RISK AND RETURN

Risk versus return: the common

understanding
Investment decisions
Done with diverse motives
Firms: expansion, desire for control
Individuals: cater for rainy day,
speculation..

But common thread is expectation of a
return
- sometimes quantifiable, sometimes not.
But Returns is not the only criteria
If it were, we would find people investing
in a single asset that yields the maximum
profit
This never happens. Or happens only out
of ignorance.
The concept of returns and risk is critical
from the viewpoint of firms making capital
budgeting decisions.
Evaluate returns and the risks associated
Return
Example: share of RIL at Rs 1000
Investment made for a year
What is the return on the investment?
Typically two parts:
Returns while holding: Dividend Yield
Returns on selling: Capital Gains
So if RIL declares a dividend of Rs 10 and
after one year price is Rs 1100 ( assuming
dividend is also at end of year, so that TVM
does not come into picture)
Funds received on sale: Rs 10 + Rs 1100
And absolute return:
Amount realised amount invested
= Rs 1110 1000 = 110 or 11%
Measuring Expected Return
In the RIL example, we have assumed price
after one year as known.
In actuality only the current price is known
So investor acts on expectations of some
return

Many methods:
Valuation models
Standard models eg CAPM
Historical returns offered in the past
Arithmetic Mean

= R
n

So if you buy shares of 6 companies and get
returns of 21%, 24%, -25%, 18%, 120% and 16%
respectively, then your average return in one year
is the arithmetic mean
= 29%

1
n
But there is a problem
Suppose you bought two shares in 2008 for
Rs 100 each. Your investment = Rs 200
Next year it increases by 100% to Rs 200.
Your investment is worth = Rs 400
The next year, in 2010 it falls by 50% to Rs
100. Your investment is worth = Rs 200
Assuming no dividend, average return is:
( 100% - 50%) /2 = 25% per annum


But in actuality, your return is zero, because the
price is Rs 100 once again

So where is the catch?
In arithmetic mean, we did not consider the
compounding effect.
The arithmetic mean result of 25% is valid
if the value of investment is kept constant
So, if at the end of the first year, you sell
one share, so that your investment remains
at Rs 200
Then in the third year you will get Rs 100
by selling the share held
So income is:
Cash realised in 2009 = Rs 200
Cash realised in 2010 = Rs 100
Less investment = - Rs 200
Return = Rs 100
So Rate of return in 2 yrs = 100/200 = 50%
Average rate of return = 25%
Geometric Mean
The Geometric Mean reflects the holding
period return and takes compounding into
account
If we take R
g
as the annual rate of return,
then for two years ( with returns of 100%
and - 50% ) we can write:
(1+ R
g
)
2
= (1+1) x (1 0.5) = 1
So R
g
= 0
Or more generally
(1+ R
g
)
n
= (1+ R
1
) (1+ R
2
) (1+ R
3
) ..
(1+ R
n
)
Or
R
g
= (1+ R
1
) (1+ R
2
) (1+ R
3
) .. (1+ R
n
) - 1

n
________________________________
Arithmetic Mean vs Geometric
Mean
R
g
= R
a
- 1/2
2

Where R
g
is geometric mean
R
a
is arithmetic mean
is standard deviation of returns
Valid only when returns follow a normal
distribution
Note that the geometric mean is always
smaller than the arithmetic mean , and the
difference depends on the variability of
returns
Which one to use?
If objective is to evaluate past performance
of return on the financial asset, geometric
mean is appropriate
However, if we have future in mind, and
need to evaluate whether to invest or not,
then judgment must be based on arithmetic
average
RISK
How do we define Risk?

Risk refers to the chances that the actual
outcome will be different from the expected
outcome
Some of the expressions of risk may be:
The maximum loss that I can incur is 20%
The chances that I will not make a profit are
50%
It is a risky investment because the chances that
the price will exceed the current level are only
20%

These are all expressions of risk but fail to
quantify it
So we need a measure of risk where the
element of subjectivity is eliminated
Assessing risks and incorporating the
assessment in the final decision is an
integral part of financial analysis


Objective in decision making is not to
eliminate risk; in fact it might not be
necessary to do so

It is important to properly assess risk and to
determine whether it is worth taking the risk
Once the risk involved in future cash flows
is properly measured, an appropriate risk-
adjusted discount rate would need to be
applied to convert future cash flows into
their present values
Share / security prices key determinants
are
Expected risk
Expected return
Risk and return may be defined for a single
asset or for a portfolio of assets
We first look at risk and return for a single
asset
Risk is the variability of the actual
return from the expected returns associated
with a given asset / investment
The greater the variability, the riskier the
security (eg shares). The more certain the
return from an asset, the less the variability,
and therefore, the less the risk (eg FD).
Rate of return
Rate of return on an asset for a given period
(usually a year) is defined as:

RoR = (Income from asset +(End price
Beginning price)) / Beginning price
Sensitivity analysis
Sensitivity analysis is a behavioural
approach to assess risk using a number of
possible return estimates to obtain a sense
of the variability among the outcomes
One approach is to estimate the worst, the
most likely and the best return associated
with the asset

Asset A Asset B
Initial outlay 50 50
Annual return
(%)
Pessimistic 14 8
Most likely 16 16
Optimistic 18 24
Range 4 16
Probability distribution
Take the example of stocks again
Returns could take many possible values,
both positive as well as negative
Also, the likelihood of these possible
returns can vary depending on many factors
You may for example, study a stock and
assess its probability distribution as:

Outcome Probability
Stock price will rise 0.80
Stock price will not
rise
0.20
Or we may have a probability distribution taking
into account the state of the economy

State of
economy
Probability
of
occurrence
Rate of
return:
Company A
Rate of
return:
Company B

Boom 0.30 25 % 50%
Normal 0.50 20% 20%
Recession 0.20 15% - 10%
Expected Rate of Return
Is the weighted average of all possible
returns multiplied by their probabilities

ie E (R) = p
i
R
i

Where E (R) is the expected return
R
i
is the return for the i
th
possible outcome
p
i
is the probability associated with R
i
n is the number of possible outcomes
n
i=1
So what is the expected rate of return for
company A, and company B ?

State of
economy
Probability
of
occurrence
Rate of
return:
Company A
Rate of
return:
Company B

Boom 0.30 25 % 50%
Normal 0.50 20% 20%
Recession 0.20 15% - 10%
expected rate of return for company A is:
E (R) = (0.30)(25%) + (0.50)(20%) +
(0.20)(15%)
= 20.5%
And for company B is:
E (R) = (0.30)(50%) + (0.50)(20%) +
(0.20)(-10%)
= 23.0%

Measures of Risk
Range:
Max value or return min value or return

Eg Share A (Rs 100) : Hi 200 Lo 50
Share B (Rs 100) : Hi 300 Lo 25

Which is riskier?
But this ignores probability of the extreme
events

To have a clear view of risk, we must
consider not only the range of values but
also the probabilities of the different values

So Range is not an appropriate measure of
risk
Average Deviation:

Probability p Return % R p x R Deviation
R E(R)
p x {(R E(R)}
0.2 15 3 - 11 -2.2
0.3 20 6 -6 -1.8
0.3 30 9 4 +1.2
0.2 40 8 14 +2.8
Expected Return 26
Sum of
deviations
(Measure of
Risk)
0
So, even with deviations we find risk is zero
Because +ve and ve deviations cancel out

So this too, is not a dependable measure of
risk
To overcome the deficiency of +ve and ve
deviations cancelling each other, we could
square them up before multiplying them
with the probabilities

This is Variance
Variance and Standard Deviation
of return
Risk is commonly measured by the
variance, or the standard deviation
The Variance of a probability distribution is
the sum of the squares of the deviations of
actual returns from the expected return,
weighted by the associated probabilities
So
2
= p
i
(R
i
E(R))
2


where
2
is the variance
R
i
is the return for the i
th
outcome
p
i
is the probability associated with R
i

E(R) is the expected return


And Standard deviation is:

= square root of variance
Exercise
Calculate SD of returns of the stocks of
company A and of company B
Company A
State of
econo
my
p
i
R
i
p
i
R
i
R
i
-
E(R)
(R
i
-
E(R))
2

p
i
(R
i
-
E(R))
2

Boom 0.30 25 7.5 4.5 20.25 6.075
Normal 0.50 20 10 - 0.5 0.25 0.125
Recessi
on
0.20 15 3 - 5.5 30.25 6.050
p
i
R
i
=
20.5
p
i
(R
i
-
E(R))
2
=
12.25

2
=
12.25
=
3.5%
DIY : Company B
State of
econo
my
p
i
R
i
Boom 0.30 50
Normal 0.50 20
Recessi
on
0.20 -10
=
Company B
State of
econo
my
p
i
R
i
p
i
R
i
R
i
-
E(R)
(R
i
-
E(R))
2

p
i
(R
i
-
E(R))
2

Boom 0.30 50 15 27 729 218.7
Normal 0.50 20 10 - 3 9 4.5
Recessi
on
0.20 -10 -2 - 33 1089 217.8
p
i
R
i
=
23
p
i
(R
i
-
E(R))
2
=
441

2
= 441 = 21%
Risk and Return of a Portfolio
Most investors invest in a portfolio of assets
So, of importance is the risk and return of
the portfolio as a whole, and not so much of
the component stocks in isolation
Expected return on a portfolio
Expected return on a portfolio is simply the
weighted average of the expected returns on the
assets comprising the portfolio
So, for a portfolio of two stocks, expected return
is:
E(R
p
) = w
1
E(R
1
) + (1-w
1
) E(R
2
)

Where w
1
is the proportion of investment in security 1

(1-w
1
)

is the proportion of investment in security 2
E(R
1
) and E(R
2
) are the expected returns in securities 1 and 2
Example
Consider a portfolio of 5 securities with
expected returns of 10%, 12%, 15%, 18%
and 20%. The portfolio proportions invested
in the securities are 10%, 20%, 30%, 20%,
and 20% respectively

What is the expected portfolio return ?
E(R
p
) = w
1
E(R
1
) + w
2
E(R
2
) + w
3
E(R
3
) +
w
4
E(R
4
) + w
5
E(R
5
)
= 0.1x10 + 0.2x12 + 0.3x15 +0.2x18
+ 0.2x20
= 15.5%

Diversification and Portfolio Risk
Before looking at portfolio risk, let us see
how diversification influences risk.
Let us look at a scenario where we can have
five states of the economy, which can
influence two stocks which we are studying
We assume equal probability for each state
Probability distribution of returns
State of the
economy
Probability Return on
stock A
Return on
stock B
Return on
portfolio
1 0.20 15% - 5% 5%
2 0.20

- 5% 15% 5%
3 0.20

5% 25% 15%
4 0.20

35% 5% 20%
5 0.20

25% 35% 30%
Graphically
-10
-5
0
5
10
15
20
25
30
35
40
1 2 3 4 5
State of economy
R
e
t
u
r
n

Return on
stock A
Return onstock
B
Return on
portfolio
Expected return
Stock A: 0.2(15%) + 0.2(-5%) + 0.2(5%) +
0.2(35%) + 0.2(25%) = 15%
Stock B: 0.2(-5%) + 0.2(15%) + 0.2(25%) +
0.2(5%) + 0.2(35%) = 15%

Portfolio: 0.2(5%) + 0.2(5%) + 0.2(15%) +
0.2(20%) + 0.2(30%) = 15%

Standard Deviation
Stock A:
2
A
= 0.2(15-15)
2
+ 0.2(-5-15)
2
+
0.2(5-15)
2
+ 0.2(35-15)
2
+ 0.2(25-15)
2

= 200 and
A
= 14.14%
Stock B:
2
B
= 0.2(-5-15)
2
+ 0.2(15-15)
2
+
0.2(25-15)
2
+ 0.2(5-15)
2
+ 0.2(35-15)
2

= 200 and
B
= 14.14%



Portfolio:
2
(A+B)
= 0.2(5-15)
2
+ 0.2(5-15)
2
+
0.2(15-15)
2
+ 0.2(20-15)
2
+ 0.2(30-15)
2

= 90 and
(A+B)
= 9.49%

So what we see is that when we invest only in
stock A, the expected return is 15% and SD is
14.14%
Similarly if we invest only in stock B, the
expected return is 15% and SD is 14.14%
But, if we invest in a portfolio consisting of stocks
A and B in equal proportion, while the expected
return stays at 15%, the SD reduces to 9.49%

So we see that in this case, diversification reduces
risk

It is important to note that risk will reduce only if
the two stocks do not move in tandem.
Or, we could say that diversification reduces risk
if returns are not perfectly positively correlated
The relationship between diversification and risk is
somewhat like this:
1 3 5 7 9 11 13 15 17 19
No. of securities
R
i
s
k
When the portfolio has just one security, the
risk of the portfolio,
p
is equal to the risk of
the single stock included in it,
1
As a second security is added, the portfolio
risk decreases
As more and more securities are added, the
portfolio risk decreases, but at a decreasing rate,
and reaches a limit
Empirical results suggest that the bulk of the
benefits of diversification, in the form of risk
reduction, is achieved by forming a portfolio of
about ten securities. Thereafter, the gain from
diversification tends to be negligible
If we have a look again at the relationship between
diversification and risk, we see that risk does not
fall below a certain level :
1 3 5 7 9 11 13 15 17 19
No. of securities
R
i
s
k
Modern portfolio theory brings out that

Total risk = Unique risk + Market risk
Unique Risk
The Unique Risk of a security represents
that portion of its total risk which stems
from firm-specific factors such as the
development of a new product, labour
problems, or emergence of new competitors
Primarily affect only that firm and not all
firms in general

So Unique risk can be washed away by
combining it with other stocks
In a portfolio, unique risks of different
stocks tend to cancel each other
Hence Unique Risk is also referred to as
Diversifiable Risk or Unsystematic Risk
Market Risk
Market Risk of a stock refers to that portion
of its risk which is attributable to economy-
wide factors, such as growth rate of GNP,
level of government spending, interest rate
structure, inflation rate etc.
These factors tend to affect all firms ( in
varying degrees ofcourse)
This risk is unavoidable, however much the
portfolio is diversified

Hence this risk is also referred to as
Non-diversifiable Risk or Systematic Risk


Portfolio Risk: the 2 security case
Unlike Portfolio expected return, portfolio
variance (or SD) is NOT the weighted
average of variance (or SD) of returns on
individual securities in the portfolio.
The overall risk of the portfolio includes the
interactive risk of an asset relative to the
other, measures by the covariance of returns
The covariance, in turn, depends on the
CORRELATION between returns on assets
in the portfolio
Portfolio Risk: the 2 security case
The Variance and SD of the return of a two-
security portfolio are:


p
2
= w
1
2

1
2
+ w
2
2

2
2
+ 2 w
1

w
2

12

p
= [w
1
2

1
2
+ w
2
2

2
2
+ 2 w
1

w
2

12

2
]
1/2


Where w
1
,w
2
are proportions of portfolio in securities 1 and 2

12
is

the coefficient of correlation between the

returns on
securities 1 and 2
The risk of a portfolio is a function of:

1. The proportions invested in the component
securities
2. The risk of the component securities
3. The correlation of returns on the component
securities

p
2
can be obtained as the sum of the elements in
the following 2x2 matrix:


w
1
2

1
2
w
1

w
2

12

2
w
2

w
1

21

2
w
2
2

2
2
The covariance
12
is equal to the
correlation coefficient,
12
, multiplied by
the two standard deviations,
1
and
2

Example
A portfolio consists of two securities 1 and
2. We know that: w
1
= 0.6, w
2
= 0.4,
1
=
0.10,
2
=0.16, and
12
=0.5. What is the
standard deviation of the portfolio return?

p
= [0.6
2
x 0.10
2
+ 0.4
2
x 0.16
2
+ 2 x 0.6 x
0.4 x 0.5 x 0.10 x 0.16]
1/2

= 10.7%
Portfolio Risk: the n security case

p
2
of an n-securities portfolio is obtained
as the sum of elements in a n x n matrix.

In such a matrix, there are n variance terms
(the diagonal terms) and n(n-1) covariance
terms (the non-diagonal terms)

If n=2, there are 2 variance terms and 2 covariance
terms
However as n increases, the number of covariance
terms is much larger than the number of variance
terms. Eg if n=10, there are 10 variance terms, but
90 (n(n-1)) covariance terms
Hence the variance of a well-diversified portfolio
is largely determined by the covariance terms

So if covariance terms are likely to be
positive or negative with the same
probability, it may be possible to get rid of
risk almost fully by resorting to
diversification.
Unfortunately, securities move together and
not independently. Ie., most covariance
terms are positive

Hence, irrespective of how widely diversified a
portfolio is, its risk does not fall below a certain
level
- the market risk

1 3 5 7 9 11 13 15 17 19
No. of securities
R
i
s
k
Unique risk
Market risk
Market Risk
The market risk of a security reflects its
sensitivity to market movements

Behaviour of Returns over Time
The return on the risky security (R
r
) is more
volatile than the return on the market
portfolio (R
M
) , whereas the return on the
conservative security, (R
c
) , is less volatile
than the return on the market portfolio (R
M
)

The sensitivity of a security to market
movements is called the beta (). Beta
reflects the slope of the linear regression
relationship between the return on the
security and the return on the market
portfolio
Relationship between Security Return and Market Return
Beta represents the most widely accepted
measure of the extent to which the return on
a security fluctuates with the return on the
market portfolio.
By definition, beta for the market portfolio
is 1
Security with beta = 1.5 : greater
fluctuation than market portfolio
Eg. If market portfolio increases by 10%,
the return on the security is expected to
increase by 15% (1.5 x 10%)
Individual security betas generally range
from 0.50 to 1.80
Very rarely negative
Relationship between Risk and
Return
Since beta is the measure of a securitys
risk, what is the relationship between beta
and the expected return from the security?

CAPM
Capital Asset Pricing Model

Introduced independently by Jack Treynor,
William Sharpe, John Lentner and Jan
Mossin between 1961 1965
They all built on the work of Harry
Markowitz

CAPM states that:

Expected Rate of Return = Risk Free Rate
of Return + Risk Premium

We could take Risk Free Rate of Return as
the rate of return earned on a risk-free
investment eg a bank deposit
So what is the Risk Premium as stated in the
CAPM ?

= Beta of the security x [ Expected return
on market portfolio - Risk-free rate of
return]

Eg if of Suzlon Energy is 1.2, the
expected rate of return on the Sensex is
15%, and the risk free rate of interest is 8%,
what is the expected rate of return on the
security ?


The risk premium on the security is:

1.2 ( 15 8 ) = 8.4 %

And so the expected rate of return on Suzlon
Energy will be:
8% + 8.4% = 16.4%

Security Market Line
The graphic relationship between beta and
the expected rate of return

Relationship between Beta and
Expected Rate of Return
0
2
4
6
8
10
12
14
16
18
20
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6
Beta
R
a
t
e

o
f

R
e
t
u
r
n
Risk premium for defensive security
R
f

Risk premium for
neutral security
Risk premium
for aggressive
security
This graphical relationship between Beta
and the expected rate of return is called the
Security Market Line