You are on page 1of 33

Measuring Returns and Risk

Marriott School of Management


Fin 410
Fall 2014

Rob Schonlau
Last updated Sept 8, 2014

Your friends temporarily entrusted you with


$2 million to invest. They asked you to
invest it in the best possible manner

From the last 2 lectures, you should be aware of a few different


types of assets you could choose to invest in and the financial
markets where those assets are traded.

Now that you know some of your options, the next logical
discussion would be about how you should go about choosing
between the various assets. But before we can do that we need to
first review/learn some tools and measures.

Before we cover the financial theory behind optimal portfolio


formation we need to first review some measures of financial
performance and risk. Lectures 3 and 4 emphasize the
mathematical measures we use for risk and return.
2

Lecture 3 outline

How do you summarize an assets financial performance?


Review of terminology and how to calculate various return
measures.
Look at the historical returns to various asset classes. Introduce
risk and return concepts (1st pass).

Lecture 4 provides a review of some of the statistical concepts that


are useful for thinking about an assets performance and risk.

How do you best summarize the financial


performance of an investment? Payoff, profit,
or returns?
Assume you bought a financial asset for P0 and then after holding
the asset for a time you sell it for P1. Both prices are in dollars.
Three ways to describe the financial performance:
Payoff: P1
Profit: P1- P0
Return:
gross returns: P1/P0
net returns :
(P1- P0)/P0 or (P1/P0)-1

Holding Period Return: (P1 P0 + dividends)/P0


4

Example: Assume you buy and sell 1 share


of Cisco and 1 share of Apache stock
Cisco stock: You buy 1 share now for $100 and sell it in 3 months for
$110.
Apache stock: You buy 1 share now for $200 and sell it in 3 months for
$215.

What is the correct measuring stick for performance?


Payoff:
$110 $215
Profit:
$10
$15
Return:
Gross: 110/100 (Cisco) and 215/200 (Apache)
Net:
(110-100)/100 and (215-200)/200

Gross Returns

Gross returns measure payoff as a percentage of the initial


investment. Gross returns are simply payoff/price.

The gross return from buying Cisco is calculated as 110/100=110%


meaning you end up with 110% of what you initially invested.

Gross returns above 100% are good. Gross returns below 100%
indicate losses.

Net Returns

Net returns measure profit as a percentage of the initial


investment. Net returns are calculated simply as
(payoff/original price) -1.

For example the net return from buying Cisco would be


calculated as 110/100 - 1 = 10%. This means your investment
grew by 10%.

Net returns above 0 are good. Net returns below 0 signal a


loss. Net returns are the growth rate of your investment.

Two ways to annualize returns:


APRs vs EARs

Returns are quoted in a variety of ways. Annual percentage


rates (APRs) ignore compounding and effective annual rates
(EARs) include compounding.

EARs represent actual growth rates while APRs do not. When a


return is an actual growth rate, we call it an effective return.
Sometimes EARs are called annual percentage yields (APYs).

For example, an account that says it pays a 10% APR will not
actually grow your deposit by 10% over a year if there is
compounding during that year.

Rates can be compounded (and measured)


at different time intervals

It is also common to work with rates that are compounded, or


measured, semi-annually, monthly, or even more often.

When you are dealing with returns over non-annual intervals it


is especially important to distinguish between effective and noneffective rates.

Review: Time value of money formulas with


different compounding intervals.

These formulas are used when you have a single cash flow to move
through time as opposed to a stream of cash flows.

PV = present value
FV = future value
r = annual interest rate (APR)
n = number of compounding intervals per year

r/n = interest rate per compounding interval


y = number of years

= 1 +

1+

= 1 +

10

APR and Effective Rates


If n1 then
You are earning interest on interest during the year.
r the effective annual rate (EAR). I.e. the effective growth
of your money over the year is not r because of compound
interest.
r/n = the effective interest rate over the compounding
interval.
(r/n)*n = APR = r

11

Summary: Rates of Return


Conventions for Annualizing Rates of Return
APR = Per-period rate Periods per year
1 + EAR = (1 + Rate per period)
1 + EAR = (1 + Rate per period)n = (1 + APR )n
n
APR = [(1 + EAR)1/n 1]n

Example: Effective returns and future value


Your investment will earn an effective return of 5% per year. Your
initial investment is $100.
After the first year, what is the value of investment?

1001.05 105

3
After the third year, what is the value of investment? 100 1.05 115.76

What is the effective 3-year return?

115.76/100-1 = 15.76%

13

Example: Converting different time intervals for


effective rates. If the 3-year effective rate (ER3) is
15.76%, what is the 1-year effective rate (ER1)?
Suggested 3-step approach to solving the problem:
Step 1: Break the problem into its individual parts using notation:
- 2 growth rates (ER1 and ER3)
- 2 different units of time (1 vs 3 years)
Step 2: Assume you will make two $1 investments: one that will
grow at the ER1 rate each year and the other that will grow at the ER3
rate over the 3 year period.
Step 3: Choose an overall investment period that is divisible by both
units of time. In this case 3 years is the lowest number divisible by
both 3 and 1. Set the future value of the two investments over the
chosen investment period equal so that you can solve for the
unknown rate.
14

Example continued: If the 3-year effective rate (ER3)


is 15.76%, what is the 1-year effective rate (ER1)?
Step 1: Break the problem into its individual pieces:
ER1 = unknown and ER3=15.76%
2 different units of time (1 vs 3 years)
Step 2: Assume you will make two $1 investments over a 3 year
period: one that will grow at the ER1 rate each year and the other
that will grow at the ER3 rate over the 3-year period. In this example
the future values would be:
FV = 1(1+ER1)3 and FV = 1(1+ER3)1 = 1(1+.1576)1
Step 3: Set the future value of the two investments equal so that
you can back out the unknown rate.
1(1+ER1)3 = 1(1+.1576)1
15

Example: EAR
Suppose you pay 1% interest on your credit card
balance each month. What is the EAR?
Step 1: Break the problem into its individual pieces:
ER1mo = 1% and ER12mo = unknown
2 different units of time (1month vs 12 months)
Step 2: Assume you will make two $1 investments over a 12 month
period: one that will grow at the ER1mo rate each month and the
other that will grow at the ER12mo rate over the year. Note that ER12mo
= EAR. In this example the future values would be:
FV = 1(1+ER1mo)12 = 1(1+.01)12 and FV = 1(1+ER12mo)1
Step 3: Set the future value of the two investments equal so that you
can back out the unknown rate.
1(1+.01)12 = 1(1+ER12mo)1
16

Example: APR
Assume a bank charges 5% semi-annually.
What is the APR?
5% is the effective 6 month rate. Because interest is applied
every six months this means that n=2. APRs dont account
for compound interest.
Effective 6 month rate = r/n and .05= r/2 which means that r
= 10%.
What is the effective annual return (EAR) on the loan?
(1+ r/n ) n*y -1 = (1.05)2*1 -1 = 10.25%

17

Concept check
(Q1) What is the difference between APR and EAR?
(Q2) If you have an initial investment of $1 and an effective
annual rate of growth of 10%, what is your investment worth at the
end of 1 year?
(Q3) Assume you have an initial investment of $100 and an
account that provides an APR of 10% with quarterly compounding.
What is your investment worth at the end of 1 year? What is the
EAR?

18

Concept check cont.


(Q4) The 3-year effective rate is 20%. What is the 2-year effective
rate?
(Q5) Assume a bank charges 5% semi-annually. What is the
APR? What is the effective annual return on the loan?

19

Averaging returns over time: arithmetic vs


geometric means

In summarizing an assets financial performance over multiple


time intervals it is common to take the average of the returns.
There are two common approaches to averaging that you
should be familiar with: arithmetic and geometric.

20

Arithmetic average
Assume you have 10 years of annual return data (r1, r2, , r10) for an
asset and you want to summarize the annual historical returns for
this asset. The arithmetic average is calculated as the simple
average of the 10 yearly returns.

Arithmetic average =

1 +2 ++10
10

The arithmetic average ignores compounding.


The arithmetic average provides the best prediction for the next
single period return assuming future returns will be drawn from the
same distribution as historical returns.
21

Geometric average

Assume you have n periods of returns: (r1, r2, , rn)


The geometric average (rg) is defined as the nth root of the product
resulting from multiplying a series of returns together as follows:
=

1 + 1 1 + 2 1 +

1/

Note that the product within the brackets is the cumulative return
over the n periods that the investor experienced and includes the
effects of compound interest.

22

Geometric average intuition, cont.

The geometric average represents the per-period return that if it


had occurred for each of the n years would give the same n-year
cumulative return as the actual observed sequence of historical
returns did.
For example, a 10-year observed cumulative return would be
calculated as follows: 1 + 1 1 + 2 1 + 10 1
To solve for the geometric average return think of a single return
(rg) occurring repeatedly in each of the n periods that would
produce the same n-year cumulative return as observed. So
1 + 1 1 + 2 1 + 1 = 1 + 1 + 1 + 1
1 + 1 1 + 2 1 +

Rearrange terms: =

1=

1 +

1 + 1 1 + 2 1 +

1/

1
23

Dollar-weighted returns

The textbook presents 3 potential measures of performance:


arithmetic average of returns, geometric average of returns,
and dollar-weighted returns.
When we want to account for varying dollar amounts under
management we calculate the IRR for the cash flows in and
out of the portfolio.
See pages 112/113 for an example.

24

Lecture 3 outline

How do you summarize an assets financial performance?


Review terminology and how to calculate various return
measures.
Look at the historical returns to various asset classes. Introduce
risk and return concepts (1st pass).

25

Which of these asset classes are most


risky?

Large firm common stock


Long-term government bonds
Treasury bills
Small firm common stock
Long-term corporate bonds

26

What is risk?
Risk is related to the probability of obtaining outcomes that are far
different than the expected value. In some sense risk measures
the likely variability of the possible results.
In this class we will use measures of dispersion (standard
deviation, variance) as proxies of risk. We will refine our measures
of risk in subsequent lectures.

Risk and investment decision:


In the presence of risk one does not know beforehand what the
return on any asset will be. However, you can form expectations
about the possible return outcomes associated with each asset
and can assign probabilities to each outcome.
27

The mean-variance framework


The variance of returns for any investment measures the disparity
between actual and expected returns.

Low Variance Investment

High Variance Investment

Expected Return

28

General preferences and the mean-variance


framework

All else equal, people prefer higher expected returns (higher


averages). Thus given a choice between two investments of the
same risk they will choose the one with higher expected return.

All else equal, people prefer lower risk (lower variance)


investments. Thus given a choice between two investments with
the same expected return they will choose the one with lower risk.

29

What kinds of returns are commonly seen in


the market?
Using annual returns

1926-2009
Geometric Ave
Arithmetic Ave
Standard Deviation

1968-2009
Geometric Ave
Arithmetic Ave
Standard Deviation

Large Stocks
(World)
9.43
11.23
19.27

Large
Stocks
(US)
9.57
11.63
20.56

Small
Stocks
(US)
11.6
17.43
37.18

LT Bonds
(US)
5.37
5.69
8.45

Large Stocks
(World)
9.9
11.77
19.36

Large
Stocks
(US)
9.32
10.89
17.95

Small
Stocks
(US)
10
13.47
27.41

LT Bonds
(US)
7.96
8.44
10.34
30

The distribution of annual returns for U.S.


Large Stocks (S&P 500), Small Stocks,
Corporate Bonds, and Treasury Bills, 19262004.
3-mo Treasury Bills
AAA Corporate Bonds

Frequency (# of years)

S&P 500
Small Stocks

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Annual Return

31

>100%

Rates of Return on Stocks, Bonds, and Bills

Concept check, cont.


(Q6) You observe the following annual returns on an asset: 10%,
5%, -5%, -3%, 15%, 10%. Write the formula for the arithmetic and
geometric averages.
(Q7) What two assumptions do we make about the average
investors preferences with regard to asset investment choice?

33

You might also like