Risk and Return – the two sides of

an investment coin…
Unit II

By :
Paayal D. Nanchahal
Return and Risk – The Basis
of Investment Decisions…
 Return is the primary motivating force that drives investment
 It represents the reward for undertaking investment.
 In return, historical return is often used as an important input in
estimating future returns
Return

Current Return Capital Return

Return from the periodic It is the price appreciation (or

cash flow, such as depreciation) divided by the
dividend,interest etc beginning price of the asset

Total return = Current return + Capital return

Measuring Returns..
 Total Returns
TR = (cash payments received + Price changes over the period )/
Price at which the asset is purchased
 It is reflected as a percentage of original
investment

 Although TR are useful but investment analysis

needs statistical tools to describe a series of
returns. They are known as Arithmetic
mean(AM) and Geometric mean (GM)
 Arithmetic Mean (AM) is the sum of each of the
values being considered divided by the total
number of values n.

X mean = ∑Xi / n
 where Xi is the Total return in one time period
Over ‘n’ time periods
 Geometric Mean (GM) returns measure the
compound rate of growth over time.
X mean = [ (1 + X1) (1 + X2) (1 + X3)…..(1+Xn) ]1/n
 The GM will always be less than the AM unless
the values being considered are identical.
 Total
Year Sensex Returns  AM = sum of TR/ 10
2000 5,209.54 = 211.98/ 10
2001 3,990.65 -23.40% = 21/19%
2002 3,262.01 -18.26%  GM = (1-0.23)(1-0.1826)
2003 3,383.85 3.74% (1+.037)(1+.735)…….
2004 5,872.48 73.54% (1+.797)^1/10
2005 6,626.49 12.84%
= 1.13
2006 9,422.49 42.19%
= 13% return
2007 13,827.77 46.75%
2008 20,325.27 46.99%
2009 9,720.55 -52.18%
2010 17,473.45 79.76%
 Risk
 Risk is the uncertainty that an investment will
earn its expected rate of return.
Risk

Systematic
Unsystematic Risk
Risk

Risk that is directly associated Risk unique to a particular security

with overall moment in the and is associated with such factors
general market or economy as business, and financial risk, as
well as liquidity risk
 Systematic Risk
 Market Risk
 The variability in returns resulting from fluctuations in overall market is
referred to as market risk.
 Includes a range of factors like recession, wars, structural changes in the
economy, and changes in consumer preference.
 Interest Rate Risk
 The variability in a security return resulting from changes in the level of
interest rates is referred to as interest rate risk
 Security price move inversely to interest rate

 Purchasing Power Risk

 Inflation is the reason for loss of PP
 The change in the inflation rate also changes the consumption pattern
and hence investment return carries an additional risk.
 This risk is related to interest rate risk
 Unsystematic Risk

Unsystematic
Risk
Financial
Business Risk Risk

The changes that take place in an The risk of using of debt financing
industry and the environment causes by the company to finance a larger
risk for the company in earning the proportion of assets
operational revenue creates
business risk.
Unsystematic Risk

Business Risk (Internal)

 Fluctuations in sales
 Loss of customers will result in loss of operational
income
 Research and development (R&D)
 Scope for further expansion of product lines
 Personnel Management
 Higher labour costs affects margins
 Fixed cost
 Single Product
Unsystematic Risk

Business Risk (External)

 Social and regulatory factors
 Harsh regulatory climate can affect future profitability
 Political Risk
 Risk due to change in government policy
 Exchange Rate risk
 The change in the exchange rate causes a change in
the value of foreign holdings, foreign trade, and the
profitability of the firms
 The exchange rate risk is applicable mainly to the
companies who operate overseas.
 Business cycle
Unsystematic Risk

Financial Risk
 The use of debt financing by the company to
finance a larger proportion of assets causes risk.
 Debt financing enables the corporate to have
funds at low cost and financial leverage to
shareholders.
 As long as Co. earnings are higher than cost of
capital, shareholders’ earnings are increased, but
when earnings are low,it may lead to bankruptcy
Measuring Risk
 The weighted return for a portfolio is the weighted
average of the returns of the individual assets in the
portfolio.

n
E(R por i )   Wi R i
i 1

where :
Wi  the percent of the portfolio in asset i
E(R i )  the expected rate of return for asset i
Example on weighted return
A portfolio consists of 50% common stocks,
40% bonds & 10% cash. If the return on
common stocks is 12%, the return on
bonds is 7%, and the return on cash is 3%,
what is the portfolio return?
Weight Return Net Return
Stocks 50% 12% 6%
Bonds 40% 7% 2.8%
Cash 10% 3% 0.3%
Total 9%
Expected Return
 Why do we measure returns while considering a future
investment?
 Expected returns are all based on probability which we have
to assign to each investment outcome
 For an Individual risky asset
 Sum of probability times possible rate of return
 Portfolio
 Weighted average of expected rates of return for the
individual investments in the portfolio
 Expected Return of a
Portfolio
Possible
Weight Probability Expected Ret. Net Expected Ret.
Ret.
Stocks 60% 60% 9% 5.4%
15%
Bonds 30% 9% 100% 9% 2.7%

Mutual
Funds 10% 11% 50% 5.5% 0.6%
Total 8.7%
 Variance of Returns for an
Individual Investment
 Variance is a measure of the variation of
possible rates of return Ri, from the expected
rate of return [E(Ri)]
n
Variance ( )   [R i - E(R i )] Pi
2 2

i 1

 [R
Standard
Deviation
( )  i
2
- E(R i )] Pi
i 1
 Variance of Returns for an Individual
Investment

Possible Rate Expected

of Return (Ri) Return E(Ri) Ri - E(Ri) [Ri - E(Ri)]2 Pi [Ri - E(Ri)]2Pi

8% 11% 0.03 0.0009 25% 0.000225

10% 11% 0.01  0.0001 25% 0.000025

12% 11% 0.01 0.0001 25% 0.000025

14% 11% 0.03 0.0009 25% 0.000225

Total 0.000500

Variance = .00050
Standard Deviation = .02236
 Variance of Returns for a
Portfolio When we evaluate a
sample of n from a
larger population

n
Variance ( )   [R i - E(R i )] /( n  1)
2 2

i 1

Standard Deviation
n
( )   [R
i 1
i - E(R i )] /( n  1)
2
 Variance of Sample of Population
Monthly Closing Prices of SBI

Average Closing
Year Price (Ri ) % Return Ri - E(Ri) [Ri - E(Ri)]2
Dec-01 205.08
Dec-02 235.38 1.15 -0.194 0.0378
Dec-03 388.26 1.65 0.307 0.0945
Dec-04 525.63 1.35 0.012 0.0001
Dec-05 760.77 1.45 0.105 0.0111
Dec-06 968.99 1.27 -0.068 0.0047
Dec-07 1588.93 1.64 0.298 0.0886
Dec-08 1497.55 0.94 -0.400 0.1597
Dec-09 1715.50 1.15 -0.197 0.0386
Dec-10 2536.62 1.48 0.137 0.0187

Expected Return Variance

E(Ri) = 1.3421 =0.4537/(10-1) = 0.05041
Risk-return Tradeoff
 A higher standard deviation means a higher risk and
higher possible return. 
Covariance
 A measure of the degree to which returns on two risky
assets move in tandem
 Covariance is the absolute measure to the extent to
which two stocks move together
1
Covij 
N 1
 [ Ri  E ( Ri )][ Rj  E ( Rj )]

where :
Covij  the covariance of stock i with stock j
E ( Ri )  the expected return on stock i
E ( R j )  the expected return on stock j
 If Covariance of returns
 is negative: it indicates an inverse relationship
between the two assets
 is Zero: it indicates the two assets are
unrelated
 is positive: it indicates an positive relationship
between the two assets
 The covariance of a random asset with
itself is nothing but its variance
 Example of Covariance
Year SBI(Ri) ITC (Rj)
Dec-01 205.08 742.69
Dec-02 235.38 659.17
Dec-03 388.26 759.83
Dec-04 525.63 1075.86
Dec-05 760.77 1052.71
Dec-06 968.99 180.85
Dec-07 1588.93 173.60
Dec-08 1497.55 190.95
Dec-09 1715.50 215.63
Dec-10 2536.62 230.38
Sum
Expected Return
E(R)

Covariance = 0.006679
Correlation
 Correlation is a statistical measurement of the relationship
between two variables. 
 Correlation coefficient varies from -1 to +1

Cov ij
rij 
 i j
where :
r  the correlation coefficient of returns
ij
Cov  the covariance of stocks i & j
ij
  the standard deviation
 Beta
 It is a historical measure of the risk an investor is
exposed to by holding a particular stock or
portfolio as compared to the market as a whole
 Beta measures systematic risk
 im 
Cov im
m
2

where :
 im  Beta of the stock
Covim  the Covariance of stock i with market index m
 m  the standard deviation of market R m
Interpretation of the Numerical Value
of Beta
 Beta = 1.0 Stock's return has same
volatility as the market return

 Beta > 1.0 Stock's return is more volatile

than the market return

 Beta < 1.0 Stock's return is less volatile

than the market return
 Significance of Beta
 High Beta Stocks
 More systematic market risk
 May be appropriate for high-risk tolerant (aggressive) investors

 Low Beta Stocks

 Less systematic market risk
 May be appropriate for low-risk tolerant (defensive) investors

 Individual Stock Betas

 May change over time
 Tendency to move toward 1.0, the market beta

 Portfolio Betas
 Weighted average of the individual asset's betas
 May be more stable than individual stock betas
Diversification of Risk
 Diversification is a technique that reduces risk by allocating
investments among various financial instruments, industries and
other categories. It means reducing risk by investing in a variety
of assets

Effect of diversification on variance

 Diversification can lower the variance of a portfolio's return below
what it would be if the entire portfolio were invested in the asset
with the lowest variance of return, even if the assets' returns are
uncorrelated
 Ratio of Portfolio
An empirical example relating diversification
Average Standard Standard Deviation
to risk reduction Deviation of Annual
Number of Stocks in
to Standard
Portfolio
Portfolio ReturnsDeviation of a Single
 In 1977 Elton and Gruber considered a population
Stock of 3290
securities1 available for possible
49.24% inclusion in a 1.00
portfolio,
and to consider
2 the average risk .Their results0.76
37.36 are
summarized4 in the following table.
29.69 0.60
 It can be seen
6 that most of26.64
the gains from diversification
0.54
come for8n≤30. 24.98 0.51
10 23.93 0.49
20 21.68 0.44
30 20.87 0.42
40 20.46 0.42
50 20.20 0.41
400 19.29 0.39
500 19.27 0.39
1000 19.21 0.39
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