Estimating Risk and Return on Assets

In this module, we will study the basics of risk and return relationship, probability and probability
distribution in determining the expected rate of return on investment, measuring the variability of
probability of distribution using standard deviation, and analyzing the risk-return relationship in
portfolio of assets.
At the end of the module, you should be able to:
1. Understand the concept of basic risk and return.
2. Apply probability and probability distribution in determining the expected rate of return on an
investment.
3. Measure the variability of a probability distribution using standard deviation.
4. Explain the coefficient of variable as a tool to measure risk.
5. Learn how to analyze the risk-return relationship in a portfolio of assets. 6. Understand how portfolio
risk is affected by change of investment.

Risk and Return Concept

Risk is the changeability of an asset’s future earnings. It can also refer to the possibility that some
disadvantageous event will occur. Whenever future outcomes are not totally certain or predictable,
then, we can say that there is risk. In business, uncertainty of the future profits creates the possibility of
risk. Risk can be a possibility of loss or not achieving what is expected. Risk involves the chance an
investment's actual return will differ from the expected return. Risk includes the possibility of losing
some or all of the original investment. A risky financial asset is an investment with a return that is not
warranted. Financial assets carry diverge levels of risk. For example, an investor in corporate bonds is
generally of a lesser risk than holding a stock. A prospective investor in government bonds yielding 12
percent return is risk free simply because government bonds are not risky. But an investor who puts his
money in a newly organized business is in risk. Further study analysis of the situation should be done
because of the uncertainty of the expected returns.

Risk and Return Relationship

Considering our definition of risk above in relation to financial assets, we can further say that
investment risk is related to the probability of getting fewer returns than expected. The
possibility of negative or low earnings yields riskier investment and vice versa. Investors expects
that the higher the risk, the higher the returns most of the times. Financial Management 2
To lessen risk if not totally eliminating it, an investor can utilize historical information to
describe past returns and risks.

Probability and Probability Distribution

Probability is the possibility that an event will happen. Probabilities range between 0 to 1.0.
Example: The weather forecaster says that there is 70 percent chance that it will rain today. So,
there is 30 percent that it will not rain. If all the possible events or results are enumerated and the
probability is assigned to each event, the listing is called probability distribution.

expected rate of return

Expected Return
The return on an investment as estimated by an asset pricing
model. It is calculated by taking the average of the probability distribution of all possible returns. For exa
mple, a model might state that an investment has a 10% chance of a 100% return and a 90% chance of a 
50% return. The expected return is calculated as:

Expected Return = 0.1(1) + 0.9(0.5) = 0.55 = 55%.

It is important to note that there is no guarantee that the expected rate of return and the actual
return will be the same. See also: Abnormal return.

Expected rate of return

The rate of return expected on an asset or a portfolio. The expected rate of return on a single asset is equ
al to the sum of each possible rate of return multiplied by the respective probability of earning on each ret
urn. For example, if a security has a 20% probability of providing a 10% rate of return, a 50% probability o
f providing a 12% rate of return, and a 25% probability of providing a 14% rate of return, the expected rate 
of return is (.20)(10%) + (.50)(12%) + (.25)(14%), or 12%.

Calculating Expected Return of a Portfolio

Calculating expected return is not limited to calculations for a single

investment. It can also be calculated for a portfolio. The expected return for an
investment portfolio is the weighted average of the expected return of each of
its components. Components are weighted by the percentage of the
portfolio’s total value that each accounts for. Examining the weighted average
of portfolio assets can also help investors assess the diversification of their
investment portfolio.

To illustrate the expected return for an investment portfolio, let’s assume the
portfolio is comprised of investments in three assets – X, Y, and Z. $2,000 is
invested in X, $5,000 invested in Y, and $3,000 is invested in Z. Assume that
the expected returns for X, Y, and Z have been calculated and found to be
15%, 10%, and 20%, respectively. Based on the respective investments in each
component asset, the portfolio’s expected return can be calculated as follows:

Expected Return of Portfolio = 0.2(15%) + 0.5(10%) + 0.3(20%)

= 3% + 5% + 6%

= 14%
Thus, the expected return of the portfolio is 14%.

Note that although the simple average of the expected return of the portfolio’s
components is 15% (the average of 10%, 15%, and 20%), the portfolio’s
expected return of 14% is slightly below that simple average figure. This is due
to the fact that half of the investor’s capital is invested in the asset with the
lowest expected return.

What is Standard Deviation?

From a statistics standpoint, the standard deviation of a dataset is a measure of the magnitude of
deviations between the values of the observations contained in the dataset. From a financial
standpoint, the standard deviation can help investors quantify how risky an investment is and
determine their minimum required return on the investment.

 
 

Calculating Standard Deviation

We can find the standard deviation of a set of data by using the following formula:

Where:

 Ri – the return observed in one period (one observation in the data set)
 Ravg – the arithmetic mean of the returns observed
 n – the number of observations in the dataset

By using the formula above, we are also calculating Variance, which is the square of the standard
deviation. The equation for calculating variance is the same as the one provided above, except
that we don’t take the square root.

Standard Deviation Example

An investor wants to calculate the standard deviation experience by his investment portfolio in
the last four months. Below are some historical return figures:

 
 

The first step is to calculate Ravg, which is the arithmetic mean:

The arithmetic mean of returns is 5.5%.

Next, we can input the numbers into the formula as follows:

 
The standard deviation of returns is 10.34%.

Thus, the investor now knows that the returns of his portfolio fluctuate by approximately 10%
month-over-month. The information can be used to modify the portfolio to better the investor’s
attitude towards risk.

If the investor is risk-loving and is comfortable with investing in higher-risk, higher-return

securities and can tolerate a higher standard deviation, he/she may consider adding in some
small-cap stocks or high-yield bonds. Conversely, an investor that is more risk-averse may not be
comfortable with this standard deviation and would want to add in safer investments such as
large-cap stocks or mutual funds.

Normal Distribution of Returns

The normal distribution theory states that in the long run, the returns of an investment will fall
somewhere on an inverted bell-shaped curve. Normal distributions also indicate how much of the
observed data will fall within a certain range:

 68% of returns will fall within 1 standard deviation of the arithmetic mean
 95% of returns will fall within 2 standard deviations of the arithmetic mean
 99% of returns will fall within 3 standard deviations of the arithmetic mean

The graphic below illustrates this concept:

 
 

Hence, standard deviations are a very useful tool in quantifying how risky an investment is.
Actively monitoring a portfolio’s standard deviations and making adjustments will allow
investors to tailor their investments to their personal risk attitude.