TAGOLOAN Community College MODULE WEEK NO.

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Baluarte, Tagoloan, Misamis Oriental
University Tel.No. (08822)740-835/(088)5671-215
Logo

College of Business Administration

COURSE Code: Investment and Portfolio Management
2ND Semester of A.Y. 2021-202

Introduction

This course is designed to help learners figure the value of probability distribution of either rates of
returns and historical rates of returns under different scenarios. Thus, investors’ value of investments
should exceed its initial value. This course shall likewise educate learners characterizing the
relationship between risk and return.
COU
RSE
MOD
ULE
Rationale

● The calculation of expected rate of return is useful for investors looking to build out a model
portfolio while knowing its limitations.
● In order to make investment decisions, investors often estimate the expected return of a
potential investment.
● Expected value is a concept that the helps investors assess the value of a potential investment
based on different future outcomes and a probability for each outcome.
● Any investment should be made taking time considerations and risk tolerance into account.

Intended Learning Outcomes

After discussion, students should be able to:

A. Calculate the expected rates of return of an investment portfolio;

B. Explain the importance of a stock’s variance, standard deviation and coefficient

variation; and

C. Project the probable risk of portfolio investments when affected by certain

economic conditions.

Activity

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ILO1

Online Discussion

Provide powerpoint/video presentation

Conduct Online Problem-solving exercise

ILO2

Online instruction

Provide powerpoint/video presentation

Assignment

ILO3
COU
RSE Online instruction
MOD
ULE Quescussion

Discussion
Calculating Expected Rates of Return

- Expected Rate of Return is the expected value of the probability distribution of possible returns it
can provide to investors. The return on the investment is an unknown variable that has different
values associated with different probabilities.
- Risk is the uncertainty that an investment will earn its expected rate of return.
- Point of estimate is where an investor expects that an investment will provide a certain rate of
return. Investor should acknowledge the uncertainty of this point estimate return and admit the
possibility that, under certain conditions, the annual rate of return might go low or high. If the
investor expects a 10 percent rate of return, he must acknowledge that there is a possibility to go as
low as 10 percent or as high as 25 percent. The larger range of possible returns implies that the
investment is riskier.

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Measuring the Risk of Expected Rates of Return

- Variance is neither good nor bad for investors in and of itself. However, high variance in a stock is
associated with higher risk, along with a higher return. Low variance is associated with lower risk
and a lower return. High variance stocks tend to be good for aggressive investors who are less risk-
averse, while low variance stocks tend to be good for conservative investors who have less risk
tolerance. The larger the variance for an expected rate of return, the greater the dispersion of
expected returns and the greater the uncertainty, or risk, of the investment. Perfect certainty has
no variance of return because there is no deviation from expectations and therefore no risk or
uncertainty.
- Standard deviation is a measure of how much an investment's returns can vary from its average
return. It is a measure of volatility and in turn, risk. In research, a low standard deviation means
that most of the numbers are close to the average. A high standard deviation means that the
numbers are more spread out.
- Coefficient of variation is a measure used to assess the total risk per unit of return of an
investment. The coefficient of variation (COV) can determine the volatility of an investment. It is
calculated by dividing the standard deviation of an investment by its expected rate of return. Since
COU most investors are risk-averse, they want to minimize their risk per unit of return. Coefficient of
RSE variation provides a standardized measure of comparing risk and return of different investments. A
MOD rational investor would select an investment with lowest coefficient of variation.
ULE
Example1:

1. Let us take a portfolio of investment of ABC Company after 10 years, which has a 20% probability of
giving a 15% return, a 50% probability of generating a 10% return, and a 30% probability of resulting
in a -5%. The expected return on investment ABC would then be calculated as follows:

Expected Return = 0.2(15%) + 0.5(10%) + 0.3(-5%)

= 3% + 5% – 1.5%
= 6.5%
Therefore, the probable long-term average return for the Investments of ABC is 6.5%.
 
Example2:
2. Let’s assume the portfolio is comprised of investments in three assets – X, Y, and Z. Php20,000 is
invested in X, Php50,000 invested in Y, and Php30,000 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 = 0.20(15%) + 0.50(10%) + 0.30(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.
 
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3. An investor is certain of a return of 10 percent, and the probability of receiving that return is 1.0.
Expected Return of Portfolio = 1.0(10%)

= .1

= 10%

4. Investments affected/dependent by certain economic conditions:

Economic Conditions Probability Rate of return

Strong economy, no inflation .15 .20

Weak economy, above average inflation .15 -.20

No major change in economy .70 .10

Expected Return of Portfolio = {(.15)(.20)+(.15)(-.20)+(.70)(.10)}

COU
RSE = .03 + -.03 + .07
MOD
ULE 2
=.07
2 2
Variance = {(.15)(.20-.07)+(.15)(.-20-.07)+(.70)(.10-.07)}

=.002535 + .010935 + .00063

= .0141

Standard Deviation = √ .0141 (square root)

= .11874 = 11.874%

If conditions for two or more investment alternatives are not similar – that is, if there are major differences
in the expected rates of return – it is necessary to use a measure of relative variability to indicate risk per
unit of expected return. A widely used relative measure of risk is the coefficient of variation (CV)

CV = Standard Deviation of Returns

Expected Rate of Returns

CV = .11874/.07000

= 1.696

Part 1. Exercise

Direction. Submit your answers through Google Classroom or FB Messenger .

Problem 1. With the probabilities summing to 100%. An investor is contemplating to make a risky
Php100,000 investment, where there is a 25% chance of receiving no return at all. There is also a 50%
probability of generating a Php10,000 return, and a 25% chance that the investment will create a Php50,000
return. Based on this information, calculate the expected rate of return. (10 points)
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Problem 2. You are thinking about investing your money in the stock market. You have the following three
stocks in mind: stock A, B, and C. You know that the economy is expected to behave according to the
following table. You also believe that the likelihood of each scenario is identical (the sum of all probabilities
is similar with Problem 1, thus, all states of nature have equal probabilities). Which among the three
investments has the highest percentage of volatility? Justify your answer. (70 points)

State of the Economy RA RB RC

Depression -20% 5% –5%

Recession 10% 20% 5%

Normal 30% -12% 5%

Boom 50% 9% -3%

COU
RSE Assessment
MOD Google Classroom
ULE Part II. Reflection

● What would cause an investment to unexpectedly over perform or underperform?

● The standard deviation on the rate of return on an investment is a measure of its
volatility or risk. What would a standard deviation of zero mean?

Resources and Additional Resources

● Analysis of Investment and Management of Portfolios by Keith C Brown and
Frank K Reilly (Textbook)
● Investment Analysis and Portfolio Management by Japhur (Online Book)

Noel Q. Formoso
Assistant Professor lV
[email protected]