Measuring Total (Stand-Alone) Risk:

The Standard Deviation

Risk the chance that some unfavorable event will occur.

Probability distribution a listing of all possible outcomes, or events, with a probability (chance of occurrence) assigned to each outcome.
^

Expected rate of return (k) the rate of return expected to be realized from the investment; the mean value of the probability distribution of possible results. k = P1k1 + P2k2 + . + Pnkn
n

= Piki
i=1

Standard Deviation A measure of the tightness, or variability, of a set of outcomes.

The symbol for which is , the Greek letter sigma

Example: Suppose the investor is trying to decide which investment is more beneficial considering the following probabilities:
Rate of Return on Stock if This State Occurs
State of Economy Boom Normal Recession Probability of This State Occurring 0.2 0.5 0.3 Martin Product 110% 22 (60) U.S. Electric 20% 16 10

1.0

Computation for Expected Rate of Return

Martin Products
k = 0.2(110%) + 0.5(22%) + 0.3(-60%) = 15% U.S. Electric
^

k = 0.2(20%) + 0.5(16%) + 0.3(10%) = 15%

The smaller the standard deviation, the tighter the probability distribution, and, accordingly, the lower the riskiness of the investment
Martin Product U.S. Electric

-60

15

110

Calculation of Standard Deviation

2.
Subtract the Expected Rate of Return from each possible outcomes* 1. 3. 4.

5.

6. Take the square root of the variance to obtain THE STANDARD DEVIATION

Calculate Multiply Square Sum the the the result products to each Expected by the Deviation get THE Rate of probability THE Return DEVIATION of occurrence VARIANCE

110% 22% -60%

15% 15% 15%

= = =

95%

9,025 x 0.2 = 1,805.0

7%
-75%

49

x 0.5 =

24.5

5,625 x 0.3 = ________ 1,687.5

3,517.0

59.3%

* Note: we are calculating the standard deviation of Martin Product

THE RISKIER
Using the same procedures, we find U.S. Electrics Standard Deviation to be 3.6% while that of Martin Product is 59.3%

The larger standard deviation indicates a greater variation of returns, thus a greater chance that the expected return will NOT be realized

The Coefficient of Variation

Standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return

The Coefficient of Variation shows the risk per unit of return, and it provides a more meaningful basis for comparison when the expected returns of two alternatives are NOT the same.

U.S. Electric Coefficient of = Variation Standard Deviation = 3.6% = 0.24 Expected Rate of Return 15%

Biobotics Coefficient of = Variation 7.5% = 0.21 35%

15

35

Rate of Return (%)

RISK AVERSION

Suppose you have $1million to invest, to which firm would you put your money, Martin Product with high risk or U.S. Electric with lesser risk?

YOU ARE A RISK AVERSE INVESTOR A risk averse investors require a higher rates of return to invest in higher risk securities. BUT! Risk Aversion affects security PRICES.

Martin Product
RISK

U.S. Electric
RISK

INVESTOR PRICE OF STOCK INVESTOR INVESTOR

INVESTOR INVESTOR INVESTOR

PRICE OF STOCK

IF INVESTORS ARE RISK AVERSE, THEY WOULD BUY STOCKS FROM LESS RISKY COMPANY.

Martin Product
RISK

U.S. Electric
RISK

PRICE OF STOCK

RATE OF RETURN

RATE OF RETURN

PRICE OF STOCK

THEN RATE OF RETURN WILL FALL

RISK PREMIUM

The portion of the expected return that can be attributed to the additional risk of an investment; it is the difference between the expected rate of return on a given risky asset and that on a less risk asset.

HOLDING COMBINATIONS OF ASSETS

PORTFOLIO is a collection of investment securities or assets.

PORTFOLIO RETURNS is simply the weighted average of the expected returns on the individual stocks in the portfolio.

EXAMPLE OF PORTFOLIO RETURNS

Investment Expected Return
8% 19% 16% 13% x x x x

AT&T General Electric Microsoft Citigroup

Investment Proportion = 2% = 4.75% = 4% = 3.25%

Expected Portfolio Return 14%

PORTFOLIO RISK

PORTFOLIOS RISK is usually smaller than the weighted average of the individual stocks standard deviation. In fact, it is theoretically possible to combine two stock that by themselves are quite risky as measured by their standard deviations and to form a portfolio that is completely riskless, or risk-free.

PORTFOLIO RISK
W CO. 40% 25% 15% 40% M CO.

25%
15%

0 02 05

0 -10%

01

05

-10%

CORRELATION COEFFICIENT A measure of the degree of relationship between two variables

Perfectly Negative Correlation returns moves in opposite direction Perfectly Positive Correlation returns moves in the same direction

DIVERSIFICATION REDUCES THE RISK

As a rule, the riskiness of a portfolio is reduced as the number of stocks in the portfolio increases. But the extent to which adding stocks to a portfolio reduces its risk depends on the degree of correlation among the stocks: The smaller the positive correlation coefficient, the greater the diversification effect of adding stock to a portfolio.

Firm Specific Risk versus Market Risk

Firm Specific Risk

That part of a securitys risk associated with random outcomes generated by events, or behaviors, specific to the firm; it can be eliminated by proper diversification

Market Risk

That part of a securitys risk that cannot be eliminated by diversification because it is associated with economic, or market, factors that systematically affect most firms

RELEVANT RISK

The risk of a security that cannot be diversified away, or its market (systematic) risk. This reflects a securitys contribution to the risk of a portfolio.