Part IV – Risk and Returns
Stated in another
Chapter 8 lays the groundwork, defining the terms
risk and return and explaining why investors think
about risk in different ways depending on whether
they want to understand the risk of a specific
investment or the risk of a broad portfolio of
investments. Perhaps the most famous and widely
applied theory in all of finance, the Capital Asset
Pricing Model (or CAPM), is introduced here. The
CAPM tells investors and managers alike what
return they should expect given the risk of the asset
they want to invest in.
Risk and Return Fundamentals
In most important business decisions there are two
key financial considerations: risk and return.
Analysts use different methods to quantify risk,
depending on whether they are looking at a single
asset or a portfolio – a collection, or group, of assets.
WHAT IS RISK?
In the most basic sense, risk is a measure of the
uncertainty surrounding the return that an
investment will earn. The term risk is used
interchangeably with uncertainty to refer to the
variability of returns associated with a given asset.
WHAT IS RETURN?
The total rate of return is the total gain or loss
experienced on an investment over a given period.
Mathematically shown:
where
In most cases, t is 1 year, and r therefore represents
an annual rate of return.
Risk Preferences
Different people react to risk in different ways.
Economists use three (3) categories to describe how
investors respond to risk:
1. Risk-averse – is an investor who prefers less
risky over more risky investments, holding
the rate of return fixed.
way, a risk-averse investor will not make the
riskier investment unless it offers a higher
expected return to compensate the investor
for bearing the additional risk.
2. Risk neutral – chooses investments based
solely on expected returns, disregarding the
risks. A risk neutral investor will always
choose the investment with the higher
expected return regardless of its risk.
3. Risk-seeking – is one who prefers
investments with higher risk and may even
sacrifice some expected return when
choosing a riskier investment. An example of
this are people who join the lottery.
RISK OF A SINGLE ASSET
Here we examine the different statistical methods to
quantify risk, and next we apply those methods to
portfolios.
Risk Assessment
The notion that risk is somehow connected to
uncertainty is intuitive. Scenario analysis provides a
simple way to quantify that intuition, and probability
distributions offer an even more sophisticated way to
analyze the risk of an investment.
Scenario Analysis
Scenario analysis uses several possible alternative
outcomes (scenarios) to obtain a sense of variability
of returns. One common method involves
considering pessimistic (worst), most likely
(expected), and optimistic (best) outcomes and
returns associated with them for a given asset.
The range can be found by subtracting the return
associated with the pessimistic outcome from the
return associated with the optimistic outcome. The
greater the range, the more risk the asset has.
Probability Distributions
The probability of a given outcome is its chance of
occurring. A probability distribution is a model that
relates probabilities to the associated outcomes. The
simplest type of this is called the bar chart.
If we knew all the possible outcomes, which may be
infinite, we could develop a continuous probability
distribution.
Risk Measurement
The risk of an asset can be measured quantitatively
by using statistics, the most common of which is
standard deviation.
Standard Deviation
The standard deviation measures the dispersion of
an investment’s return around the expected return.
The expected return, r(bar), is the average return
that an investment is expected to produce over time.
The expression for standard deviation of returns is
In general, the higher the standard deviation, the
greater the risk.
Normal Distribution
A normal probability distribution resembles a
symmetrical “bell-shaped” curve. The symmetry of
the curves mean that half the probability is
associated with the values to the left of the peak and
half with the values to the right.
Coefficient of Variation – Trading off Risk and
Return
The coefficient of variation, CV, is a measure of
relative dispersion that is useful in comparing the
risks of assets with differing expected returns.
A higher coefficient of variation means that an
investment has more volatility related to its expected
return. The lower the coefficient of variation is, the
higher the expected return and the lesser the risk.
RISK OF A PORTFOLIO
New investments must be considered in light of their
impact on the risk and return of an investor’s portfolio
of assets. The goal is to create an efficient portfolio,
one that provides the maximum return for a given
level of risk. As part of the analysis, we will look at
the statistical concept or correlation, which underlies
the process of diversification that is used to develop
an efficient portfolio.
Portfolio of Return and Standard Deviation
The return of portfolio is a weighted average of the
returns on the individual assets from which it is
formed.
Correlation
Correlation is a statistical measure of the
relationship between any two series of numbers. If
two series tend to vary in the same direction, they
are positively correlated. If the series vary in
opposite directions, they are negatively correlated.
The degree of correlation is measured using the
correlation coefficient, which ranges from +1 for
perfectly correlated series to -1 for perfectly
negatively correlated series.
Diversification
To reduce overall risk, it is best to diversify by
combining, or adding to the portfolio, assets that
have the lowest possible correlation.
Some assets are uncorrelated – that is, there is no
interaction between their returns. Combining
uncorrelated assets can reduce risk, not as
effectively as combining negatively correlated
assets but more effectively than combining positively
correlated assets.
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