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Returns
Dollar Returns
the sum of the cash received and the change in value of the asset, in dollars.
Time 0 1 Percentage Returns
the sum of the cash received and the change in value of the asset divided by the initial investment.

Dividends Ending market value

Risk and Return

Initial investment

Returns
Dollar Return = Dividend + Change in Market Value dollar return percentage return = beginning market val ue

Returns: Example
Dollar Return:
$520 gain
$20 $3,000

dividend + change in market val ue beginning market val ue

Time

1 Percentage Return:

= dividend yield + capital gains yield

-$2,500

20.8% =

$520 $2,500

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Holding 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

Holding Period Return: Example

Suppose your investment provides the following returns over a four-year period:
Year Return 1 2 3 4 10% -5% 20% 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%

Historical Returns, 1926-2004

Series Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation Average Annual Return 12.3% 17.4 6.2 5.8 3.8 3.1 Standard Deviation 20.2% 32.9 8.5 9.2 3.1 4.3
90% 0% + 90%

Average Stock Returns and Risk-Free Returns

The Risk Premium is the added return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock market data is the long-run excess of stock return over the risk-free return.
The average excess return from large company common stocks for the period 1926 through 2005 was: 8.5% = 12.3% 3.8% The average excess return from small company common stocks for the period 1926 through 2005 was: 13.6% = 17.4% 3.8% The average excess return from long-term corporate bonds for the period 1926 through 2005 was: 2.4% = 6.2% 3.8%

Distribution

Source: Stocks, Bonds, Bills, and Inflation 2006 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

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Risk Premia
Suppose that the RBI announced that the current rate for one-year Treasury bills is 5%.
Annual Return Average

The Risk-Return Tradeoff

18%

Small-Company Stocks
16% 14% 12% 10% 8% 6%

What is the expected return on the market of small-company stocks? If average excess return on small company common stocks for the period 1926 through 2005 was 13.6%. Given a risk-free rate of 5%, we have an expected return on the market of small-company stocks of 18.6% = 13.6% + 5%

Large-Company Stocks

T-Bonds
4% 2% 0% 5% 10% 15% 20% 25% 30% 35%

T-Bills

Annual Return Standard Deviation

Risk Statistics
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.

Normal Distribution
A large enough sample drawn from a normal distribution looks like a bell-shaped curve.
Probability

The probability that a yearly return will fall within 20.2 percent of the mean of 12.3 percent will be approximately 2/3.

3 2 48.3% 28.1%

1 7.9%

0 12.3% 68.26% 95.44% 99.74%

+1 32.5%

+2 52.7%

+3 72.9%

Return on large company common stocks

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Example Return and Variance

Year 1 2 3 4 Totals Actual Return .15 .09 .06 .12 Average Return .105 .105 .105 .105 Deviation from the Mean .045 -.015 -.045 .015 .00 Squared Deviation .002025 .000225 .002025 .000225 .0045

More on Average Returns

Arithmetic average return earned in an average period over multiple periods Geometric average average compound return per period over multiple periods The geometric average will be less than the arithmetic average unless all the returns are equal. Which is better?
The arithmetic average is overly optimistic for long horizons. The geometric average is overly pessimistic for short horizons.

Variance = .0045 / (4-1) = .0015

Standard Deviation = .03873

Geometric Return: Example

Recall our earlier example:
Year Return Geometricaverage return = 1 2 3 4 10% -5% 20% 15%

Geometric Return: Example

Note that the geometric average is not the same as the arithmetic average:
Year Return r +r +r +r Arithmeticaverage return = 1 2 3 4 1 10% 4 2 -5% 10% 5 % + 20% + 15% 3 20% = = 10 % 4 4 15%

(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 an average of 9.58% per year, realizing a holding period return of 44.21%.
1 .4421= (1. 095844 )4

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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 (to another security or index)

Expected Return, Variance, and Covariance

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.
Rate of Return Probability Stock Fund Bond Fund 33.3% -7% 17% 33.3% 12% 7% 33.3% 28% -3%

Scenario Recession Normal Boom

Expected Return

Covariance
Stock Bond Product -0.0180 0.0000 -0.0170 Weighted -0.0060 0.0000 -0.0057 -0.0117 -0.0117

Stock Fund Rate of Squared

Bond Fund Rate of Squared Return Deviation 17% 0.0100 7% 0.0000 -3% 0.0100 7.00% 0.0067 8.2%

Scenario
Recession Normal Boom Sum Covariance

Scenario
Recession Normal Boom Expected return Variance Standard Deviation

Return Deviation -7% 0.0324 12% 0.0001 28% 0.0289 11.00% 0.0205 14.3%

Deviation Deviation -18% 10% 1% 0% 17% -10%

Deviation compares return in each state to the expected return. Weighted takes the product of the deviations multiplied by the probability of that state.

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Correlation
= = Cov( a, b) a b .0117 = 0.998 (.143)(.082)

The Return and Risk for Portfolios

Scenario
Recession Normal Boom Expected return Variance Standard Deviation Stock Fund Rate of Squared Return Deviation -7% 0.0324 12% 0.0001 28% 0.0289 11.00% 0.0205 14.3% Bond Fund Rate of Squared Return Deviation 17% 0.0100 7% 0.0000 -3% 0.0100 7.00% 0.0067 8.2%

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.

Portfolios
Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio squared deviation -7% 17% 5.0% 0.0016 12% 7% 9.5% 0.0000 28% -3% 12.5% 0.0012 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08%
Scenario Recession Normal Boom Expected return Variance Standard Deviation

Portfolios
Rate of Return Stock fund Bond fund Portfolio squared deviation -7% 17% 5.0% 0.0016 12% 7% 9.5% 0.0000 28% -3% 12.5% 0.0012 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08%

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 + w S rS

The expected rate of return on the portfolio is a weighted average of the expected returns on the securities in the portfolio. E (rP ) = w B E( rB ) + w S E (rS )

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

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

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Portfolios
Scenario Recession Normal Boom Expected return Variance Standard Deviation Rate of Return Stock fund Bond fund Portfolio squared deviation -7% 17% 5.0% 0.0016 12% 7% 9.5% 0.0000 28% -3% 12.5% 0.0012 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08%

Portfolios
Rate of Return Stock fund Bond fund Portfolio squared deviation -7% 17% 5.0% 0.0016 12% 7% 9.5% 0.0000 28% -3% 12.5% 0.0012 11.00% 0.0205 14.31% 7.00% 0.0067 8.16% 9.0% 0.0010 3.08%

Scenario Recession Normal Boom Expected return Variance Standard Deviation

The variance of the rate of return on the two risky assets portfolio is
2 2 s2 P = (wBs B ) + (wS s S ) + 2(w Bs B )(w S s S )? BS

Observe the decrease in risk that diversification offers. An equally weighted portfolio (50% in stocks and 50% in bonds) has less risk than either stocks or bonds held in isolation.

where BS is the correlation coefficient between the returns on the stock and bond funds.

Diversification and Portfolio Risk

Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns. This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another. However, there is a minimum level of risk that cannot be diversified away, and that is the systematic portion.

Portfolio Risk and Number of Stocks

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

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Systematic Risk
Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc.

Unsystematic (Diversifiable) Risk

Risk factors that affect a limited number of assets Also known as unique risk and asset-specific risk Includes such things as labor strikes, part shortages, etc. The risk that can be eliminated by combining assets into a portfolio If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away.

Total Risk
Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk. For well-diversified portfolios, unsystematic risk is very small. Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.

Risk When Holding 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.e., systematic risk).

i =

Cov( Ri , RM ) 2 ( RM )

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The Formula for Beta

Relationship between Risk and Expected Return (CAPM) Expected Return on the Market:

i =

Cov( Ri , RM ) 2 ( RM )

R M = RF + Market Risk Premium

Expected return on an individual security:

Clearly, your estimate of beta will depend upon your choice of a proxy for the market portfolio.

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

Expected Return on a Security

This formula is called the Capital Asset Pricing Model (CAPM):
R i = RF + i ( R M RF )
Expected return on a security = RiskBeta of the + free rate security Market risk premium

Relationship Between Risk & Return

Expected return

R i = RF + i ( R M R F )
RM RF
1.0

Assume i = 0, then the expected return is RF. Assume i = 1, then R i = R M

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Relationship Between Risk & Return

Expected return

13.5%
3%
1.5

i = 1.5

RF = 3%

R M = 10%

R i = 3% +1 .5 (10% 3%) = 13 .5%

10