Introduction to risk, return, and the opportunity cost of capital

So, don't ask me no questions And I won't tell you no lies So, don't ask me about my business And I won't tell you goodbye - Rossington, VanZant

Stock market indexes

DOW JONES INDUSTRIAL AVERAGE (The Dow) Value of a portfolio holding one share

in each of 30 large industrial firms.

STANDARD

& POOR'S COMPOSITE INDEX (The S&P 500)

Value of a portfolio holding shares in 500 major firms. Holdings are proportional to the number of shares in issue.

Stocks, Bonds, Bills, and Ending Average Wealth Return Inflation 1925 - 2009
$100,000.00
$10,000.00 $1,000.00 $100.00 $10.00 $1.00

$12,233 $2,587 $84.39 $20.53 $12.14

Large Company Stocks Small Company Stocks Government Bonds Treasury Bills Inflation

$0.10

Hypothetical value of $1 invested at year-end 1925. Assumes reinvestment of income and no transaction costs or taxes This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. 3/1/2010. Copyright 2010 Ibbotson Associates, Inc.

Volatility of Stock and Bond Returns

1926 - 2006
Stocks 50% 40% 50% 40% Bonds

30%
Monthly Returns

30% 20%
10% 0% -10% -20% -30% 1946 1966 -40% 1986 2006 1926 1946 1966 1986 2006

20%
10% 0% -10% -20% -30% -40% 1926

Monthly returns in percent from 1926-2006. This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. 3/1/2006. Copyright 2006 Ibbotson Associates, Inc. .

Rates of Return 1926-2009

60

Percentage Return

40

20 0 -20
-40
Common Stocks Long T-Bonds T-Bills

-60

Source: Ibbotson Associates

Year

Stocks, Bonds, Bills, and Inflation

Summary Statistics 1926 - 2009
Compound Annual Return Large Company Stocks Small Company Stocks Government Bonds 9.66% Arithmetic Annual Return 11.8% Risk (Standard Deviation) 20.5% Distribution of Annual Returns

11.7%

16.5%

33.0%

*
5.7% 6.1% 9.4%

Treasury Bills Inflation

3.7%
2.9%

3.8%
3.1%

3.1%
4.2%

*The 1933 Small Company Stock total return was 142.9%. This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. 3/1/2010. Copyright 2010 Ibbotson Associates, Inc.

Large Company Stocks Histogram 1926-2009

Source: Ibbotson Associates 2010

Risk Premiums 1926-2009

Portfolio
Small-firm stocks Common stocks (S&P 500) Long-term govt bonds Treasury bills Average Risk Premium 12.24% 7.71 2.22

Average Market Risk Premia (by country)

Risk premium, %

Country

Expected return on market portfolio (= expected return on average-risk US stock)

current expected rm = interest + market risk rate (rf) premium If expected risk premium = long-run average* rm = interest rate (rf) + 7.71%*

* Note: This can change a little bit from year to year.

Risk and Return

Expected Return
Prefer more to less.

Variance and Standard Deviation (Risk)

Prefer less to more.

Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation square root of variance.

Calculating standard deviation of returns

Year Rate of return Deviation from average Squared deviation

1988
1989 1990

16.8
31.5 - 3.2

.1
14.8 -19.9

.01
219.04 396.01

1991
1992 Total

30.6
7.7 83.4

13.9
- 9.0

193.21
81.0 889.27

Average rate of return = 83.4/5 = 16.68 = 16.7 Variance = average of squared deviations = 889.27/5 = 177.854

Std deviation = square root of variance =

177.854

= 13.34%

Calculating variance and standard deviation of Merck returns from past monthly data
Month 1 2 3 4 5 6 Total Mean: Variance: Std dev: Return 5.4% 1.7 - 3.6 13.6 - 3.5 3.2 16.8 16.8/6 = 2.8% 205.41/6 = 34.235 Sq root of 34.235 = 5.85% per month Deviation from mean return 2.6% - 1.1 - 6.4 10.8 - 6.3 0.4 Squared deviation 6.76 1.21 40.96 116.64 39.69 0.16 205.41

Total risk (standard deviation) for common stocks, 1989 - 1994

Stock AT&T Biogen Standard deviation 21.4% 51.5 Stock Exxon Ford Motor Standard deviation 12.1% 28.0

Bristol-Myers Squibb
Coca Cola

18.6
21.6

General Electric
McDonalds

19.6
21.7

Compaq

43.5

Microsoft

53.6

Risk and Diversification

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called diversifiable risk. Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk.

Diversification eliminates unique risk

Portfolio standard deviation Unique risk

Market risk

10

Number of securities

Reduction of Portfolio Risk

40%
35% 30% 25% Risk

20% 15%
10% 5% 0% 1 2 3 4 5 6 7 8

Number of Randomly Selected Assets in Portfolio

Risk is measured by standard deviation. This is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. 3/1/2000. Copyright 2000 Ibbotson Associates, Inc.

Stock Diversification
Diversifiable Risk Market Risk

Risk 1

6 8 16 30 Number of Stocks in Portfolio

50

100

1000

This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2000. Copyright 2000 Ibbotson Associates, Inc.

Where do Diversification Benefits Come from?

Concepts of Correlation and Covariance Expected Return on portfolio

Standard Deviation of Portfolio Returns

Portfolio Risk and Return

Expected Portfolio Return (x 1 r1 ) ( x 2 r2 )

2 2 Portfolio Variance x 1 1 x 2 2 2( x 1x 2 12 1 2 ) 2 2

Portfolio Return
Example Suppose you invest 60% of your portfolio in WalMart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The expected return on your portfolio is:

Expected Return (.60 10) (.40 15) 12%

Example

Portfolio Risk

Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance.

Portfolio Variance [(.60)2 x(19.8)2 ] [(.40)2 x(29.7)2 ] 2(.40x.60x 19.8x29.7) 564.5 Standard Deviation 564.5 23.8 %

To calculate portfolio variance add up the boxes

The shaded boxes contain variance terms; the remainder contain covariance terms.
1

2
3 4

STOCK

5
6

N
1 2 3 4 5 6 STOCK N

Beta and Unique Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. How can we measure exposure to market risk? Beta - Sensitivity of a stocks return to the return on the market portfolio. Beta is a measure of sensitivity to market movements.

Beta Computation
im Bi 2 m
Covariance with the market

Variance of the market

Beta
Calculating the variance of the market returns and the covariance between the returns on the market and those of Anchovy Queen. Beta is the ratio of the variance to the covariance (i.e., = im/m2) (1) (2) (3) (4) (5) (6) (7) Product of deviations from average returns (cols 4 x 5) 130 12 170 120 0 24 456

Month 1 2 3 4 5 6 Average

Deviation Market Anchovy Q from average return return market return -8% -11% -10% 4 8 2 12 19 10 -6 -13 -8 2 3 0 8 6 6 2 2 Variance = m 2

Deviation Squared from average deviation Anchovy Q from average return market return -13% 100 6 4 17 100 -15 64 1 0 4 36 Total 304 = 304/6 = 50.67

Covariance = im = 736/6 = 76 Beta () = im /m 2 = 76/50.67 = 1.5

Market risk (beta) for common stocks 1994

Stock

Beta

Stock

Beta

AT&T Biogen Bristol Myers Squibb Coca Cola Compaq

.92 2.20 .97 1.12 1.18

Exxon .51 Ford Motor Co. 1.12 General Electric 1.22 McDonalds 1.07 Microsoft 1.23

Market risk (beta) for common stocks 2010*

Stock Beta Stock Beta

AT&T Biogen Bristol Myers Squibb Coca Cola Hewlett-Packard

.63 .68 .59 .51 1.03

Exxon Ford Motor Co. General Electric McDonalds Microsoft

.39 2.79 1.72 .52 1.06

* Source: Finance.yahoo.com, which is based on 36 months of data and S&P500 as market index.

Firm Goals to Diversify?

Since diversification reduces risk, should firms be concerned about diversification?
Investors may diversify more easily. Value Additivity