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You are on page 1of 6

Thomas Emilsson, 2010-10-15

Risk and Return

When making investments, there needs to be an estimation of the risks and returns that can

be realized.

Risk is basically described as a measure of the uncertainty of returns in an investment, while

returns are the cash flows from the investment.

Investors are always concerned about the link between risk and return in a potential

investment. The return on your money will always be relative to the risk involved.

In other words, lower risk provides more certainty with lower returns, whereas higher risk

has more volatility with higher returns.

Portfolio and Variability

An investment portfolio is defined as the sum total of a firms or investors assets. This could

include stocks, bonds, futures, options, real estate, etc. Every portfolio carries a certain

amount of risk depending what they are invested in. This is known as portfolio risk.

Statistics are employed to measure portfolio risk. The most important aspect when dealing

with risk is to know how to accurately measure variability. Variability is simply put a

measure of uncertainty.

When calculation variability, probabilities are assigned to each deviation which are

calculated to obtain one single value called variance.

The other statistical tool we use is derived from the variance. The standard deviation is easily

calculated by taking the square root of the variance. The standard deviation is by far the most

widely used method of measuring variability and is defined as a measure of dispersion of

returns from the expected return.

You can estimate the variability of any portfolio of stocks or bonds using the procedure

described in the following example.

Rate of Return, Variance and Standard Deviation

Example 1:

You are offered to play in a game of chance that offers the following odds and payoffs. Each

play of the game costs $100, so the net profit per play is the payoff less $100.

1

Introduction to Risk, Return and Opportunity Cost of Capital

Probabillity

.10

.50

.40

Payoff

500

100

0

Net Profit

400

0

-100

Expected return = (.10 x 400) + (.5 x 0) + (.4 x -100) = 0%

What is the variance of this rate of return?

= (400 - 0) x .10 + (0 - 0) x .5 + (-100 - 0) x .4 = 20,000

What is the standard deviation of this rate of return?

= 20000 = 141

The standard deviation is in the same units as the rate of return, meaning that the games

standard deviation is 141%. This is a very high standard deviation and therefore not a game

you should take part in.

Example 2:

This time you are offered to play the following game.

You start by investing $100 Two coins are flipped. If both coins turn up heads, you get $140.

If both coins turn up tails, you get $80 back. If the coins each show something different, you

get $110 back.

(1)

(2)

(3)

Squared Deviation

+ 40

+ 10

+ 30

0

900

0

+ 10

- 20

0

- 30

0

900

Standard deviation = square of root varia nce =

450 = 21.2%

Expected return = (.25 x 40) + (.25 x -20) + (.5 x 10) = 10%

What is the variance of this rate of return?

= (40 - 10) x .25 + (10 - 10) x .5 + (-20 - 10) x .25 = 450

What is the standard deviation of this rate of return?

= 450 = 21

2

Introduction to Risk, Return and Opportunity Cost of Capital

This games expected return is 10%, the variance of the percentage return is 450 and the

standard deviation is the square root of 450, or 21. This is the same unit as the rate of return,

so the games variability is 21%.

Summary

These two examples is a simple way of showing how to calculate variance and standard

deviation. In principle, you could estimate the variability of any portfolio of stocks or bonds

by the procedure above.

The risk of an asset can be completely expressed by all possible outcomes and the

probability of each. In practice, this is a little harder to do, therefore variance and standard

deviation is utilized for this purpose. We must for that reason observe the past when

predicting the future. It is reasonable to assume that portfolios with a history of high

variability have the least predictable future performance.

3

Introduction to Risk, Return and Opportunity Cost of Capital

Portfolio Risk

Thomas Emilsson, 2010-10-15

Case: Calculations

Diversification and Portfolio Risk

Diversification reduces risk in a portfolio of stock. To fully understand the effect of

diversification, we need to know the risk of the portfolios individual shares.

We will here use an example of a portfolio consisting of stocks from the U.S stock market.

In the portfolio we will have two stocks, 60% is invested in Wal-Mart and the remainder is

invested in Boeing. Over the coming year we expect that Wal-Mart will give a return of 10%

and Boeing, 14%.

The expected return of this portfolio is simply a weighted average of the expected returns on

the individual stocks:

Question 1: What is the expected return of this portfolio?

When you have calculated the expected return of your portfolio it is then time to calculate

the risk of this portfolio.

In the past the standard deviation of return was 19.8% for Wal-Mart and 29.8% for Boeing.

In this case we assume a correlation coefficient of 1.0. We believe that these figures are a

good representation of possible future outcomes.

Question 2: What is the variance of this portfolio?

Question 3: What is the standard deviation of this portfolio?

Wal- Mart

Wal- Mart

Boeing

x1212

x1x 212

x1x 2121 2

Boeing

x1x 212

x1x 21212

x 2222

In the next exercise we assume that Boeing and Wal-Mart do not move in perfect lockstep.

In this case we will use the correlation coefficient of .35.

Question 4: What is the variance of this portfolio with a correlation coefficient of .35?

Question 5: What is the standard deviation of this portfolio?

4

Introduction to Risk, Return and Opportunity Cost of Capital

Wal- Mart

Wal- Mart

Boeing

x1212

x1x 212

x1x 21212

Boeing

x1x 212

x1x 21212

x 2222

Question 6: In which of the following situations would you get the largest reduction in risk

by spreading the above investment across these two stocks?

a.

b.

c.

d.

There is no correlation.

There is modest negative correlation.

There is perfect negative correlation.

Risk

Answers

1. What is the expected return of this portfolio?

Expected portfolio return = (.60 x 10) + (.40 x 14) = 11.6%

2. What is the variance of the portfolio with a correlation coefficient of 1.0?

Wal - Mart

Wal - Mart

Boeing

x 12 12 (.60) 2 (19.8) 2

x 1 x 2 12 1 2 .40 .60

1 19.8 29.8

Boeing

x 1 x 2 12 1 2 .40 .60

119.8 29.8

x 22 22 (.40) 2 (29.8) 2

+ 2(.6 x .4 x 1 x 19,8 x 29.8) = 566.4

5

Introduction to Risk, Return and Opportunity Cost of Capital

The standard deviation is the square root of the portfolio variance.

= 566.4 = 23.8%

4. What is the variance of the portfolio with a correlation coefficient of .35?

Wal - Mart

Wal - Mart

IBM

x 12 12 (.60) 2 (19.8) 2

x 1x 212 1 2 .40 .60

1 19.8 29.8

IBM

x 1 x 212 1 2 .40 .60

.35 19.8 29.8

x 22 22 (.40) 2 (29.8) 2

+ 2(.6 x .4 x .35 x 19.8 x 29.8) = 382.3

5. What is the standard deviation of this portfolio?

The standard deviation is the square root of the portfolio variance.

= 382.3 = 19.6%

6. In which of the following situations would you get the largest reduction in risk by

spreading the above investment across these two stocks?

Answer: d

When two stocks are perfectly negatively correlated, there is always a portfolio strategy

that will completely eliminate risk. This is something that in common stocks really never

occur.

6

Introduction to Risk, Return and Opportunity Cost of Capital

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