Security Analysis & Portfolio Management

Risk & Return

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 Recommended Texts
1. Security Analysis & Portfolio Management – 2nd Edition –
by: Punithavathy Pandian, Vikas Publishing House Pvt.
Ltd.
2. Investment Analysis & Portfolio Management – 4th Edition
– by: Prassanna Chandra – CFM Tata McGraw-Hill
professional Series in Finance.
3. Security Analysis & Portfolio Management – 6th Edition –
by: Fischer & Jordan, Pearson Education.
4. Investments – Principles & Concepts – 11th Edition –
by: Jones, John Wiley Publishing company

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 Security Analysis
• A three-step process
1) The analyst considers prospects for the economy,
given the state of the business cycle
2) The analyst determines which industries are likely to
fare well in the forecasted economic conditions
3) The analyst chooses particular companies within the
favored industries
– EIC analysis (a top-down approach)

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 Portfolio Management
• Literature supports the efficient markets
hypothesis
– On a well-developed securities exchange, asset prices
accurately reflect the tradeoff between relative risk
and potential returns of a security.
• Market efficiency and portfolio management
– A properly constructed portfolio achieves a given level
of expected return with the least possible risk
• Portfolio managers have a duty to create the best possible
collection of investments for each customer’s unique needs
and circumstances -Diversification is the key.
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 Individual Securities
• The characteristics of individual securities that are
of interest are the:
– Expected Return
– Variance and Standard Deviation
– Covariance and Correlation

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Basics of Risk & Return

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 Return on a Single Asset
• Return on an asset/ investment for a given period, say a
year, refers to the actual annual income received plus any
change in the market price, usually expressed as a % of
the opening market price.

• Total return = Dividend + Capital gain

• Rate of return = Dividend Yield + Capital gain yield

𝐷𝐼𝑉1 𝑃1 −𝑃0 𝐷𝐼𝑉1 +(𝑃1 −𝑃0 )

• 𝑅1 = + =
𝑃0 𝑃0 𝑃0

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 Example
• If the price of a share on April 1 (beginning) is Rs.25,
annual dividend received at the end of the year is Re.1 &
the year-end price on March 31 is Rs.30; the rate of return
is:
• [1 + (30 – 25)]÷ 25 = 24%;

• where Dividend Yield (Annual Income ÷ Beginning Price) is

[1 ÷ 25] = 0.04 or 4% & Capital Gains/ loss Yield [(Ending
Price – Beginning Price)÷ Beginning Price] is [(30 –
25)÷25] = 0.20 or 20%.

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 Expected Return
• The expected rate of return on a stock represents the mean of a
probability distribution of possible future returns on the stock.
E[r] =S (piri)
i=1

• The table below provides a probability distribution for the returns on stocks A and B
• State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%

• The state represents the state of the economy one period in the future i.e. state 1
could represent a recession and state 2 a growth economy.

• The probability reflects how likely it is that the state will occur. The sum of the
probabilities must equal 100%.
• For Stock A -12.5% & For Stock B -20%
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 Little More about Return
• Return Relative: The rate of return stated relative to
one unit: (return/100 + 1). For example, a return of
32% has a return relative of 1.32 (32/100 + 1)

• This is required in the computation of Cumulative

Wealth Index or a Geometric mean as in such
computations, negative returns can not be used.

• Even though the total return is negative, the ‘return

relative’ cannot be negative – at worst, it is zero.
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 Little More about Return
• The Cumulative Wealth Index captures the cumulative effect of
total returns & is calculated as:
• CWIn= WI0(1+R1)(1+R2) ……………(1+Rn)

• WI0 = the beginning index value, which is typically one rupee; &
Ri = total return for year i ( i= 1,2,3….n)

• If a stock earns the following returns for 5 years period i.e.

R1=0.14, R2=0.12, R3= -0.08, R4=0.25, R5=0.02; the CWI at the
end of 5 year period, assuming a beginning index value of one
rupee is = 1(1.14) (1.12) (0.92) (1.25) (1.02) = 1.498

𝑪𝑾𝑰𝒏
• Total return thus, will be 𝑹𝒏 = -1
𝑪𝑾𝑰𝒏−𝟏

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 Real Return
• The nominal/ money returns can be converted to Real
Returns by making an adjustment to the factor of
Inflation i.e. [(1 + Nominal Return) ÷ (1 + Inflation
Rate)] - 1

• If the total return for an equity stock during a year was

18.5% & the rate of inflation was 5.5%, the real
(inflation adjusted) total return was:

• (1.185 ÷ 1.055) – 1 = 0.123 or 12.3%

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 Summary statistics to measure Return
• Two commonly used summary statistics are the arithmetic mean &
geometric mean
σ𝒏
𝒊=𝟏 𝑹𝒊
ഥ=
• Arithmetic Mean = 𝑹
𝒏

• Geometric Mean is the nth root of the product resulting from

multiplying a series of return relatives minus 1.
• GM = [(1+R1)(1+R2)……………(1+Rn)]1/n – 1

• The GM is always less than the AM, except when all the return
values being considered are equal. The difference between GM &
AM depends on the variability of distribution – the greater the
variability, the greater is the difference.
• Relationship = (1 + GM)2 ≈ (1 + AM)2 – (SD)2
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 What is Risk?
• A risky situation is one which • Types of Risk
has some probability of loss – Default Risk
• The higher the probability of – Credit Risk
loss, the greater the risk – Purchasing Power Risk
• If there is no possibility of loss, – Interest Rate Risk
there is no risk – Systematic (Market) Risk
• The riskiness of an investment – Unsystematic Risk
can be judged by describing – Event Risk
the probability distribution of its – Liquidity Risk
possible returns – Foreign Exchange (FX)
Risk

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 What is investment risk?
1. Typically, investment returns are not known with
certainty.
2. Investment risk pertains to the probability of earning a
return less than that expected.
3. The greater the chance of a return far below the
expected return, the greater the risk.
4. One way to measure risk is to calculate the variance
and standard deviation of the distribution of returns.

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 Probability Distributions
• A probability distribution is
simply a listing of the
probabilities and their
associated outcomes
Potential Outcomes

• Probability distributions are

often presented graphically
as in these examples
Potential Outcomes

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 Normal Distribution Curve
– A normal distribution curve is symmetrical, bell-shaped curve
defined by the mean and standard deviation of a data set. The
normal curve is a probability distribution with a total area under the
curve of 1.
• Classified by 2 parameters: Mean (µ) and standard deviation (σ).
These represent location and spread.
• Random variables that are approximately normal have the following
properties wrt individual measurements:
– Approximately half (50%) fall above (and below) mean
– Approximately 68% fall within 1 standard deviation of mean
– Approximately 95% fall within 2 standard deviations of mean
– Virtually all (99.7%) fall within 3 standard deviations of mean
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 Normal Distribution Curve

One standard deviation away from the mean (µ) in either direction on
the horizontal axis accounts for around 68 %of the data. Two standard
deviations away from the mean accounts for roughly 95 % of the data
& with three standard deviations representing about 99.7 % of the
data.
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 Probability distribution

Stock X

Stock Y

Rate of
-20 0 15 50 return (%)
 Which stock is riskier? Why?
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 The Variance & Standard Deviation
• The variance and standard Less Risky
deviation describe the
dispersion (spread) of the Riskier

potential outcomes around

the expected value

  R 
N
2

• Greater dispersion  
2
R t t R
generally (not always!) t 1

means greater uncertainty

and therefore higher risk R   2R

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 Standard Deviation (σ)
• Standard Deviation, σ, is a statistical measure of the variability of
a distribution around its mean.
σ𝑛
𝑖=1(𝑅𝑖 − 𝑅)
2
• (For Historical Return) σ =
(𝑛−1)
• The standard deviation calculated for historical returns with a
divisor of (n-1) is a standard deviation calculated from the sample
as an estimate of the standard deviation of the population from
which the sample was drawn.

• (For Expected Return) σ = σ𝑛𝑖=1(𝑅𝑖 − 𝑅)2 𝑥 𝑃𝑟𝑖

• The greater the standard deviation of returns, the greater the
variability/ dispersion of returns & the greater the risk of asset/
investment.

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 Determining Standard Deviation
Period Ri Deviation (Ri - Av. Ri )2
Return in %
Ri - Av. Ri
1 7 3.6 12.96
2 3 -0.4 0.16
3 -9 -12.4 153.76
4 6 2.6 6.76
5 10 6.6 43.56
Av. Ri = 3.4 ∑ = 217.2
σ = (217.2 ÷ 4)1/2= 7.4%

Q. Compute the σ of two companies A & B as per the information given

below. Give your observations on the result:
Company A: Ri (%)= 6,7,8,9,10 and corresponding Pi (%)= 10, 25,30,25,10.
Company B: Ri (%)= 4,6,8,10,12 and corresponding Pi (%)= 10, 20,40,20,10.

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 Observations on Standard Deviation
• σ A = 1.14 and σ B = 2.149

•Though the expected returns are same for A & B, the variations
in expected returns are different (A’s expected return is stable in
comparison to B) – the σ helps in measuring the variability of
return (including both systematic & unsystematic risks)

•However, standard deviation is an absolute measure of

dispersion & does not consider variability of return in relation to
the expected value.

•It may be misleading in comparing the risk surrounding

alternative assets if they differ in size of expected returns.
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 Test your Understanding -1
• A stock earns the following returns over a five year period: R1 = 7 %
R2 = 3%, R3 = -9 %, R4 = 6 %, R5 = 10 %. Calculate the following:
• (a) arithmetic mean return,
• (b) cumulative wealth index, and
• (c) geometric mean return.
• (d) variance &
• (e) standard deviation

• (a) 3.4%; (b) 1.169; (c) 3.2%;

• (d) Variance – 54.3; (e)SD – 7.4

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 Test your Understanding-2
• The probability distribution of the rate of return on a stock is given
below:
State of Economy Probability Rate of Return
• Boom 0.40 25 %
• Normal 0.30 12 %
• Recession 0.30 -6 %
• What is the standard deviation of return?

• SD = 12.84

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 Test your Understanding-3
• An investor has analyzed a share for one-year holding
period. The share is currently selling for Rs.43 but pays
no dividends & there is fifty-fifty chance that the share
will be sold for either Rs.55 or Rs.60 by the year end.

• What is the expected return & risk if 250 shares are

acquired with 80% borrowed funds? Assume the cost
of borrowed funds to be 12%. (ignore commissions &
taxes).

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 Analysis
ഥ = {[(55-43) ÷ 43] x 0.50 } + {[(60-43) ÷ 43] x 0.50} =
• Mean Return = 𝑿
33.721

• Standard Deviation = σ = 5.81

• Computation of Return & Risk of buying 250 shares
• Investment in 250 shares = Rs.250 x 43 = Rs.10,750 of which borrowed fund
(80%) = Rs.8,600
• Expected return from 250 shares = 10, 750 x 33.72% = Rs.3624.90
• Less, Interest on borrowed fund = Rs.8,600 x 12% = Rs.1032
• So, Net Return = Rs.(3624. 90 – 1032) = Rs.2592.90
• Risk in investing in 250 shares = Rs.10,750 x 5.81% = Rs.624.58
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