[INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

CHAPTER TWO
RISK AND RETURN
2.1 Introduction
In this chapter, we start from the basic premise that investors like returns and dislike risk.
Therefore, people will invest in risky assets only if they expect to receive higher returns. We
define precisely what the term risk means as it relates to investments. We examine procedures
managers use to measure risk, and we discuss the relationship between risk and return.
The chapter includes an Over view and components of return, types of risk, measuring historical
risk, measuring expected return and risk.
Risk is how investors characterize how much uncertainty exists on return. It is the difference
between expected return and actual return. Uncertainty means not knowing exactly what will
happen in the future because of change in tax laws, consumer demand, the economy, or interest
rates. Risk can be classified as systematic risk and unsystematic risk. Components of investment
risk are: Business Risk, Liquidity Risk, Financial Risk, Exchange Rate Risk, Country Risk, and
Market Risk.
2.2 Measuring Historical Return
If you buy an asset of any sort, your gain (loss) from that investment is called the return on your
investment. Return is a reward and motivating force behind every investment. It is the amount or
rate of gain or profit which accrues to an investment. The rate of return required by a firm to a
great extent depends upon the risk involved, higher the risk, greater is the return expected by the
firm.
Return on investment has two components;
1. Regular income in the form of interest or dividend and
2. Capital appreciation (an increase in price).

Example 1: Suppose, at the beginning of the year, the stock for a company was selling for $37
per share. If you had bought 100 shares, you would have a total out lay of $3700. Suppose, over
the year, the stock paid a dividend of $1.85per share. By the end of the year, then, you would
have received income of:

Dividend= $1.85 x 100= $185

Also, suppose the value of the stock has risen to $40.33per share by the end of the year. Your
100 shares are now worth $4,033, so you have a capital gain of:
Capital gain = ($40.33 - $37) x 100 = $333
Therefore, the total return on your investment is the sum of the dividend and the capital gain.
Total return = dividend income + capital gain (loss)
= $185 + $333 = $ 518
Notice that, if you sold the stock at the end of the year, the total amount of cash you would have
would equal your initial investment plus total return. Then, total cash if the stock is sold is:

Admas University Page 1

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

Total cash = initial investment + total return

$ 3700 + $ 518 = $ 4,218
As a check, notice that this is the same as the proceeds from the sale of the stock plus the
dividends:
Proceeds from stock sale + dividends = $40.33 x 100 + 185= $ 4,218
It is usually more convenient to summarize information about returns in percentage terms, rather
than in dollar terms, because that way your return does not depend on how much you actually
invest. The question is, how much do we get for each dollar we invest? To answer this question,
let Pt be the price of the stock at the beginning of the year and let D t+1 be the dividend paid on
the stock during the year.

In the example above, the price at the beginning of the year was $37 per share and the dividend
paid during the year on each share was $1.85. Therefore, dividend yield is:

Dividend yield= D t+1/ Pt

= $1.85/37 = .05= 5%, this implies that for each dollar we invest, we get five

cents in dividends.

The second component of the return from investment is the capital gains yield. This is calculated
as the change in the price during the year (the capital gain) divided by the beginning price:

Capital gains yield = (P t+1 -Pt)/ Pt

= (40.33 -37)/37 = .09= 9%. This means that per dollar we invest, we get nine
cents in capital gain. Putting it together, per dollar invested, we get 5 cents in dividends and nine
cents in capital gains: so we get a total of 14 cents. Our percentage return is 14%.

Simply, the total percentage return of an investment can be calculated as:

Percentage return = dividend paid at end of period + Change in market value over period
Beginning market value
= ($1.85 + (40.33 – 37))/ 37 = 5.18/37 = .14 = 14%

Or Total Return = (Ending Capital / Starting Capital) – 1

($4,218/$3,700)-1 =0.14 or 14%

Example 2: A $1,000 investment that was purchased at the beginning of the first year declines
by 50% during the first year (to $750). Compute total return from an investment?
Total Return = (Ending Capital / Starting Capital) – 1
($750/$1,500)-1 =-0.5 or -50%
Average annual return: Used to compare the performance of two investments with returns on
periods of different lengths. The AR is found by taking the average of the yearly returns.

Admas University Page 2

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

For N years with returns R1, R2, R3, and RN, the average annual return is:
Average Annual Return = (R1 + R2 + R3 +...+ RN) / N

2.3 Measuring of Risk

A person making an investment expects to get some return from the investment in the future.
But, return, as future is uncertain, so is the future expected. It is this uncertainty associated with
the returns from an investment that introduces risk in to an investment. Uncertainty means not
knowing exactly what will happen in the future because of change tax laws, consumer demand,
the economy, or interest rates.

We can distinguish between the expected return and the realized from an investment. The
expected return is uncertain future return that an investor expects to get from his investment. The
realized return, on the contrary, is the certain return that an investor has actually obtained from
his investment at the end of the holding period. The investor makes the investment decision
based on the expected return from the investment. The actual return realized from the investment
may not correspond to the expected return. This possibility of variation of the actual return from
the expected return is termed as risk. Where realization corresponds to expectations exactly,
there would be no risk. Risk arises where there is a possibility of variation between expectation
and realizations with regard to an investment.

Thus risk can be defined in terms of variability of returns. “Risk is the potential for variability in
returns”. An investment whose returns are fairly stable is considered to be a low risk investment,
where as an investment whose returns fluctuate significantly is considered to be a high risk
investment. Equity shares whose returns are likely to fluctuate widely are considered risky
investments. Government securities whose returns are fairly stable are considered to possess low
risk.
2.3.1. Components of investment risk
 Business Risk: The uncertainty of income caused by the nature of a company’s
business that measured by a ratio of operating earnings (income flows of the firm). The
sources of business risk mainly arises from a companies’ products/services, ownership
support, industry environment, market position, management quality etc.

 Liquidity Risk: The uncertainty introduced by the secondary market for a company to
meet its future short term financial obligations. When an investor purchases a security,
they expect that at some future period they will be able to sell this security at a profit and
redeem this value as cash for consumption. Its ability to be redeemable for cash at a
future date.
 Financial Risk - Financial risk is the risk borne by equity holders due to firm’s use of
debt. If the company raises capital by borrowing money, it must pay back this money at
some future date plus the financing charges (interest etc charged for borrowing the

Admas University Page 3

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

money). This increases the degree of uncertainty about the company, because it must
have enough income to pay back this amount at some time in the future.
 Exchange Rate Risk - The uncertainty of returns for investors that acquire foreign
investments and wish to convert them back to their home currency. This is particularly,
important for investors that have a large amount of over-seas investment and wish to sell
and convert their profit to their home currency. The more volatile exchange rates
between the home and investment currency, the greater the risk of differing currency
value that eroding the investments value.
 Country Risk - This is also termed political risk, because it is the risk of investing
funds in another country whereby a major change in the political or economic
environment could occur. This could devalue your investment and reduce its overall
return. This type of risk is usually restricted to emerging or developing countries that do
not have stable economic or political arenas.
 Market Risk - The price fluctuations or volatility increases and decreases in the day-
to-day market. This type of risk mainly applies to both stocks and options and tends to
perform well in a bull (increasing) market and poorly in a bear (decreasing) market.
Generally with stock market risks, the more volatility within the market, the more
probability of increase or decrease investment.
2.3.2. Types of Risk
There are a number of risks that can affect your investments. While some of these risks can be
reduced through a number of avenues - some of them simply have to be accepted and planned for
any investment decision. Based on this, there are two main types of risk; these are systematic risk
and unsystematic risk.
Systematic risk: It is also called non-diversified risk. It is unavoidable/non controllable. It may
also be called a market risk. Is the risk that cannot be reduced or predicted in any manner and it
is almost impossible to predict or protect yourself against this type of risk. Examples of this type
of risk include interest rate increases or government legislation changes recession, war, and
structural changes in the economy.
Unsystematic Risk: is also called diversifiable risk /controllable or non-market risk.
Unsystematic risk can be minimized or eliminated through diversification of security holdings.
The variability in scrip’s total return that is not related to the overall market variability is called
unsystematic risk. It represents the portion of an investment risk that can be eliminated by
holding diversified stocks. This risk occurs due to management changes in the company, labor
problems, strikes etc. Total variability in returns of a security represents the total risk of that
security. Systematic risk and unsystematic risk are the two components of total risk. Thus,

Total risk = Systematic risk + Unsystematic risk.

Admas University Page 4

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

2.3.3. Measuring historical risk

Risk refers to the possibility that the actual outcome of the investment will differ from the
expected outcome. Put differently, risk refers to variability or dispersion. If an asset return has no
variability, it is riskless. Suppose you are analyzing the total return of an equity stock over the
period of time apart from knowing the mean return, you would also like to know about the
variability of in returns. The most commonly used measures of risk in finance are variance or its
square root the standard deviation. The variance and standard deviation of historical return series
are defined as follows:

∑( )

=√
Where:
= variance of return
= standard deviation of return
Ri = Return from the stock in period i (=1,…., n)
Arithmetic return (average return)
n = number of period
Example 3: Consider returns from the stock over a six years period.R1 = 15%, R2 =12%, R3 =
20%, R4= -10% R5 =14%and R6 =9%. Calculate the variance and standard deviation of return.
Solution:
Period Return Ri Deviation (Ri- ) Square of deviation (Ri-
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
∑ =60 ∑ (Ri- = 546
= 10
∑ ( ) =109.2

∑ ( ) =∑ ( ) =10.4

Admas University Page 5

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

2.4. Measuring expected (ex-ante) return and risk

2.4.1. Expected rate of return: Investors estimate future rate of return based on historical
return and by assigning probability to each year rate of return. The expected rate of return
is the weighted average of all possible returns multiplied by their respective probabilities.
In symbols,
E(R) ∑
Where: E(R)= expected return
Ri = return from the stock at year i
Pi = probability of return at year i
n = number of possible year
2.4.2. Expected risk: Risk refers to the dispersion of a variable. It is commonly measured by
the variance or the standard deviation. The variance of the probability distribution is the
sum of the squares of the deviations of the actual returns from the expected return,
weighed by the associated probabilities. In symbols,
σ2 = ∑ Pi (Ri –E(R))2
Where: σ2 =variance
Ri =return for the ith possible outcome
Pi =probability associated with the ith possible outcome
E(R) = expected return
Since variance is expressed as squared returns, it is somewhat difficult to grasp. So its square
root, the standard deviation, is employed as an equivalent measure.
σ = (σ2)1/2 Where: σ = standard deviation

Example 4: The table below provides a probability distribution for the returns on stocks A and
B. compute expected return and expected risk by using variance and standard deviation.
Year Probability Return on Stock A Return on Stock B

1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

Solution: Expected return for stock A and B calculated as follows:

 E[R]A = .2(5%) + .3(10%) + .3(15%) + .2(20%) = 12.5%
 E[R]B = .2(50%) + .3(30%) + .3(10%) + .2(-10%) = 20%,
Decision:
Based on expected return stock B will perform well than stock A, so investment manager should
select and invest on stock B to get future better return.

Admas University Page 6

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

Variance and Standard deviation on Stocks A and B:

Stock A =>

Stock B =>

Decision:
Based on expected risk, investor may select the second stock to minimize risk. Generally, the
above result shows that as return increase, risk also increase and investors select security based
on their risk tolerance.

EXERCISES
1. At the beginning of last year, you invested $4,000 in 80 shares of the Chang Corporation.
During the year, Chang paid dividends of $5 per share. At the end of the year, you sold the
80 shares for $59 a share. Compute total return on these shares and indicate how much was
due to the price change and how much was due to the dividend income.
2. The expected rate of return and possibilities of their occurrence for security A and Security B
are given below

Year Probability Return on Security A Return on Security B

1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
Required:
A. Compute expected return, variance and standard deviation for security A and Security B.
B. On the basis of expected return alone, discuss whether security A or security B is
preferable.
C. On the basis of standard deviation alone, discuss whether security A or B is preferable.
D. Compute the coefficient of variance for security A and security B which security has the
greater relative dispersion.

Admas University Page 7

 [INVESTMENT ANALYSIS AND PORTFOLIO MANAGEMENT] Chapter Two

3. During the past five years, you owned two stocks that had the following annual rates of
return:
Year Stock T Stock B
1 0.19 0.08
2 0.08 0.03
3 -0.12 -0.09
4 -0.03 0.02
5 0.15 0.04
A. Compute the arithmetic mean annual rate of return for each stock. Which stock is most
desirable by this measure?
B. Compute the standard deviation of the annual rate of return for each stock. By this
measure, which is the preferable stock?

Admas University Page 8