interest and principal
when due)
Return to question.
d. credit risk
The risk that bond’s credit rating will be lowered, causing the
bond’s price to fall
Return to question.
f. event risk
The risk that a bond or stock holder will be negatively affected by
an unanticipated and damaging event
Return to question.
g. call risk
The risk that a bond will be called by the issuer prior to maturity
Return to question.
h. political risk
This type of risk is the uncertainty caused by the possibility of
adverse political events occurring in another country
Return to question.
Chapter 2
2–2 Calculate the relative risk of stocks or portfolios using betas.
2–3 Calculate the return of a stock or portfolio using the capital asset
pricing model.
Rs = Rf + (Rm – Rf) Bs
where
Rs = the required return of the individual stock
Rf = the risk-free rate
Bs = the stock’s beta
Rm = the stock market’s return
(Rm – Rf) = the “market premium”—the extra rate of return that
stock market investors obtain over investors in T-bills
Return to question.
5. The risk-free rate is 1.25%, the market rate of return is 9%, and the beta of
ABC stock is .80. Given this information, and using the capital asset pricing
model, what is the required return of ABC stock?
.0125 + [(.09 – .0125) .80] = .0745 or 7.45%
Return to question.
Chapter 3
2–4 Explain how to achieve risk reduction through diversification.
Chapter 4
2–5 Explain the importance of client time horizons to portfolio risk.
Campbell, Lettau, Malkiel and Xu. “Have Individual Stocks Become More
Volatile? An Empirical Exploration of Idiosyncratic Risk,” 2000.
Perritt, Gerald W. Small Stocks, Big Profits. Homewood, IL: Dow Jones-Irwin,
1994.
Smith, Randall. “Zero-Coupon Bond’s Price Swings Jolt Investors Looking for
Security.” The Wall Street Journal, p. C1. June 6, 1984.