Chapter 2

RISK AND RETURN BASICS

Chapter 2 Questions

What are the sources of investment returns?

How can returns be measured?
What is risk and how can we measure risk?
What are the components of an investment s
required return to investors and why might
they change over time?

Sources of Investment
Returns
Investments provide two basic types of
return:
Income returns
The owner of an investment has the right to any
cash flows paid by the investment.

Changes in price or value

The owner of an investment receives the benefit
of increases in value and bears the risk for any
decreases in value.

Income Returns
Cash payments,
usually received
regularly over the life
of the investment.
Examples: Coupon
interest payments
from bonds,
Common and
preferred stock
dividend payments.

Returns From Changes in

Value
Investors also
experience capital gains
or losses as the value
of their investment
changes over time.
For example, a stock
may pay a $1 dividend
while its value falls from
$30 to $25 over the
same time period.

Measuring Returns
Dollar Returns
How much money was made on an investment
over some period of time?
Total Dollar Return = Income + Price Change

Holding Period Return

By dividing the Total Dollar Return by the
Purchase Price (or Beginning Price), we can
better gauge a return by incorporating the size of
the investment made in order to get the dollar
return.

Annualized Returns
If we have return or income/price change
information over a time period in excess of
one year, we usually want to annualize the
rate of return in order to facilitate
comparisons with other investment returns.
Another useful measure:
Return Relative = Income + Ending Value
Purchase Price

Annualized Returns
Annualized HPR = (1 + HPR)1/n 1
Annualized HPR = (Return Relative)1/n 1
With returns computed on an annualized
basis, they are now comparable with all other
annualized returns.

Compute annualized
returns
a. Investment held for 18 months and
the HPR = 23.53%.
b. Investment held for 1 month and the
HPR = 1.5%.

Measuring Historic Returns

Starting with annualized Holding Period
Returns, we often want to calculate
some measure of the average return
over time on an investment.
Two commonly used measures of
average:
Arithmetic Mean
Geometric Mean

Arithmetic Mean Return

The arithmetic mean is the simple average of
a series of returns.
Calculated by summing all of the returns in the
series and dividing by the number of values.
RA = (HPR)/n
Oddly enough, earning the arithmetic mean
return for n years is not generally equivalent to
the actual amount of money earned by the
investment over all n time periods.

Arithmetic Mean Example

Year Holding Period Return
1
10%
2
30%
3 -20%
4
0%
5
20%
RA = (HPR)/n = 40/5 = 8%

Geometric Mean Return

The geometric mean is the one return that, if
earned in each of the n years of an
investments life, gives the same total dollar
result as the actual investment.
It is calculated as the nth root of the product
of all of the n return relatives of the
investment.
RG = [(Return Relatives)]1/n 1

Geometric Mean Example

Year Holding Period Return Return Relative
1
10%
1.10
2
30%
1.30
3
-20%
0.80
4
0%
1.00
5
20%
1.20

RG = [(1.10)(1.30)(.80)(1.00)(1.20)] 1/5 1
RG = .0654 or 6.54%

Arithmetic vs. Geometric

To ponder which is the superior measure, consider
the same example with a $1000 initial
investment. How much would be accumulated?
Year Holding Period Return Investment Value
1
10%$1,100
2
30%$1,430
3 -20%
$1,144
4
0% $1,144
5
20%$1,373

Arithmetic vs. Geometric

How much would be accumulated if you earned
the arithmetic mean over the same time period?
Value = $1,000 (1.08)5 = $1,469
How much would be accumulated if you earned
the geometric mean over the same time period?
Value = $1,000 (1.0654)5 = $1,373
Notice that only the geometric mean gives the
same return as the underlying series of returns.

Investment Strategy Reinvesting Income

Generally, the income returns from an investment are
in your pocket cash flows.
Over time, your portfolio will grow much faster if you
reinvest these cash flows and put the full power of
compound interest in your favor.
Dividend reinvestment plans (DRIPs) provide a tool
for this to happen automatically; similarly, Mutual
Funds allow for automatic reinvestment of income.
See Exhibit 2.5 for an illustration of the benefit of
reinvesting income.

What is risk?
Risk is the uncertainty associated with the
return on an investment.
Risk can impact all components of return
through:

Fluctuations in income returns;

Fluctuations in price changes of the investment;
Fluctuations in reinvestment rates of return.

Sources of Risk
Systematic Risk Factors
Affect many investment returns simultaneously; their
impact is pervasive.
Examples: changes in interest rates and the state of
the macro-economy.

Asset-specific Risk Factors

Affect only one or a small number of investment
returns; come from the characteristics of the specific
investment.
Examples: poor management, competitive
pressures.

How can we measure risk?

Since risk is related to variability and
uncertainty, we can use measures of variability
to assess risk.
The variance and its positive square root, the
standard deviation, are such measures.
Measure total risk of an investment, the
combined effects of systematic and asset-specific
risk factors.

Variance of Historic Returns

2 = [(Rt-RA)2]/n-1

Standard Deviation of
Historic Returns
Year Holding Period Return
1
10%
RA = 8%
2
30%
2 = 370
3 -20%
= 19.2%
4
0%
5
20%
2 = [(10-8)2+(30-8)2+(-20-8)2+(0-8)2+(20-8)2]/4
= [4+484+784+64+144]/4
= [1480]/4

Using the Standard

Deviation
If returns are normally distributed, the
standard deviation can be used to
determine the probability of observing a
rate of return over some range of
values.

Why Risk and Return

Matter
Combined with time they embody the
very essence of FINANCE as an area
of study
Individuals and Institutions managing
tomorrow today

Risk and Return Matter

The Capital Allocation

Process
In a well-functioning economy, capital flows

efficiently from those who supply capital to

those who demand it.
Suppliers of capital: individuals and
institutions with excess funds. These groups
are saving money and looking for a rate of
return on their investment.
Demanders or users of capital: individuals
and institutions who need to raise funds to
finance their investment opportunities. These
groups are willing to pay a rate of return on
the capital they borrow.

S&P 500 Index, Total Returns:

Dividend Yield + Capital Gain or
Loss, 1968-2010

Market Holding Period

Returns

Companies that were all

that
!
Washington Mutual Was a savings bank holding company,

which was largest savings and loan association, and 6th largest
bank in the US. In June 2008 total assets were $307 Billion US.
It became the largest bank failure in US history on September 25,
2008. Washington Mutual was recommended as an investment in
Forbes Magazine in 2006!
Bear Sterns Was a global investment bank, until its failure May
30, 2008 in a fire sale to JPMorgan Chase. In 2005-2007, Bear
Stearns was recognized as the Most Admired securities firm in
Fortune Magazines Americas Most Admired Companies.
Lehman Brothers Was a global financial services firm with
$19.2 Billion US in revenue. On September 15, 2008, the firm
filed for Chapter 11 bankruptcy protection.

Others ..

General Motors GM manufactures, services, and sells, cars and trucks in over 140
countries. Recently the company employed over 244,500 people around the world.
In 2008 they had the third highest global revenues among automakers on the Fortune
Global 500. On 6/1/2009, GM filed for Chapter 11 bankruptcy protection, and became
majority owned by the US government.
Dell Is one of the largest technological corporations in the world, and was listed #38
on the 2010 Fortune 500 list. In recent years, Dell has been hit with quality/reliability
issues as well as customer service problems. It once held the position of #1 desktop
PC and #1 laptop maker. But due to eroding profits, those positions are now held by
HP and Acer (the current top 2 makers in both categories). In June 2010, founder
Michael Dell said he has considered taking the company private.
Nortel Networks Corporation - was a well known global telecommunications
equipment manufacturer, that employed 94,500 worldwide. It had a market
capitalization of $398 Billion CDN in September 2000. At its height, Nortel accounted
for more than a third of the total value of all the companies listed on the Toronto Stock
Exchange (TSX). On January 14, 2009, Nortel filed for bankruptcy protection in the
US, UK, and Canada. In June 2009, the company announced it would cease
operations and sell off all of its business units. Nortel was once recommended by
professionals as an investment in almost all Canadian newspapers, magazines, and
investment talk shows.

Normal distribution
assumption
Using expected risk and return only usually is

based on assumption of normally distributed

returns
E.g. standard normal distribution curve

Possible return
distributions

Coefficient of Variation
The coefficient of variation is the ratio of the
standard deviation divided by the return on the
investment; it is a measure of risk per unit of
return.
CV = /RA
The higher the coefficient of variation, the riskier
the investment.
From the previous example, the coefficient of
variation would be:
CV =19.2%/8% = 2.40

Components of Return
The required rate of return on an
investment is the sum of the nominal
risk-free rate (Nominal RFR) and a risk
premium (RP) to compensate the
investor for risk.
Required Return = Nominal RFR + RP
Or to be more technically correct:
RR = (1 + Nom RFR) x (1 + RP) - 1

The Risk-Return
Relationship
The Capital Market Line (CML) is a
visual representation of how risk is
rewarded in the market for investments.
The greater the risk, the greater the
required return, so the CML slopes
upward.

Components of Return
Over Time
What changes the required return on an
investment over time?
Anything that changes the risk-free rate or the
investments risk premium.
Changes in the real risk-free rate of return and the
expected rate of inflation (both impacting the
nominal risk-free rate, factors that shift the CML).
Changes in the investments specific risk (a
movement along the CML) and the premium
required in the marketplace for bearing risk
(changing the slope of the CML).