the trade-off between risk and return professor thomson fin 3013
TRANSCRIPT
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The Trade-off betweenRisk and Return
Professor ThomsonFin 3013
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Risk and Return
The return earned on investments represents the marginal benefit of investing.
Risk is one of the marginal costs of investing (the other is the pure time value of money).
A trade-off always arises between expected risk and expected return.
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Risk and Return
Valuing risky assets - a task fundamental to financial management
Three-step procedure for valuing a risky asset
1. Determine the asset’s expected cash flows2. Choose discount rate that reflects asset’s risk3. Calculate present value (PV cash inflows - PV
outflows)
The three-step procedure is called discounted cash flow (DCF) analysis.
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Financial Return
Total return: the total gain or loss experienced on an investment over a given
period of time
Component
s of the total
return
Income stream from the investment
Capital gain or loss due to changes in asset prices
Total return can be expressed either in dollar terms or in percentage terms.
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Cash Flow Time Line
Pt-1 cash payments Pt
+-----------------------------------------------+Time t-1 Time t
Pt = Price at time t (today)
Capital Gain = Pt – Pt-1
= Price today – Price last period
Dollar Return = Cash Payments + Capital Gain
= Cash Payments + Pt – Pt-1
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Example 6.1
• You purchased a stock last year for $25. It has paid $1 in dividends and is not worth $21. What is your Dollar Return?
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Example 6.2
• You bought an 11% coupon bond one year ago for $1125. You can sell that bond today for $1100. What is your Dollar Return?
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Holding Period Return (hpr) or
Percentage Return
• This is the most common way to express the gains or losses over a period
• It is the $Return relative to the amount invested
1
1%Return
t
tt
P
PPCashPmthpr
1+hpr is often called the wealth relative
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Example 6.1 (Revised)
• You purchased a stock last year for $25. It has paid $1 in dividends and is not worth $21. What is your Dollar Return?
• What is your hpr?
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Example 6.2 Revised
• You bought an 11% coupon bond one year ago for $1125. You can sell that bond today for $1100. What is your Dollar Return?
• What is your hpr?
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Measuring Wealth over TimeYear
hpr $1 Investment $1 Investment each year
1 15% 1*(1.15) = 1.15Vt-1(1+it) = Vt
1*(1.15)=1.15Vt-
Vt- Vt-1 (1+it) = Vt
2 -10% 1.15*(0.90) =1.035
(1+1.15)*(0.90) = 1.935
3 13% 1.035*1.13 = 1.1696
(1+1.935)*(1.13) = 3.3166
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Arithmetic Average Return
• Add the individual hpr’s and divide by the number of years
%00.63
%13%10%15
x
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Geometric Rate of Return
• Multiply by the wealth relatives, raise to the 1/N power and subtract 1
• Is the constant rate of wealth building over time that results in the observed future value
%36.50536.01)]13.1)(90.0)(15.1[(
1)]1)...(1)(1)(1[(
31
1
321
NNrrrrg
By Financial Calculator: P/YR=1
I/YR(FV=1.1696, PV=-1, N=3) = 5.36%
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IRR from a Constant Investment
t CF
0 -1
1 -1
2 -1
3 3.3166
P/YR=1
•Press IRR = 5.10%
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Value of $1 Invested in Equities, Treasury Bonds and Bills, 1900 - 2003
Year
$15,579
$148
$61
$22
10,000
100,000
1,000
100
10
1
Equities Bonds
Bills Inflation
1900 1920 1940 1960 1980 2000 2003
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Geometric Return Calculation
• A $1 investment in Large Stocks (with dividends reinvested) was worth 15579 after 103 years. The geometric mean return can be computed as (P/Yr = 1)
I/YR(FV=15579, PV=-1, N=103)=9.83% StocksI/YR(FV=148, PV=-1, N=76)=4.97% Long US
BondI/YR(FV=61, PV=-1, N=76)=4.07% US
Treasury BillsI/YR(FV=22, PV=-1, N=76)=3.05% Inflation
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Geometric Real Rates of Return• To compute the long run real rate of return
one can divide the ending value of the investment by the ending value of the inflation figure to determine the purchasing power of the investment. Then compute the return using “Real Dollars”
• Real value of the Large Stocks at end of period is 15579/22 = 708.14
• I/YR(FV=708.14, PV=-1, N=103)=6.58%• I/YR(FV=6.73, PV=-1, N=103)=1.87% Long US
Bond• I/YR(FV=2.73, PV=-1, N=103)=1.00% TBill
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Arithmetic versus Geometric Returns (1900-2003)
Stocks Bonds Bills
Nominal Returns Arithmetic Avg
11.7 5.2 4.1
Nominal Returns Geometric
9.8 5.0 4.1
Real ReturnsArithmetic Avg
8.5 2.3 1.1
Real Returns Geometric
6.6 1.9 1.0
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Annual Returns for Securties
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
1980 1985 1990 1995 2000
Year
Ret
urn
Stocks
Bonds
T-Bills
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IRR From a Constant Annual Investment (Jan 1, each year) through Oct 2002
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
15%
20%
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
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88
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89
19
90
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92
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94
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95
19
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97
19
98
19
99
20
00
20
01
20
02
Year of First Investment
Stocks
LongGovBond
Tbills
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IRR From a Constant Annual Investment (Jan 1, each year) through Dec 2003
-5%
0%
5%
10%
15%
20%
25%
30%
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
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92
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93
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94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
Year of First Investment
Stocks
LongGovBond
Tbills
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IRR From a Constant Annual Investment (Jan 1, each year) through Dec 2004
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
20%
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
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19
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19
97
19
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19
99
20
00
20
01
20
02
20
03
20
04
Year of First Investment
Stocks
LongGovBond
Tbills
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Dollar Gain per Dollar Invested From a Constant Annual Investment (Jan 1, each year) through Dec 2004
0.00
1.00
2.00
3.00
4.00
5.00
6.00
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
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94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
Year of First Investment
Stocks
LongGovBond
Tbills
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Take home message
• If you have a short holding period, stocks are very risky, but from a longer term perspective they have provided the best returns both recently and historically
• Investment is not about saving money for the future, its about earning money from the money you invested so that most of your portfolio is from the earning of that portfolio and not from your deposits into that fund
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Percentage Returns on Bills, Bonds, and Stocks, 1900 - 2003
Difference between average return of stocks and bills = 7.6%
Difference between average return of stocks and bonds = 6.5%
Risk premium: the difference in returns offered by a risky asset relative to the risk-free return
available
Nominal (%) Real (%)Asset Class Average Best Year Worst Year Average Best Year Worst Year
Bills 4.1 14.7 0.0 1.1 19.7 -15.1Bonds 5.2 40.4 -9.2 2.3 35.1 -19.4Stocks 11.7 57.6 -43.9 8.5 56.8 -38
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Why are Treasury Bills considered risk free?
• If the government default on Treasury Bills, your last concern will be the money you might have earned on the TB
• When you buy a Treasury Bill, you purchase it at a discount and redeem it at par, so you know when you buy it, what your return will be
• If you buy a stock, you don’t know what you will sell it for, or what dividends it will pay; thus, it is risky
• The yield on Treasury Bills, is generally taken to be the risk free return
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Distribution of Historical Stock Returns, 1900 - 2003
Histogram of Nominal Returns on Equities 1900-2003
<-30 -30 to -20 to -10 to 0 to 10 to 20 to 30 to 40 to >50 -20 -10 0 10 20 30 40 50
Percent return in a given year
Probability distribution for future stock returns is unknown. We can approximate the unknown distribution by assuming a normal
distribution.
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Variability of Stock ReturnsNormal distribution can be described by
its mean and its variance. A Normal Distribution is symmetric around the
mean• Variance (2) - the expected value of
squared deviations from the mean
1
)(1
2
2
N
RRVariance
N
tt
Units of variance (%-squared) - hard to interpret, so calculate standard deviation, a
measure of volatility equal to square root of 2
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The Normal Distribution
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Volatility of Asset Returns
AssetClass Average(%) Std. Dev. (%) Average(%) Std. Dev. (%)
Equities 11.7 20.1 8.5 20.4Bonds 5.2 8.2 2.3 10Bills 4.1 2.8 1.1 4.7
Nominal Returns Real Returns
Asset classes with greater volatility pay higher average returns.
• Average return on stocks is more than double the average return on bonds, but stocks are 2.5 times more volatile.
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Average Returns and St. Dev. for Asset Classes, 1900-2003
1. Investors who want higher returns have to take more risk
2. The incremental reward from accepting more risk seems constant
Bills Bonds
Stocks
Average Return (%)
Standard Deviation (%)
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Average Return and St. Dev. for Individual Securities, 1994-2003
Average risk for all stocks in this period was 60%
For various asset classes, a trade-off arises between risk and return. Does the trade-off appear to hold for all
individual securities?
Anheuser-Busch 19.2 16.1Coca Cola 12.1 22.6Wendy's International 11.8 23.3Archer Daniels Midland 7.6 23.5General Motors 8.3 26.0General Electric 20.3 32.1Merck 17.8 32.7Nordstrom 14.3 38.1Wal-Mart 22.7 44.7American Airlines (AMR) 10.0 47.8Advanced Micro Devices (AMD) 17.6 56.4Average of individual 11 stocks 14.7 33.0Average for portfolio of U.S stocks 12.5 21.0
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Average Return and St. Dev. for Individual Securities, 1994-2003
Average Return (%)
Standard Deviation (%)
Wal-MartAnheuser-Busch
Archer Daniels Midland
American Airlines
No obvious pattern here
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Diversification
Most individual stock prices show higher volatility than the price volatility of portfolio
of all common stocks.
How can the standard deviation for individual stocks be higher than the standard deviation of the portfolio?
Diversification: investing in many different assets reduces the volatility of the portfolio.
The ups and downs of individual stocks partially cancel each other out.
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Annual Return: Coke, Wendy's, 50/50 Portfolio
-20
-10
0
10
20
30
40
50
Year
Retu
rn%
Coke
Wendy's
Ptf
The standard deviation of the portfolio is lower than the standard deviation of either Coke or Wendy’s
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The Impact of Additional Assets on the Risk of a Portfolio
Po
rtfo
lio
Sta
nd
ard
Dev
iati
on
Number of StocksNumber of Stocks
Systematic RiskSystematic Risk
1 2 3 111 2 3 11
Portfolio of 11 stocks
AMD
Unsystematic RiskUnsystematic Risk
AMD + American Airlines
AMD + American Airlines + Wal-Mart
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Diversification reduces portfolio volatility, but only up to a point. Portfolio of all stocks still
has a volatility of 21%.
Systematic risk: the volatility of the portfolio that cannot be eliminated through
diversification.Unsystematic risk: the proportion of risk of
individual assets that can be eliminated through diversification, for example, by buying
mutual funds. Because this risk can be eliminated, there is no reward for holding
unsystematic risk
What really matters is systematic risk….how a group of assets move together.
Systematic and Unsystematic Risk
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Anheuser Busch stock had higher average returns than Archer-Daniels-Midland stock,
with smaller volatility.
Systematic and Unsystematic Risk
American Airlines had much smaller average returns than Wal-Mart, with similar volatility.
The tradeoff between standard deviation and average returns that holds for asset classes
does not hold for individual stocks.
Because investors can eliminate unsystematic risk through diversification, market rewards
only systematic risk.
Standard deviation contains both systematic and unsystematic risk.
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Investment performance is measured by total return.
Trade-off between risk and return for assets: historically, stocks had higher returns and
volatility than bonds and bills.
One measure of risk: standard deviation (volatility)
Unsystematic and (systematic) risk: risk that can (cannot) be eliminated through
diversification, respectively
Risk and Return
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Dollar Returns
Total dollar return = income + capital gain / loss
Terrell bought 100 shares of Micro-Orb stock for $25
A year later:Dividend = $1/shareSold for $30/share
Dollar return = (100 shares) x ($1 + $5) = $600
Owen bought 50 shares of Garcia Inc. stock for $15
A year later:No dividends paidSold for $25/share
Dollar return = (150 shares) x ($15)
= $500
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Percentage Returns
Terrell’s dollar return exceeded Owen’s by $100. Can we say that Terrell was better off?
No, because Terrell and Owen’s initial investments were different: Terrell spent $2,500 in initial
investment, while Owen spent $750.
Percentage return: total dollar return divided by the initial investment
investment initialreturndollar total
return percentage Total
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Percentage Returns
%2424.0
500,2$
5$1$100 '
returnpercentagesTerrell
%6767.0
750$
10$50 '
returnpercentagesOwen
In percentage terms, Owen’s investment performed better than Terrell’s did.