HISTORICAL RETURNS

Method for calculating returns 1. Dollar Return: includes capital gain or loss as well as income (2 cash streams are expected) a. Formula: Capital gain or loss + Income = (Ending value Beginning value ) + Income b. Clicker Q: this includes the total dollar amount of any capital gain (or loss) that occurred as well as any income that you received from a specific investment 2. Percentage Return: returns across diff. investments are more easily compared because theyre standardized (tells you if return is good or bad) & can be used for most types of investments a. Formula: Percentage Return= (End value Beginning value + Income) (Beginning value) X 100%

Assessment method for investment returns good, average, or bad Says historical returns are helpful to predict future returns but past performance isnt necessarily indication of future returns

HISTORICAL RISKS
1. Computing Volatility (good measure if looking at historical return) a. Can quantify risk- high degree of variability (volatility) in historical returns means high degree of future uncertainty b. Volatility has a large bearing using Standard Deviation to help understand stocks future reaction i. Clicker Q: This is the measure of the past volatility/risk of an investment, which includes firm specific & market risk ii. The larger the SD, higher the risk Risk of Asset Classes a. Stocks are more volatile than bonds or T-bills Risk vs. Return a. With any investment, theres riskreturn tradeoff which the Coefficient of Variation (CoV) relatively measures i. CoV tells us in relationship to this risk/reward scenario, how much extra reward do we need in return for taking this risk? ii. The higher the risk, the higher the return we require iii. Amount of risk (measured by volatility) per unit of return iv. As an investor, you want to receive a very high return (denominator) with a very low risk (numerator) a smaller CoV indicates a better risk-reward relationship

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FORMING PORTFOLIOS
1. 2. Portfolio : a combination of investment assets held by an investor to reduce risk a. Formed to reduce risk & maximize returns (in relation to risk) Diversifying to Reduce Risk a. Firm-specific risk (micro-econ) referred to as Diversifiable risk, particular to 1 firm i. Poor sales/earnings in a quarter b. Market risk (macro-econ) attributable to overall economic factors; non-diversifiable i. If interest rates rise, this effects ALL firms ii. Formula: Total Risk= Firm-Specific risk + Market risk Modern Portfolio Theory (risks reduced when securities are combines in a portfolio) a. Efficient portfolio is the combo of securities that produce the highest return for the amount of risk taken b. Optimal portfolio is the best portfolio of securities for the investors level of risk aversion c. Dominant Portfolio : higher expected return for the same (or less) risk, or the same (higher) expected return with lower risk

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