RETURN, RISK AND SML

1/8/2015

PGP Term 2

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%.
1/8/2015

PGP Term 2

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.

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PGP Term 2

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

Firm Y
-70

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15

Expected Rate
of Return
PGP Term
2

100

Rate of
Return (%)

Selected Realized Returns,

1926 2004
Small-company stocks
Large-company stocks
L-T corporate bonds
L-T government bonds
U.S. Treasury bills

Average Standard
Return Deviation
17.5%
33.1%
12.4
20.3
6.2
8.6
5.8
9.3
3.8
3.1

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

2005 Yearbook (Chicago: Ibbotson Associates, 2005), p28.
1/8/2015

PGP Term 2

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.

1/8/2015

PGP Term 2

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.
Scenario
Recession
Normal
Boom
1/8/2015

Rate of Return
Probability Stock Fund Bond Fund
33.3%
-7%
17%
33.3%
12%
7%
33.3%
28%
-3%
PGP Term 2

Expected Return

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

1/8/2015

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

PGP Term 2

Bond
Rate of
Return
17%
7%
-3%
7.00%
0.0067
8.2%

Fund
Squared
Deviation
0.0100
0.0000
0.0100

Expected Return

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

E (rS ) 1 (7%) 1 (12%) 1 (28%)

3
3
3
E1/8/2015
(rS ) 11%
PGP Term 2
9

Variance
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

(7% 11%) .0324

2

1/8/2015

PGP Term 2

10

Variance
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

1
.0205 (.0324 .0001 .0289)
3
1/8/2015

PGP Term 2

11

Standard Deviation
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
8.2%

14.3% 0.0205
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PGP Term 2

12

Covariance
Scenario
Recession
Normal
Boom
Sum
Covariance

Stock
Bond
Deviation Deviation
-18%
10%
1%
0%
17%
-10%

Product
-0.0180
0.0000
-0.0170

Weighted
-0.0060
0.0000
-0.0057
-0.0117
-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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PGP Term 2

13

Correlation

Cov(a, b)

a b

.0117

0.998
(.143)(.082)

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PGP Term 2

14

The Return and Risk for Portfolios

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Stock Fund
Rate of
Squared
Return Deviation
-7%
0.0324
12%
0.0001
28%
0.0289
11.00%
0.0205
14.3%

Bond Fund
Rate of
Squared
Return Deviation
17%
0.0100
7%
0.0000
-3%
0.0100
7.00%
0.0067
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.
1/8/2015
PGP Term 2

15

Portfolios
Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

9.0%
0.0010
3.08%

The rate of return on the portfolio is a weighted average of

the returns on the stocks and bonds in the portfolio:

1/8/2015

rP wB rB wS rS
5% 50% (7%) 50% (17%)
PGP Term 2

16

Portfolios
Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%

Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

9.0%
0.0010
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 ) wB E (rB ) wS E (rS )

1/8/2015

9% 50% (11%) 50% (7%)

PGP Term 2

17

Portfolios
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%
11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

9.0%
0.0010
3.08%

The variance of the rate of return on the two risky assets

portfolio is

P2 (wB B )2 (wS S )2 2(wB B )(wS S ) BS

where BS is the correlation coefficient between the returns
on the stock and bond funds.
1/8/2015
PGP Term 2
18

Portfolios
Scenario
Recession
Normal
Boom
Expected return
Variance
Standard Deviation

Rate of Return
Stock fund Bond fund Portfolio
-7%
17%
5.0%
12%
7%
9.5%
28%
-3%
12.5%
11.00%
0.0205
14.31%

7.00%
0.0067
8.16%

squared deviation
0.0016
0.0000
0.0012

9.0%
0.0010
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.
1/8/2015
PGP Term 2

19

% in stocks
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50.00%
55%
60%
65%
70%
75%
80%
85%
90%
1/8/2015
95%
100%

Risk

Return

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.08%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.00%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolio Return

The Efficient Set

Portfolo Risk and Return Combinations
100%
stocks

12.0%
11.0%
10.0%
9.0%
8.0%

100%
bonds

7.0%
6.0%
5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

We can consider other

portfolio weights besides
50% in stocks and 50% in
PGP Term
bonds
2

20

% in stocks
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
1/8/2015
95%
100%

Risk

Return

8.2%
7.0%
5.9%
4.8%
3.7%
2.6%
1.4%
0.4%
0.9%
2.0%
3.1%
4.2%
5.3%
6.4%
7.6%
8.7%
9.8%
10.9%
12.1%
13.2%
14.3%

7.0%
7.2%
7.4%
7.6%
7.8%
8.0%
8.2%
8.4%
8.6%
8.8%
9.0%
9.2%
9.4%
9.6%
9.8%
10.0%
10.2%
10.4%
10.6%
10.8%
11.0%

Portfolio Return

The Efficient Set

Portfolo Risk and Return Combinations
12.0%
11.0%
10.0%

100%
stocks

9.0%
8.0%
7.0%
6.0%

100%
bonds

5.0%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0%

Portfolio Risk (standard deviation)

Note that some portfolios are

better than others. They have
higher returns for the same level of
PGP
risk
Term or
2 less.
21

Portfolios with Various Correlations

return

100%
stocks

= -1.0

100%
bonds

= 1.0
= 0.2

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PGP Term 2

Relationship depends
on correlation
coefficient
-1.0 < < +1.0
If = +1.0, no risk
reduction is possible
If = 1.0, complete
risk reduction is
possible

22

return

The Efficient Set for Many Securities

Individual Assets

Consider a world with many risky assets; we can

still identify the opportunity set of risk-return
combinations
of variousPGPportfolios.
1/8/2015
Term 2
23

return

The Efficient Set for Many Securities

minimum
variance
portfolio
Individual Assets

The section of the opportunity set above the

minimum variance portfolio is the efficient frontier.
1/8/2015

PGP Term 2

24

return

Optimal Portfolio with a Risk-Free

Asset
100%
stocks

rf
100%
bonds

In addition to stocks and bonds, consider a world

that also has risk-free
securities like T-bills. 25
1/8/2015
PGP Term 2

return

Riskless Borrowing and Lending

100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across the Tbills and a balanced mutual fund.
1/8/2015

PGP Term 2

26

return

Riskless Borrowing and Lending

rf

With a risk-free asset available and the efficient

frontier identified, we choose the capital allocation line
with
the
steepest
slope.
1/8/2015
PGP Term 2
27