RETURN and RISK

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 Investment returns
The rate of return on an investment can be calculated as
follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested

For example, if $1,000 is invested and $1,100 is returned

after one year, the rate of return for this investment is:
($1,100 - $1,000) / $1,000 = 10%.
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 What is investment risk?
• Two types of investment risk
➢ Stand-alone risk
➢ Portfolio risk
• Investment risk is related to the probability of
earning a low or negative actual return.
• The greater the chance of lower than expected or
negative returns, the riskier the investment.

3
 Probability distributions
• A listing of all possible outcomes, and the
probability of each occurrence.
• Can be shown graphically.

Firm X

Firm Y
Rate of
-70 0 15 100 Return (%)

Expected Rate of Return 4

 Investment categories
• T-Bills

• Bonds (government and corporate)

• Stocks (large-company and small-company)

5
 Selected Realized Returns,
1926 – 2004
Average Standard
Return Deviation
Small-company stocks 17.5% 33.1%
Large-company stocks 12.4 20.3
L-T corporate bonds 6.2 8.6
L-T government bonds 5.8 9.3
U.S. Treasury bills 3.8 3.1

Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition)

2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.
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 Selected Realized Returns,
1926 – 2017
Average Standard
Return Deviation
Small-company stocks 16.5% 31.7%
Large-company stocks 12.1 19.8
L-T corporate bonds 6.4 8.3
L-T government bonds 6.0 9.9
U.S. Treasury bills 3.4 3.1

Source: Based on Duff & Phelps 2018 SBBI Yearbook Stocks, Bonds,
Bills, and Inflation, p 2-6.
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 Selected Realized Returns,
1926 – 2020
Average Standard
Return Deviation
Small-company stocks 16.2% 31.3%
Large-company stocks 12.2 19.7
L-T corporate bonds 6.5 8.5
L-T government bonds 6.1 9.8
U.S. Treasury bills 3.3 3.1

Source: Data from Stocks, Bonds, Bills & Inflation, Morningstar, Inc.
(From CFA Institute Research Foundation “Revisiting the Equity
Risk Premium”)
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Investor attitude towards risk
• Risk aversion – assumes investors dislike risk
and require higher rates of return to encourage
them to hold riskier securities.

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Investor attitude towards risk
• Risk aversion – assumes investors dislike risk
and require higher rates of return to encourage
them to hold riskier securities.

• Risk premium – the difference between the

return on a risky asset and a riskless asset,
which serves as compensation for investors to
hold riskier securities.

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 States of the economy
• Some external factors that have an impact
on the issue under consideration

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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%
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 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%

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 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 % 14
 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 % − 1 1 % ) = .0 3 2 4
2

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 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
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 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%

1 4 .3 % = 0 .0 2 0 5
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 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.
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 Correlation

Cov(a, b)
=
 a b
− .0117
= = −0.998
(.143)(.082)

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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. 20
 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 % )
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 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 % )
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 Variance
• How to capture variance using a box /
matrix structure

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 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. 24
 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. 25
 The Efficient Set
% 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% We can consider other
75%
80%
8.7%
9.8%
10.0%
10.2%
portfolio weights besides
85% 10.9% 10.4% 50% in stocks and 50% in
90%
95%
12.1%
13.2%
10.6%
10.8%
bonds … 26
100% 14.3% 11.0%
 The Efficient Set
% 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. 27
100% 14.3% 11.0%
 Portfolios with Various Correlations
• Relationship depends
on correlation
return

100%
 = -1.0 stocks coefficient
-1.0 <  < +1.0
• If  = +1.0, no risk
 = 1.0 reduction is possible
100%
 = 0.2 • If  = –1.0, complete
bonds risk reduction is
 possible

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The Efficient Set for Many Securities

return

Individual Assets

P
Consider a world with many risky assets; we can
still identify the opportunity set of risk-return
combinations of various portfolios. 29
The Efficient Set for Many Securities

return

minimum
variance
portfolio

Individual Assets

P
The section of the opportunity set above the
minimum variance portfolio is the efficient frontier.
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Optimal Portfolio with a Risk-Free
Asset
return
100%
stocks

rf
100%
bonds


In addition to stocks and bonds, consider a world
that also has risk-free securities like T-bills. 31
 Riskless Borrowing and Lending
return
100%
stocks
Balanced
fund

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

rf

P
With a risk-free asset available and the efficient
frontier identified, we choose the capital allocation line
with the steepest slope. 33