Risk and Return: Stocks

Realized Rates of Return

Three months ago, Peter Lynch purchased 100 shares of Iomega Corp. at $50 per share. Last month, he received dividends of $0.25 per share from Iomega. These shares are worth $56 each today.

Compute Peters realized return from his investment in Iomega common shares.

Dollar Returns
Total

amount invested $50(100) = $5,000 Total dividends received $0.25(100) = $25 Total proceeds from sale of stock $56 (100) = $5,600 Capital gain $5,600 $5,000 = $600

Dollar Returns
Total

Dollar Return = Dividends + Capital Gain (or Loss) = $25 + $600 = $625

Capital

gain is part of the total dollar return even if it is not yet realized.

Holding Period Return

The

Holding Period is defined as the length of time over which the assets percentage return is computed. Peter Lynchs case, the holding period is 3 months long.

In

Holding Period Return

The Holding Period Return (HPR) is defined as: Pt + D t Pt - 1 HPR t = Pt - 1

where Pt is the price at the end of period t, Pt 1 is the price at the end of period t 1, and Dt is the dividend received during period t.

Holding Period Return

In Peter Lynchs case, Pt 1 = $50 Pt = $56 Dt = $0.25 Pt + D t Pt - 1 HPR t = Pt - 1 $56 + $0 .25 - $50 = = 0.125 or 12 .50% $50

Holding Period Return

The total return of 12.50% consists of:
Dividend Yield = $0 .25 = 0.50% $50

and $56 - $50 = 12 .00% Capital Gains Yield = $50

APR and APY from HPR

In

Peter Lynchs case, the Annual Percentage Rate (APR) is 4 (12.50%) = 50.00% Annual Percentage Yield (APY) is (1.125)4 1 = 60.18%

The

Probability Concepts

Random variable Something whose value in the future is subject

to uncertainty.

Probability The relative likelihood of each possible

outcome (or value) of a random variable. Probabilities of individual outcomes cannot be negative nor greater than 1.0. Sum of the probabilities of all possible outcomes must equal 1.0.

Probability Concepts
Mean

The long run average of the random variable. Equals the expected value of the random
variable.
Variance

(and Standard Deviation)

Measure the dispersion in the possible

outcomes. Standard deviation is the square-root of the variance. Higher variance implies greater dispersion in the possible outcomes.

Probability Concepts

Covariance Measures how two random variables vary

together (or co-vary). Covariance can be negative, positive or zero. Its magnitude has no bounds.

Correlation Coefficient A standardized measure of co-variation

between two random variables. Always lies between -1.0 and +1.0.

Probability Concepts

Positive Covariance (or correlation) When one random variables outcome is above the Negative Covariance (or correlation) When one random variables outcome is above the
mean, the other is likely to be below its mean.

mean, the other is also likely to be above its mean.

Zero Covariance (or correlation) There is no relationship between the outcomes of the
two random variables.

Computing the Basic Statistics

A security analyst has prepared the following probability distribution of the possible returns on the common stock shares of two companies: Compu-Graphics Inc. (CGI) and Data Switch Corp. (DSC).

Probability Return on CGI 0.30 10% 0.50 14% 0.20 20%

Return on DSC 40% 16% 20%

The Mean
Let N represent the number of possible outcomes, pn represent the probability of the nth outcome, xn represent the value of the nth outcome. The mean of the distribution (mx) is computed as:

mx =

pn xn
n =1

The Mean
For CGI, the mean (or expected) return is: 3
m CGI =

pn xn

n =1

= 0.30 (10%) + 0.50 (14%) + 0.20 (20%) = 14 .00% Similarly, the mean return for DSC is 24.00%

The Variance and the Standard Deviation

The variance of the distribution of returns for the stock is computed as:

pn ( xn x )
2 n 1

Variance and Standard Deviation

The variance of the distribution of a random variable x is computed as:

pn ( xn x )
2 x n 1

The standard deviation is the square-root of the variance.

2 x

Variance and Standard Deviation

The variance of CGIs returns is:

2
2 CGI

pn ( xn x ) 2
n 1

0.30 (10 14) 0.50 (14 14) 0.20 (20 14) 12.00
2

The Variance and the Standard Deviation

The Standard Deviation of CGIs return is:

12.00 3.46%
Similarly, the variance of DSCs returns is 112.00, and its standard deviation is 10.58%

The Covariance
The Covariance of two random variables x and y is computed as:
Cov( X , Y ) pn ( xn x )( yn y )
n 1 N

The Covariance
The covariance of the returns on CGI and DSC is thus:

Cov(CGI , DSC ) x , y pn ( xn x )( yn y )
0.30 (10 14)( 40 24) 0.50 (14 14)(16 24) 0.20 (20 14)( 20 24) 24.00
n 1

The Correlation Coefficient

The Correlation Coefficient between the returns on two random variables (x and y) is computed as:
r

x.y y

x,y

The Correlation Coefficient

The correlation coefficient between CGI and DSC is thus:
r X ,Y
Cov( X , Y )

XY

r X ,Y

24.00 3.46 10.58

r X ,Y 0.655

Summary of Results for CGI and DSC

CGI Mean Standard Deviation Correlation Coefficient 14.00% 3.46% DSC 24.00% 10.58% -0.655

Summary of Results for CGI and DSC

The

mean return is a measure of the expected return from the security.

The expected return on DSC is 1.7 times higher than the expected return on CGI.

The

standard deviation is a measure of the specific risk of the security.

The specific risk of DSC is 3 times higher than the specific risk of CGI.

The

returns on DSC and CGI are negatively correlated.

Summary of Results for CGI and DSC

DSC has higher returns and higher risk than CGI. Without going further, the only recommendation that we have is a variation on the old Wall Street saying you can sleep well or eat well. As we will see in a minute, modern portfolio theory can add much more value.

Portfolios of Securities
A portfolio is a combination of two or more securities. Combining securities into a portfolio reduces risk. An efficient portfolio is one that has the highest expected return for a given level of risk. We will look at two-asset portfolios in fair detail. Our results will hold for n-asset portfolios.

Notation
Let

the return to asset i be Ri with expected return ri (i = 1,2). Let si represent the standard deviation of the returns on asset i (i = 1,2). Let rij represent the correlation coefficient between two assets i and j. Let wi represent the proportion invested in asset i (i = 1,2).

Portfolio Weights
Suppose

you have $600 to invest. You buy $400 worth of CGI stock and $200 worth of DSC stock. Let CGI be stock no. 1 and DSC be stock no. 2.
$400 $200 = 0.667 and w y = = 0.333 wx = $600 $600

Expected Return of the Portfolio

The portfolios expected return is:

rp w1r1 (1 w1 )r2
mx =

pn xn
n =1

Expected Return of the Portfolio

The expected return of the portfolio of CGI and DSC is:

2 1 rp 14% 24% 3 3

rp 17.33%

Portfolio Risk
The risk of the portfolio (as measured by its standard deviation) is: 2 2

2 p w1 1 (1 w1 ) 2 2 2w1 (1 w1 )Corr ( R1 , R2 ) 1 2

As you can see, p is not a simple weighted average of 1 and 2.

Portfolio Risk
The risk of the portfolio of $400 worth of CGI stock and $200 worth of DSC stock is:
p

2 3 3.46 13 10.58 22 3 13 (0.655)(3.46)(10.58)

2 2 2 2

p 2.67%

Diversification of Risk
Note that while the expected return of the portfolio is between those of CGI and DSC, its risk is less than either of the two individual securities. Combining CGI and DSC results in a substantial reduction of risk diversification! This benefit of diversification stems primarily from the fact that CGI and DSCs returns are negatively correlated.

Efficient Portfolios
A

portfolio is an efficient portfolio if

no other portfolio with the same expected return has lower risk, or no other portfolio with the same risk has a higher expected return.
Investors

prefer efficient portfolios over inefficient ones. The collection of efficient portfolio is called an efficient frontier.