Chapter 1: A brief history of risk and return.

- If you buy an asset of any time, your gain or loss from that investment is the return on your investment.
- PV of a growing annuity:
periods of number n
period per rate growth g
period per return of rate r
payment first
1
1
1
=
=
=
=
(
(
(

=
|
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+
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P
g r
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PV
r
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- Total Dollar Return: The return on an investment measured in dollars that accounts for all cash flows and capital gains
or losses. = Dividend Income + Capital Gain (or loss). Total dollar return = ($1.40 x 40shs) + 40($49 $35). Total
dollar return = $56 + $560 = $616.
- Dividend Yield: The annual stock dividend as a percentage of the initial stock price. {Dividend Income/Org Stock Price}.
Dividend yield = $1.40 / $35 = 4%.
- Capital Gains Yield: The change in stock price as a percentage of the initial stock price. {(Ending stock price
Beginning Stock Price) / Beginning Stock Price}. Capital gain yield = ($49

$35) / $35 = 40%.

- Total Percent Return: The ROI measured as a % that accounts for all cash flows & capital gains or losses. = Dividend
Yield + Capital Gains Yield. OR (Gain orig investment) / orig investment. Total percentage return = 4% + 40% = 44%
- Effective Annual Return (EAR): The ROI expressed on a per-year or annualized basis.:::: 1+EAR=(1+Holding
Period Percentage Return)M (thats to the M power). ------ 1 + EAR = (1 + HPR)
m
-----

m = the number of holding
periods in a year.---In this example, m = 1.5 (12 months / 8 months). Therefore: 1 + EAR = (1 + .44)
1.5
= 1.7280. -----
EAR = (1.7280) 1. ------So, EAR = .7280 or 72.80%.
- Historical Average Return:
n
return yearly
Return Average Historical
n
1 i

=
=
- Large company Stock Stock portfolio based on the S&P 500 index, which has 500 of the largest company in US.
- Small Company Stock Corresponds to the smallest 20% of the companies listed on the NYSE.
- Long term corporate bond- Portfolio of high quality bonds with 20 years to mature.
- Long term US government bonds: Portfolio of US government Bonds with 20 years to maturity.
- US Treasury Bills: Portfolio of Treasury Bills (T-Bills) with a 3 month maturity.
- Total Market Capitalization (CAP): equal to its stock price multiplied by the number of shares of stock.
- Risk Free Rate The rate of return on a riskless investment.
- Risk Premium The extra return on a risky asset over the risk free rate; the reward for bearing risk.
- Variance: A common measure of volatility or return dispersion. Sometimes, return dispersion is also call variability.
- Standard Deviation: The square root of the variance. Sometimes the square root is called volatility
- Var: = The sum of the squared deviations but the number of returns less 1 = .027/(4-1)=.009
- Standard Deviation: SD = Square Root of Variance or .009 = .09487
- Normal Distribution: A symmetric, bell shaped frequency distribution that is completely defined by its avg & STD
- Geometric Average Return: the average compound return earned per year over a multiyear period.
- Arithmetic Average Return: The return earned in a average year over a multiyear period.
- Calculating the geometric average return: for numbers 10%, 12%, 3%, -9%. = (1.10 x 1.12 x 1.03 x .91) raised to
the power 1.
o Take each of the N annual return and add a 1 to each after converting to decimal.
o Multiple all the numbers from step 1 together.
o Take the result from step 2 and raise it to the 1/N power where N is number of components.
o Finally, subtract 1 from the result in 3.
Also you can use this formula: (Ending Compound dollar amount)/(Beginning amount
invested)^(1/N) 1
- Which one to use?: The geometric average tells you what you actually earned per year on average compounded
annually. The arithmetic average tells you what you earned in a typically year.
- Blumes Formula: A formula used to combine the two averages. R(T)= (T-1)/(N-1) * Geometric average + (N-T)/(N-1)
* Arithmetic average. On this, T is the number of years in the future we are forecasting for. N is observation period
o return arithmetic
1 - N
T - N
return geometric
1
1
) ( +

=
N
T
T R
o % 76 . 10 % 7 . 11
1 - 84
40 - 84
% 7 . 9
1 84
1 40
) ( = +

= T R
- If They say Average Return they are meaning Arithmetic average unless stated otherwise:
- Dollar Weighted Average Return: average compound rate of return earned per year over a multiyear period
accounting for investment inflows, and outflows. Use the IRR function in excel for this type of problem.
o Example: So we invest $1000 at the start and get a 10% return. The next year we invest $4000 and get a
return in year 2 of -5%. What was the net return? So the 1
st
year we had 1000 and a 10% return so we have
$1100. The next year we add $4000 to is, so we have $5100 but then we have a -5% return which gives us an
ending total of $4845. So we map out our cash flow each year in order to find the Dollar weighted average
return. Year 0: -1000, Year 1: -4000, Year 2: $4845. = IRR of -2.6%.
o IRR: Internal rate of return. On the calculator, go to Apps, Finance, #8. Enter it like this IRR=(-1000, {-4000,
4845}). = -2.59%.



1) Risky assets, on average, earn a risk premium. Or there is a reward, on average, for bearing risk.
2) The greater the potential reward, the greater is the risk.
3) Invest as Early as Possible