Risk and Return

16-9
Risk and Returns
Stock Valuation
Nguyen Viet Dung, PhD.
16-10
Returns
Dollar Returns
the sum of the cash received and the change in value of the asset, in dollars.
Dividends Ending market value
Time
1 Percentage Returns
the sum of the cash received and the change in value of the asset divided by the original investment.
Initial investment
Stock Valuation
Returns
Dollar Return = Dividend + Change in Market Value
percentage return =
dollar return beginning market value
dividend + change in market value beginning market value
= dividend yield + capital gains yield

Stock Valuation Nguyen Viet Dung, PhD.
16-12
Returns: Example
Suppose you bought 100 shares of Wal-Mart (WMT) one year ago today at $25. Over the last year, you received $20 in dividends (= 20 cents per share 100 shares). At the end of the year, the stock sells for $30. How did you do? Quite well. You invested $25 100 = $2,500. At the end of the year, you have stock worth $3,000 and cash dividends of $20. Your dollar gain was $520 = $20 + ($3,000 $2,500). $520 Your percentage gain for the year is 20.8% = $2,500
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Returns: Example
Dollar Return:
$520 gain
$20 $3,000
Time
1 Percentage Return:
-$2,500
Stock Valuation
20.8% =
$520 $2,500
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HoldingHolding -Period Returns

The holding period return is the return that an investor would get when holding an investment over a period of n years, when the return during year i is given as ri:
holding period return = = (1 + r1 ) (1 + r2 ) L (1 + rn ) 1
Stock Valuation
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Holding Period Return: Example

Suppose your investment provides the following returns over a four-year period:
Year Return 1 10% 2 -5% 3 20% 4 15%
Your holding period return = = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) 1 = (1.10) (.95) (1.20) (1.15) 1 = .4421 = 44.21%
Stock Valuation
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An investor who held this investment would have actually realized an annual return of 9.58%:
Year Return 1 10% 2 -5% 3 20% 4 15%
Geometric average return = (1 + rg ) 4 = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) rg = 4 (1.10) (.95) (1.20) (1.15) 1 = .095844 = 9.58%
So, our investor made 9.58% on his money for four years, realizing a holding period return of 44.21% 1.4421 = (1.095844) 4
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Note that the geometric average is not the same thing as the arithmetic average:
Year Return 1 10% 2 -5% 3 20% 4 15%
Arithmetic average return = =
r1 + r2 + r3 + r4 4
10% 5% + 20% + 15% = 10% 4
Stock Valuation
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Holding Period Returns

A famous set of studies dealing with the rates of returns on common stocks, bonds, and Treasury bills was conducted by Roger Ibbotson and Rex Sinquefield. They present year-by-year historical rates of return starting in 1926 for the following five important types of financial instruments in the United States:
Large-Company Common Stocks Small-company Common Stocks Long-Term Corporate Bonds Long-Term U.S. Government Bonds U.S. Treasury Bills
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Stock Valuation
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Return Statistics
The history of capital market returns can be summarized by describing the
average return
R=
( R1 + L + RT ) T
( R1 R ) 2 + ( R2 R ) 2 + L ( RT R ) 2 T 1
the standard deviation of those returns
SD = VAR =
the frequency distribution of the returns.

Stock Valuation
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Historical Returns, 19261926-2002

Series Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation Average Annual Return 12.2% 16.9 6.2 5.8 3.8 3.1 Standard Deviation 20.5% 33.2 8.7 9.4 3.2 4.4 Distribution
90%
0%
+ 90%
Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
Stock Valuation
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Average Stock Returns and RiskRisk-Free Returns

The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock market data is this long-run excess of stock return over the riskfree return.
The average excess return from large company common stocks for the period 1926 through 1999 was 8.4% = 12.2% 3.8% The average excess return from small company common stocks for the period 1926 through 1999 was 13.2% = 16.9% 3.8% The average excess return from long-term corporate bonds for the period 1926 through 1999 was 2.4% = 6.2% 3.8%
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Risk Premia
Suppose that The Wall Street Journal announced that the current rate for on-year Treasury bills is 5%. What is the expected return on the market of smallcompany stocks? Recall that the average excess return from small company common stocks for the period 1926 through 1999 was 13.2% Given a risk-free rate of 5%, we have an expected return on the market of small-company stocks of 18.2% = 13.2% + 5%
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The RiskRisk-Return Tradeoff

18%
Small-Company Stocks
16%
Annual Return Average
14% 12% 10% 8% 6%
Large-Company Stocks
T-Bonds
4% 2% 0% 5% 10% 15% 20% 25% 30% 35%
T-Bills
Annual Return Standard Deviation
Stock Valuation
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Rates of Return 19261926-2002

60 40
20
-20
Common Stocks Long T-Bonds T-Bills
-40 -60 26 30 35 40 45 50 55
60
65
70
75
80
85
90
95 2000
Stock Valuation
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Risk Premiums
Rate of return on T-bills is essentially risk-free. Investing in stocks is risky, but there are compensations. The difference between the return on T-bills and stocks is the risk premium for investing in stocks. An old saying on Wall Street is You can either sleep well or eat well.
Stock Valuation
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Stock Market Volatility

The volatility of stocks is not constant from year to year.
60 50 40 30 20 10 0
Stock Valuation
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There is no universally agreed-upon definition of risk. The measures of risk that we discuss are variance and standard deviation.
The standard deviation is the standard statistical measure of the spread of a sample, and it will be the measure we use most of this time. Its interpretation is facilitated by a discussion of the normal distribution.
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The 20.5-percent standard deviation we found for stock returns from 1926 through 1999 can now be interpreted in the following way: if stock returns are approximately normally distributed, the probability that a yearly return will fall within 20.5 percent of the mean of 12.2 percent will be approximately 2/3.
19 26 19 35 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 19 98
Risk Statistics
Normal Distribution
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Normal Distribution
S&P 500 Return Frequencies
16 16
11 9
12 10 8 5 6 4
2 1 0 -58% -48% -38% -28% -18% -8% 2% 12% 22% 32% 42% 1 1
2 2 0 0 52% 62%
Annual returns
Stock Valuation
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The Capital Asset Pricing Model (CAPM)
Stock Valuation
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Individual Securities
The characteristics of individual securities that are of interest are the:
Expected Return Variance and Standard Deviation Covariance and Correlation
Stock Valuation
Return frequency
Normal approximation Mean = 12.8% Std. Dev. = 20.4%
14 12 12
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Expected Return, Variance, and Covariance

Scenario Probability Recession 33.3% Normal 33.3% Boom 33.3% Rate of Return Stock Bond -7% 17% 12% 7% 28% -3%
Consider the following two risky asset world. There is a 1/3 chance of each state of the economy and the only assets are a stock fund and a bond fund.
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Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%
Scenario
Recession Normal Boom Expected return Variance Standard Deviation
Stock Valuation
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Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock fund Rate of Squared Return Deviation -7% 3.24% 12% 0.01% 28% 2.89% 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 1.00% 7% 0.00% -3% 1.00% 7.00% 0.0067 8.2%
E (rS ) = 1 ( 7%) + 1 (12%) + 1 (28%) 3 3 3 = E (rS ) 11%

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Scenario
E (rB ) = 1 (17%) + 1 (7%) + 1 ( 3%) 3 3 3 E (rB ) = 7%

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Scenario
(11% 7%)2 = 3.24%

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Scenario
(11% 12%)2 = .01%

10
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Scenario
(11% 28%)2 = 2.89%

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Scenario
1 2.05% = (3.24% + 0.01% + 2.89%) 3

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Scenario
14.3% = 0.0205
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The Return and Risk for Portfolios

Scenario
Note that stocks have a higher expected return than bonds and higher risk. Let us turn now to the risk-return tradeoff of a portfolio that is 50% invested in bonds and 50% invested in stocks.
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Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio -7% 17% 5.0% 12% 7% 9.5% 28% -3% 12.5% 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08% squared deviation 0.160% 0.003% 0.123%
The rate of return on the portfolio is a weighted average of the returns on the stocks and bonds in the portfolio:
rP = wB rB + wS rS
5% = 50% ( 7%) + 50% (17%)

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rP = wB rB + wS rS 9.5% = 50% (12%) + 50% (7%)

12
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rP = wB rB + wS rS
12.5% = 50% (28%) + 50% ( 3%)

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The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio.
E ( rP ) = wB E ( rB ) + wS E (rS )
9% = 50% (11%) + 50% (7%)

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The variance of the rate of return on the two risky assets portfolio is
2 = (wB B )2 + (wS S )2 + 2(wB B )(wS S )BS P
where BS is the correlation coefficient between the returns on the stock and bond funds.
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Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than stocks or bonds held in isolation.
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The Efficient Set for Two Assets

% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50.00% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.08% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%
Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.00% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%
P o rtfo lio R e tu rn
Portfolo Risk and Return Combinations
12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%
100% stocks 100% bonds
5.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Portfolio Risk (standard deviation)
We can consider other portfolio weights besides 50% in stocks and 50% in bonds
Stock Valuation
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% in stocks
0% 0% 5% 5% 10% 10% 15% 15% 20% 20% 25% 25% 30% 30% 35% 35% 40% 40% 45% 45% 50% 50% 55% 55% 60% 60% 65% 65% 70% 70% 75% 75% 80% 80% 85% 85% 90% 90% 95% 95% 100% 100%
Risk
8.2% 8.2% 7.0% 7.0% 5.9% 5.9% 4.8% 4.8% 3.7% 3.7% 2.6% 2.6% 1.4% 1.4% 0.4% 0.4% 0.9% 0.9% 2.0% 2.0% 3.1% 3.1% 4.2% 4.2% 5.3% 5.3% 6.4% 6.4% 7.6% 7.6% 8.7% 8.7% 9.8% 9.8% 10.9% 10.9% 12.1% 12.1% 13.2% 13.2% 14.3% 14.3%
Return
7.0% 7.0% 7.2% 7.2% 7.4% 7.4% 7.6% 7.6% 7.8% 7.8% 8.0% 8.0% 8.2% 8.2% 8.4% 8.4% 8.6% 8.6% 8.8% 8.8% 9.0% 9.0% 9.2% 9.2% 9.4% 9.4% 9.6% 9.6% 9.8% 9.8% 10.0% 10.0% 10.2% 10.2% 10.4% 10.4% 10.6% 10.6% 10.8% 10.8% 11.0% 11.0%
P o rtfo lio R e tu rn
12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%
100% stocks 100% bonds
5.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
We can consider other portfolio weights besides 50% in stocks and 50% in bonds
Stock Valuation
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% in stocks
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Risk
8.2% 7.0% 5.9% 4.8% 3.7% 2.6% 1.4% 0.4% 0.9% 2.0% 3.1% 4.2% 5.3% 6.4% 7.6% 8.7% 9.8% 10.9% 12.1% 13.2% 14.3%
Return
7.0% 7.2% 7.4% 7.6% 7.8% 8.0% 8.2% 8.4% 8.6% 8.8% 9.0% 9.2% 9.4% 9.6% 9.8% 10.0% 10.2% 10.4% 10.6% 10.8% 11.0%
P o rtf o lio R e tu rn
12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0%
100% stocks 100%
5.0% bonds 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
Note that some portfolios are better than others. They have higher returns for the same level of risk or less. These compromise the efficient frontier.
Stock Valuation
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Two-Security Portfolios with Various Correlations

return
= -1.0
100% stocks
100% bonds
= 1.0 = 0.2
Relationship depends on correlation coefficient -1.0 < < +1.0 If = +1.0, no risk reduction is possible If = 1.0, complete risk reduction is possible
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Portfolio Risk as a Function of the Number of Stocks in the Portfolio

In a large portfolio the variance terms are effectively diversified away, but the covariance terms are not.
Diversifiable Risk; Nonsystematic Risk; Firm Specific Risk; Unique Risk Portfolio risk Nondiversifiable risk; Systematic Risk; Market Risk n Thus diversification can eliminate some, but not all of the risk of individual securities.
15
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The Efficient Set for Many Securities

return
Individual Assets
Consider a world with many risky assets; we can still identify the opportunity set of risk-return combinations of various portfolios.
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return
minimum variance portfolio Individual Assets
Given the opportunity set we can identify the minimum variance portfolio.
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return
minimum variance portfolio Individual Assets
The section of the opportunity set above the minimum variance portfolio is the efficient frontier.
16
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Optimal Risky Portfolio with a Risk-Free Asset

return
100% stocks
rf
100% bonds
In addition to stocks and bonds, consider a world that also has risk-free securities like T-bills
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Riskless Borrowing and Lending

return
100% stocks Balanced fund
rf
100% bonds
Now investors can allocate their money across the T-bills and a balanced mutual fund
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Riskless Borrowing and Lending

return
rf
With a risk-free asset available and the efficient frontier identified, we choose the capital allocation line with the steepest slope
17
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Market Equilibrium
return
M rf
P
With the capital allocation line identified, all investors choose a point along the linesome combination of the risk-free asset and the market portfolio M. In a world with homogeneous expectations, M is the same for all investors.
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The Separation Property

return
M rf
The Separation Property states that the market portfolio, M, is the same for all investorsthey can separate their risk aversion from their choice of the market portfolio.
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return
M rf
Investor risk aversion is revealed in their choice of where to stay along the capital allocation linenot in their choice of the line.
Stock Valuation
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Market Equilibrium
return
100% stocks Balanced fund
rf
100% bonds
Just where the investor chooses along the Capital Asset Line depends on his risk tolerance. The big point though is that all investors have the same CML.
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Market Equilibrium
return
100% stocks Optimal Risky Portfolio
rf
100% bonds
All investors have the same CML because they all have the same optimal risky portfolio given the risk-free rate.
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return
100% stocks Optimal Risky Portfolio
rf
100% bonds
The separation property implies that portfolio choice can be separated into two tasks: (1) determine the optimal risky portfolio, and (2) selecting a point on the CML.
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Optimal Risky Portfolio with a Risk-Free Asset

return
100% stocks First Optimal Risky Portfolio 100% bonds Second Optimal Risky Portfolio
rf1 rf0
By the way, the optimal risky portfolio depends on the risk-free rate as well as the risky assets.
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Definition of Risk When Investors Hold the Market Portfolio

Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta ()of the security. Beta measures the responsiveness of a security to movements in the market portfolio.
i =
Stock Valuation
Cov ( Ri , RM )
2 ( RM )
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Estimating with regression

Security Returns
Slope = i
Return on market %
Ri = i + iRm + ei
20
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Estimates of for Selected Stocks

Stock Bank of America Borland International Travelers, Inc. Du Pont Kimberly-Clark Corp. Microsoft Green Mountain Power Homestake Mining Oracle, Inc.
Stock Valuation
Beta 1.55 2.35 1.65 1.00 0.90 1.05 0.55 0.20 0.49
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The Formula for Beta
i =
Cov( Ri , RM )
2 ( RM )
Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.
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Relationship between Risk and Expected Return (CAPM)
Expected Return on the Market:

R M = RF + Market Risk Premium
Expected return on an individual security:

R i = RF + i ( R M RF )
Market Risk Premium
This applies to individual securities held within welldiversified portfolios.

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Expected Return on an Individual Security

This formula is called the Capital Asset Pricing Model (CAPM) Ri = RF + i ( RM RF )
Expected return on a security = RiskBeta of the + free rate security Market risk premium
Assume i = 0, then the expected return is RF. Assume i = 1, then Ri = RM

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Relationship Between Risk & Expected Return
Expected return
Ri = RF + i ( RM RF ) RM RF
1.0
Stock Valuation
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Relationship Between Risk & Expected Return

Expected return
13.5% 3%
i = 1 .5
Stock Valuation
RM =10% R i = 3% + 1.5 (10% 3%) = 13.5%

RF = 3%
1.5
22

Risk and Return

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16-9

Risk and Returns

Nguyen Viet Dung, PhD.

dollar return beginning market value

dividend + change in market value beginning market value

= dividend yield + capital gains yield

HoldingHolding -Period Returns

Nguyen Viet Dung, PhD.

Holding Period Return: Example

Nguyen Viet Dung, PhD.

Holding Period Return: Example

Geometric average return = (1 + rg ) 4 = (1 + r1 ) (1 + r2 ) (1 + r3 ) (1 + r4 ) rg = 4 (1.10) (.95) (1.20) (1.15) 1 = .095844 = 9.58%

Holding Period Return: Example

Arithmetic average return = =

10% 5% + 20% + 15% = 10% 4

Nguyen Viet Dung, PhD.

Holding Period Returns

Nguyen Viet Dung, PhD.

the standard deviation of those returns

the frequency distribution of the returns.

Historical Returns, 19261926-2002

Nguyen Viet Dung, PhD.

Average Stock Returns and RiskRisk-Free Returns

The RiskRisk-Return Tradeoff

Annual Return Average

14% 12% 10% 8% 6%

Annual Return Standard Deviation

Nguyen Viet Dung, PhD.

Rates of Return 19261926-2002

Nguyen Viet Dung, PhD.

Nguyen Viet Dung, PhD.

Stock Market Volatility

Nguyen Viet Dung, PhD.

The Capital Asset Pricing Model (CAPM)

Nguyen Viet Dung, PhD.

Nguyen Viet Dung, PhD.

Normal approximation Mean = 12.8% Std. Dev. = 20.4%

Expected Return, Variance, and Covariance

Expected Return, Variance, and Covariance

Nguyen Viet Dung, PhD.

Expected Return, Variance, and Covariance

E (rS ) = 1 ( 7%) + 1 (12%) + 1 (28%) 3 3 3 = E (rS ) 11%

Expected Return, Variance, and Covariance

E (rB ) = 1 (17%) + 1 (7%) + 1 ( 3%) 3 3 3 E (rB ) = 7%

Expected Return, Variance, and Covariance

(11% 7%)2 = 3.24%

Expected Return, Variance, and Covariance

(11% 12%)2 = .01%

Expected Return, Variance, and Covariance

(11% 28%)2 = 2.89%

Expected Return, Variance, and Covariance

1 2.05% = (3.24% + 0.01% + 2.89%) 3

Expected Return, Variance, and Covariance

The Return and Risk for Portfolios

The Return and Risk for Portfolios

5% = 50% ( 7%) + 50% (17%)

The Return and Risk for Portfolios

rP = wB rB + wS rS 9.5% = 50% (12%) + 50% (7%)

The Return and Risk for Portfolios

12.5% = 50% (28%) + 50% ( 3%)

The Return and Risk for Portfolios

9% = 50% (11%) + 50% (7%)

The Return and Risk for Portfolios