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MEASURING RISK AND RETURN:

AN ILLUSTRATION

WHAT WILL YOU LEARN?

„  Welook at past returns on four stocks and compute the

average annual return and volatility from historical
monthly data.
„  Youwill learn how to summarize the past returns on an
asset.

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WHICH ASSET IS BETTER?

Prob.

A B

return

WHICH ASSET IS BETTER?

Prob. Prob.
X

A B
Y

return return

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WHICH ASSET IS BETTER?

Prob.

return

MONTHLY HISTORICAL DATA

APPLE WALMART IBM NIKE
1/31/11 5.20% 3.97% 10.38% -3.44%
… ... ... ... ...
1/31/14 -10.77% -5.10% -5.81% -7.36%
2/28/14 5.75% 0.03% 5.38% 7.81%
3/31/14 2.00% 2.98% 3.95% -5.67%
4/30/14 9.94% 4.29% 2.07% -1.23%
5/30/14 7.87% -3.09% -5.62% 5.76%
6/30/14 2.77% -2.21% -1.68% 0.83%
7/31/14 2.87% -1.98% 5.74% -0.54%
8/29/14 7.75% 3.29% 0.92% 2.15%
9/30/14 -1.71% 1.28% -1.28% 13.56%
10/31/14 7.20% -0.26% -13.40% 4.23%
11/28/14 10.60% 14.78% -0.68% 6.80%
12/31/14 -7.19% -1.35% -1.07% -2.88%

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AVERAGE RETURN AND VOLATILITY

APPL WALMART IBM NIKE
Average monthly return 1.755% 0.540% 0.177% 2.103%
Monthly volatility 7.145% 4.815% 4.545% 6.098%

AVERAGE RETURN AND VOLATILITY

APPL WALMART IBM NIKE
Average monthly return 1.755% 0.540% 0.177% 2.103%
Monthly volatility 7.145% 4.815% 4.545% 6.098%

APPL WALMART IBM NIKE

Average annual return 21.062% 6.483% 2.123% 25.234%
Annual volatility 24.750% 16.680% 15.744% 21.125%

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Average annual return and volatility

2011-2015
30.0%

NIKE
AVERAGE ANNUAL RETURN

25.0%

APPLE
20.0%

15.0%

10.0%

WALMART
5.0%
IBM
0.0%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%
ANNUAL VOLATILITY

SUMMARY

„  You learned to compute the average return and volatility from a time series
of returns.
„  You learned to annualize average return and volatility.

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HISTORICAL RECORD ON RISK &

RETURN PATTERNS

WHAT WILL YOU LEARN?

„ Historical data on risk and return patterns

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SUMMARY STATISTICS OF ANNUAL TOTAL

RETURNS FROM 1926 TO 2009
Average Standard
Annual Ret. Deviation Distribution

Large stocks 9.8% 20.5%

Small stocks 11.9 52.8

Long-term corp. bonds 5.9 8.3

Long-term govt. bonds 5.4 8.7

U.S. Treasury bills 3.7 3.1

Inflation 3.0 4.2

– 90% 0% + 90%

The Empirical Distribution of Annual Returns for U.S. Large stocks (S&P 500), Small Stocks,
Treasury Bonds and Treasury Bills (1926-2012)
Treasury Bills
60
Frequency

40

20

0
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

Long-term Treasury Bonds

30
Frequency

20

10

0
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

Large Stocks
10
Frequency

0
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

Small stocks
10
Frequency

0
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100

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Historical risk-return trade-off

20.000

18.000
Small stocks
16.000

14.000
Historical average return

12.000
S&P 500

10.000
World stocks
8.000

6.000 World Bonds

Treasury Bonds
4.000 Treasury Bills
Inflation
2.000

0.000
0.000 5.000 10.000 15.000 20.000 25.000 30.000 35.000 40.000
Standard Deviation

FROM HISTORICAL DATA TO EXPECTED

RETURNS

„ Where do we come up with expected returns?

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HISTORICAL AVERAGE RETURNS

„ Theidea is if expected returns are constant over time, long-

run average realized returns is a good estimate of expected
future returns.
„ Should you think twice before using historical returns as
forecasts of future returns?
„ YES! Why?

HISTORICAL AVERAGE RETURNS

„ Any sample period may be biased.

„ Longerhistorical window reduce sample specificity and give
more accurate estimates
„ Wouldyou want to include data from 1600s even if good quality
data were available to us?
„ Expected returns may vary in cyclical fashion.
„ Forspecific funds and strategies, historical performance is
often upward biased: Voluntary reporting or survivorship
bias. Same point with simulated ‘paper’ portfolios that ignore
trading costs.

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SUMMARY

„ Investors face a risk-return trade-off.

„ Riskier investments have on average had higher
returns.
„ Bevery careful on using historical data to come up
with forecasts of expected returns.