Risk and Return

Lessons from Market History

 Chapter Outline
9.1 Returns
9.2 Holding-Period Returns
9.3 Return Statistics
9.4 Average Stock Returns and Risk-Free
Returns
9.5 Risk Statistics
9.6 More on Average Returns
 9.1 Returns
• Dollar Returns
the sum of the cash received Dividends
and the change in value of the
asset, in dollars. Ending
market value

Time 0 1
Percentage Returns
–the sum of the cash received and the
Initial change in value of the asset divided by
investment the initial investment.
 Returns
Dollar Return = Dividend + Change in Market Value
dollar return
percentage return 
beginning market val ue

dividend  change in market val ue


beginning market val ue

 dividend yield  capital gains yield

 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).
• Your percentage gain for the year is:
$520
20.8% =
$2,500
 Returns: Example
Dollar Return:
$520 gain $20

$3,000

Time 0 1
Percentage Return:

$520
-$2,500 20.8% =
$2,500
 9.2 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 )    (1  rn )  1
 Holding Period Return: Example
• Suppose your investment provides the following
returns over a four-year period:

Year Return Your holding period return 

1 10%
 (1  r1 )  (1  r2 )  (1  r3 )  (1  r4 )  1
2 -5%
3 20%  (1.10)  (.95)  (1.20)  (1.15)  1
4 15%  .4421  44.21%
 Holding Period Returns
• A famous set of studies dealing with 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
 9.3 Return Statistics
• The history of capital market returns can be
summarized by describing the:
– average return
( R1    RT )
R
T
– the standard deviation of those returns
( R1  R ) 2  ( R2  R ) 2   ( RT  R ) 2
SD  VAR 
T 1
– the frequency distribution of the returns
 Historical Returns, 1926-2004
Average Standard
Series Annual Return Deviation Distribution

Large Company Stocks 12.3% 20.2%

Small Company Stocks 17.4 32.9

Long-Term Corporate Bonds 6.2 8.5

Long-Term Government Bonds 5.8 9.2

U.S. Treasury Bills 3.8 3.1

Inflation 3.1 4.3

– 90% 0% + 90%

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.
9.4 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%
 Risk Premia
• Suppose that The Wall Street Journal announced that
the current rate for one-year Treasury bills is 5%.
• What is the expected return on the market of small-
company stocks?
• Recall that the 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%
 The Risk-Return Tradeoff
18%
Small-Company Stocks
16%
Annual Return Average

14%

12% Large-Company Stocks

10%

8%

6%
T-Bonds
4%
T-Bills
2%
0% 5% 10% 15% 20% 25% 30% 35%
Annual Return Standard Deviation
 9.5 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.

– 3s – 2s – 1s 0 + 1s + 2s + 3s
– 48.3% – 28.1% – 7.9% 12.3% 32.5% 52.7% 72.9% Return on
large company common
68.26% stocks
95.44%

99.74%
 Normal Distribution
• The 20.2% standard deviation we found
for large stock returns from 1926 through
2005 can now be interpreted in the
following way: if stock returns are
approximately normally distributed, the
probability that a yearly return will fall
within 20.2 percent of the mean of 12.3%
will be approximately 2/3.
 Example – Return and Variance

Year Actual Average Deviation from Squared

Return Return the Mean Deviation
1 .15 .105 .045 .002025

2 .09 .105 -.015 .000225

3 .06 .105 -.045 .002025

4 .12 .105 .015 .000225

Totals .00 .0045

Variance = .0045 / (4-1) = .0015 Standard Deviation = .03873

Realized Return

That which you have already earned

So it’s fixed.

Expected Return

That which you expect to earn

So it’s probabilistic

So if p1 , p2 ,........, pn
are the probabilities associated with returns R1 , R2 ,......, Rn
n
Then expected returns  pR
i 1
i i
 EXAMPLE
For the following, compute the expected return

Probability Return
0.2 10%
0.3 12%
0.1 15%
0.4 20%

Expected return=0.2*10%+0.3*12%+0.1*15%+0.4*20% = 15.1%

 RISK
Variability in return

Measured by the standard deviation of returns

n
s 2  p * ( R  R)
i 1
i i
2

Where p1 , p2 ,........, pn
are the probabilities associated with returns R1 , R2 ,......, Rn
n

R Is the expected return given by R pR

i 1
i i
For the following, compute the expected return and risk as measured
by standard deviation

Probability Return
0.2 10%
0.3 12%
0.1 15%
0.4 20%

Expected return=15.1%

Risk= 4.21%
 10.1 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)
10.2 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
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
 Expected Return

Stock Fund Bond Fund

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

E ( rS )  1  (  7 %)  1  (12 %)  1  ( 28 %)
3 3 3
E ( rS )  11 %
 Variance

Stock Fund Bond Fund

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

(  7 %  11 % )  . 0324
2
 Variance

Stock Fund Bond Fund

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

1
.0205  (. 0324  .0001  .0289 )
3
 Standard Deviation
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

14 . 3 %  0 . 0205
 Covariance

Stock Bond
Scenario Deviation Deviation Product Weighted
Recession -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
Covariance -0.0117

Deviation compares return in each state to the expected return.

Weighted takes the product of the deviations multiplied by the
probability of that state.
 Correlation

Cov(a, b)

s as b
 .0117
  0.998
(.143)(.082)
10.3 The Return and Risk for Portfolios
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 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
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 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  w B rB  w S rS

5 %  5 0 %  (  7 % )  5 0 %  (1 7 % )
 Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

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 )

9 %  5 0 %  (1 1 % )  5 0 %  ( 7 % )
 Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The variance of the rate of return on the two risky assets

portfolio is
σ P2  (w B σ B ) 2  (w S σ S ) 2  2 (w B σ B )(w S σ S )ρ B S
where BS is the correlation coefficient between the returns
on the stock and bond funds.
 Portfolios

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012

Expected return 11.00% 7.00% 9.0%

Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

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.
 10.4 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return Combinations

Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4% 12.0%
100%
15% 4.8% 7.6% 11.0%
stocks
20% 3.7% 7.8% 10.0%
25% 2.6% 8.0% 9.0% 100%
30% 1.4% 8.2% 8.0% bonds
35% 0.4% 8.4%
7.0%
40% 0.9% 8.6%
6.0%
45% 2.0% 8.8%
5.0%
50.00% 3.08% 9.00%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
60% 5.3% 9.4% Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8%
75% 8.7% 10.0% We can consider other
80% 9.8% 10.2%
85% 10.9% 10.4%
portfolio weights besides
90% 12.1% 10.6% 50% in stocks and 50% in
95% 13.2% 10.8%
100% 14.3% 11.0% bonds …
 The Efficient Set for Two Assets
% in stocks Risk Return
0% 8.2% 7.0% Portfolo Risk and Return Combinations

Portfolio Return
5% 7.0% 7.2%
10% 5.9% 7.4% 12.0%
15% 4.8% 7.6% 11.0%
20% 3.7% 7.8% 10.0% 100%
25% 2.6% 8.0% 9.0% stocks
30% 1.4% 8.2% 8.0%
35% 0.4% 8.4% 7.0% 100%
40% 0.9% 8.6% 6.0%
45% 2.0% 8.8%
bonds
5.0%
50% 3.1% 9.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%
55% 4.2% 9.2%
60% 5.3% 9.4% Portfolio Risk (standard deviation)
65% 6.4% 9.6%
70% 7.6% 9.8% Note that some portfolios are
75%
80%
8.7%
9.8%
10.0%
10.2%
“better” than others. They have
85% 10.9% 10.4% higher returns for the same level of
90% 12.1% 10.6%
95% 13.2% 10.8%
risk or less.
100% 14.3% 11.0%
Portfolios with Various Correlations
return

100%
 = -1.0 stocks

 = 1.0
100%
 = 0.2
bonds

s
• 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
 10.5 The Efficient Set for Many Securities

return

Individual Assets

sP

Consider a world with many risky assets; we can

still identify the opportunity set of risk-return
combinations of various portfolios.
 The Efficient Set for Many Securities

return
minimum
variance
portfolio

Individual Assets

sP
The section of the opportunity set above the
minimum variance portfolio is the efficient
frontier.
 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

s 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
 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.
 Optimal Portfolio with a Risk-Free
Asset
return 100%
stocks

rf
100%
bonds

s
In addition to stocks and bonds, consider a world
that also has risk-free securities like
T-bills.
10.7 Riskless Borrowing and Lending

return
100%
stocks
Balanced
fund

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

return

rf

sP

With a risk-free asset available and the efficient

frontier identified, we choose the capital
allocation line with the steepest slope.
 10.8 Market Equilibrium

return
M

rf

sP
With the capital allocation line identified, all investors choose a
point along the line—some combination of the risk-free asset
and the market portfolio M. In a world with homogeneous
expectations, M is the same for all investors.
 Market Equilibrium

return
100%
stocks
Balanced
fund

rf
100%
bonds

Where the investor chooses along the Capital Market

Line depends on his risk tolerance. The big point is that
all investors have the same CML.
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 (b)of the security.
• Beta measures the responsiveness of a
security to movements in the market portfolio
(i.e., systematic risk).

Cov ( Ri , RM )
bi 
s ( RM )
2
Estimating b with Regression

Security Returns

Slope = bi
Return on
market %

Ri = a i + biRm + ei
 The Formula for Beta

Cov ( Ri , RM )
bi 
s ( RM )
2

Clearly, your estimate of beta will

depend upon your choice of a proxy
for the market portfolio.
 10.9 Relationship between Risk and
Expected Return (CAPM)
• Expected Return on the Market:

R M  R F  M arket Risk P remium

• Expected return on an individual security:

R i  RF  βi (R M  RF )

Market Risk Premium

This applies to individual securities held within well-
diversified portfolios.
 Expected Return on a Security
• This formula is called the Capital Asset
Pricing Model (CAPM):

R i  RF  βi (R M  RF )
Expected
Risk- Beta of the Market risk
return on = + ×
free rate security premium
a security

• Assume bi = 0, then the expected return is RF.

• Assume bi = 1, then R i  R M
Relationship Between Risk & Return
Expected return

R i  RF  βi (R M  RF )

RM

RF

1.0 b
Relationship Between Risk & Return

13 . 5 %
Expected
return

3%

1.5 b

β i  1 .5 RF  3% R M  10 %
R i  3 %  1 . 5  (10 %  3 % )  13 . 5 %
You own a stock portfolio invested 25% in stock Q, 20% in
stock R, 15% in stock S and 40% in stock T. The betas for
these four stocks are 0.6, 1.70, 1.15 and 1.34 respectively.
What is the portfolio beta?
You own a portfolio equally invested in a risk-free asset and
two stocks. If one of the stock has a beta of 1.9 and the total
portfolio is equally as risky as the market, what must the beta
be for the other stock in your portfolio?