DFA1035 Y Fundamentals of Finance and Practice

UNIT 13 RISK, RETURN AND PORTFOLIO THEORY

Unit Structure

13.0 Overview
13.1 Learning Outcomes
13.2 Factors in the choice of investment
13.3 Risky vs. Risk Free Investments
13.4 Return on an Investment
13.4.1 Components of return

13.4.2 Return on a share

13.4.3 Expected rate of return

13.5 Risk of an asset/ investment

13.6 How to choose between two individual investments?
13.7 Portfolio Theory
13.8 Expected rate of return of portfolio
13.9 Risk of a 2-asset Portfolio
13.9.1Covariance
13.9.2 Correlation Coefficient
13.9.3 Standard deviation of a 2-asset portfolio
13.9 Diversification
13.10 Minimum variance portfolio
13.11 Activities
13.12 Summary
13.13 Suggested Reading
13.14 Useful Links

13.0 OVERVIEW

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After having grasped the concept of present value to explain the valuation of bonds and shares in
the previous Units, we shall now explain how financial investment decisions are made. The
focus in this Unit will be on the two main determinants of investment decisions namely risk and
return and the relationship between them. This Unit also provides an insight on portfolio theory,
pioneered by Harry Markowitz, which explains how risk-averse investors construct diversified
portfolios to maximise or optimise expected return based on a given level of market risk,
emphasising that higher risk is an inherent part of higher rewards. Other basic concepts to which
you will be exposed include diversification, the efficient frontier, the Capital Market Line,
portfolio leveraging and the efficient portfolio

13.1 LEARNING OUTCOMES

By the end of this Unit, you should be able to:

1. Explain the concept return and risk and identify their respective measures.
2. Evaluate the expected return and risk on an individual investment under risky conditions.
3. Define portfolio theory.
4. Calculate the expected return and risk of a two-asset portfolio.
5. Describe how diversification is achieved.
6. Explain the impact of diversification on portfolio risks.
7. Explain the two types of risks namely systematic and unsystematic risks.

13.2 Factors in the Choice of Investments

Whether the investor is an institutional investor, i.e., a company making an investment or a
private individual investor, there are five major factors to be considered while choosing where to
invest? These include the following:

(a) Security- Investments should at least preserve their capital value.

(b) Liquidity – The investments should be convertible into cash at short notice especially
where the investments are made with short term funds.
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(c) Return- The funds are invested with the ultimate aim to increase its value at the end of
the investment period. In other words, the highest return compatible with safety should
be sought.

(d) Risks- The high return on an investment is not a sufficient requirement for an investor to
take an investment decision. The volatility in returns must also be considered. In fact the
return depends on the risk of the investment. The greater is the risk, the greater is the
required return. Furthermore, an investor who puts all his funds into one type of security
concentrates the investment risks such that everything depends on the fortunes of that
security. If the security performs badly, the investor’s entire investment will make a loss
.A better and more secure investment policy is to spread investments over several types
of securities so that losses on some may be offset by gains on others.

(e) Growth prospects. The most profitable investments are likely to be in businesses with
good growth prospects.

13.3 RISKY vs. RISK FREE INVESTMENTS

Knowing whether an investment is risk free or risky is important as it plays an important role in
the calculation of the return on the investment.

The return on risk free assets such as treasury bonds, bills and notes is known with certainty. If
Rs1000 are invested in Treasury Bills today and it is known with certainty that in 1 years’ time
Rs1100 will be obtained, the return on this type of investment is termed as a risk free return. In
other words, one can say that there is 100% probability of obtaining Rs1100 in 1 years’ time.

Example: Investment on Treasury Bills

Rs1000 p=1 Rs1100 (Final wealth known with certainty)

In the case of risky assets (e.g. stocks), the return is NOT known with certainty at the time the
investment is undertaken. For example, if Rs 1000 are invested today in SBM Ltd shares and in
1 years’ time there are two equally possible outcomes namely either Rs 1300 or Rs900 may be

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obtained, then this is a case of risky investment as there is no certainty pertaining to the final
wealth.

Let’s consider the following example: Investment in SBM Shares

Rs900 (Final wealth is uncertain)

p = 0.5

Rs1000

p = 0.5 Rs1300

Average final wealth = (0.5x900) + (0.5x1300) = Rs1100

If an investment decision is taken by comparing the final wealth from investing in Treasury Bills
(certainty) and investing in SBM shares (estimated with average value); normally the rational
investor will take the asset offering the higher value of final wealth. The final wealth for the
Treasury Bill and the average final wealth for the SBM share investment are the same i.e.,
Rs1100. Which asset should the risk averse investor choose?

The investor is sure to obtain Rs1100 with the treasury bill investment, whereas with the SBM
share investment an average amount equal to Rs1100 can be obtained (with p = 0.5 of a decrease
in initial wealth and p = 0.5 of an increase in wealth). An investor will normally take the asset
which offers him Rs1100 with certainty.

Let’s now consider a third example: A Share investment in NMH Ltd which has possible
outcomes as detailed below:

Rs600 (Final wealth is uncertain)

p = 0.5
Rs1000
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Rs1400

The average final wealth obtained from the SBM investment and the NMH offer the same
average final wealth (Rs1100); however the NMH investment involves the possibility of a
higher loss than the SBM investment. A rational investor would prefer the SBM investment over
the NMH investment.

13.4 RETURN ON AN ASSET/ INVESTMENT

Read: Chapter Eleven, Page 298, Returns- Book FCF,2nd European Ed.

If you buy a bond or a share and hold it for a given period of time after which you sell it, then
your gain or loss from that investment is called the return on your investment. In other words,
the return on an investment measures the increase/decrease in wealth that an individual has
obtained through doing an investment.

Return on an investment = (Final wealth – initial amount invested)/ initial amount invested

Example 1:

An investment of Rs100 today will generate Rs115 in 1 years’ time; calculate the return of the
investment.

Return = (115 – 100)/ 100 = 15%

13.4.1 Components of return

The return on investment very often comprises an income element and a capital element.
Investment on bonds will yield inflows in the form of yearly or semi-annual coupons as well as
proceeds from sale of the bond if disposed before maturity or the face value if the bond is held
till maturity. The coupons which are cash receipts are considered as the income element while
any increase in value of the bond at the time of disposal is termed as a capital gain. If the value
of the bond over time falls, then the investor faces a capital loss.

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13.4.2 Return on a share

Read: Chapter Eleven, Page 301, Calculating Returns- Book FCF,2nd European Ed.

The return on a share over a single period, is simply the sum of dividends received (Dt ) and the
capital gain or loss (Pt – Pt-1) during that period expressed as a percentage of the price of the
share at the start of the period (Pt-1) :

Return on share = (Dt) + (Pt – Pt-1)

Pt-1

Example 2:

A share was bought at Rs50; in one year’s time, its price has increased to Rs55 and it also pays a
dividend of Rs6. Calculate the return on the investment.

Return = (55 + 6 – 50)/ 50 = 0.22 or 22%.

Now, if instead of increasing, the stock price had decreased to Rs40; then return would be

(40 +6 – 50)/ 50 = -0.08 or -8%.

13.4.3 Expected rate of return

Read: Chapter Twelve, Page 328, Expected Returns - Book FCF,2nd European Ed.

If an investor undertakes an investment today and he wants to calculate the return on the
investment, this can easily be done IF the final wealth is known with certainty (e.g. risk free
asset). On the other hand, in the case of risky assets, as the final wealth that will be generated
from the investment is not known with certainty, the exact return on a risky investment cannot be
calculated. In such circumstances, an average estimate of the return can be obtained through the
calculation of the expected rate of return. The actual return obtained at the end of the
investment period may differ from the expected rate of return.

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For instance, an investor makes an investment in a risky asset today over a period of one year.
He currently estimates an expected return equal to 10%, i.e. he estimates that the value of his
initial investment will increase by 10% in one year’s time. At the end of one year, the actual
return on the investment can be e.g. equal to 8%, 9%...or 11 %.

The return obtained from a risky asset usually depends on the economic conditions that prevail
over the investment period. If strong economic conditions prevail, then return will also be high
(e.g. under strong economic conditions, a company has a good performance and obtains good
financial results; therefore it would normally pay higher dividends on its stocks). If economic
conditions are poor then return will be low (e.g. company generates low/ no profits; therefore it
would pay low dividends or no dividends).

In order to calculate the expected rate of return, the following must be estimated:

(i) Future economic conditions (states) and the possible returns attached to the
different states;
(ii) The probabilities associated with the different states and returns.
n

Expected rate of return from investment = ∑ (possible return)*(probability of return)

s=1

Expected rate of return = E (R) = P1R1 + P2R2 + P3R3 + …. + PnRn

Where s represents the different economic situations and future economic situations range from 1
to n.

Example:

Possible Return Expected

Economic Conditions (S) Probability (Ps) (Rs) return

Strong economy, no inflation 0.15 0.20 0.03

Weak economy, above average

inflation 0.15 -0.20 -0.03

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No major Change in Economy 0.70 0.10 0.07

Expected rate of return

E (R) 0.07

13.5 Risk of an investment

Read: Chapter Eleven, Page 306, The variability of returns- Book FCF,2nd European Ed.

Referring again to the examples in 13.3, the expected rate of return from the equity investment in
SBM Ltd and that in NMH Ltd is equal to 10%; in the case of the former, there is a smaller
dispersion of actual returns (Rs900/ Rs1300) around expected final wealth (Rs1100) as compared
to the latter (Rs600/ Rs1400). The smaller the dispersion of returns, the less risky the asset. The
greater the dispersion, greater is the risk of the investment. The risk is measured through the
variance (or standard deviation) of the investment.

Variance of rate of return (σ2) = ∑ Ps [Rs – E(R)] 2

s=1

Standard deviation of rate of return = (Variance of rate of return) ½

Let us now use the same example as in 13.4.3 to evaluate the risk.

Probability (Ps) [Rs – E(R)] 2 Ps * [Rs – E(R)] 2

0.15 (0.20 – 0.07)2 0.002535

0.15 (-0.20 – 0.07)2 0.010935

0.70 (0.10 – 0.07)2 0.00063

0.0141
Variance of
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return

Standard deviation of return = (0.0141) ½ = 0.1187

13.6 How to choose between two individual investments?

Let us now see how an investor chooses between two investments.

The following information pertaining to investment in Security A and investment in Security B

is provided:

Security Expected Return Standard Deviation

A 10% 0 (Risk free)
B 10% 0.1187

The risk averse investor will prefer the investment that provides the same amount of return with
lower risk or no risk. From the Table above, the investor will choose to invest in Security A.

In other words, we can conclude that an individual, who must choose between several financial
products, will choose the financial product that offers the minimum risk for a given level of
return; or the financial product that offers the maximum return for a given level of risk.

When the financial products have different levels of risk and return (e.g. investment A: return =
7%, std. dev. = 4% and investment B: return = 10%, std. dev. = 6%), they cannot be directly
compared by the investor to take an investment decision. In this case the investor will use a
relative measure called the coefficient of variation. It indicates the level of risk per unit of
expected return. An investor will choose the asset that has lowest level of risk per unit of return
or the lowest coefficient of variation.

Coefficient of variation (CV) = standard deviation of returns/ expected rate of return

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13.7 Portfolio Theory

Read: Chapter Twelve, Page 332, Portfolios- Book FCF,2nd European Ed.

An investor seldom invests in only one security. The very famous adage that we should not put
all our eggs in one basket provides adequate justification for investing in more than one security,
in other words in a portfolio. A portfolio is simply obtained when an individual buys a group of
individual financial assets. For example the individual decides to buy ordinary shares issued by several
companies and bonds issued by companies as well as the government.

In fact, in 1952, Harry Markowitz published "Portfolio Selection," a paper which revolutionised
modern investment theory and practice. He came up with the Modern Portfolio Theory whose
fundamental premise is that any stock has a probability to go up or down depending on the
market and thus its inclusion or exclusion in a portfolio does not matter individually. However,
when they are placed together, the interaction between the stocks reduces the overall price
volatility which then contributes to the stability of the portfolio. Any portfolio is designed with
returns in mind and MPT allows an investor to choose an expected return and then seek to
minimise the risk associated with the combination of stocks.

Thus, in selecting investments, the investor should consider both expected return and variability
of return on the portfolio as a whole.

13.8 Expected rate of return of portfolio

14 Read: Chapter Twelve, Page 332, Portfolio Expected Returns- Book FCF,2nd
European Ed.

It is an estimation of the return that may be obtained from a portfolio of assets (i.e. the total
return that may be obtained from a group of individual financial assets). The expected return may
differ from the actual return of the portfolio.

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Expected rate of return of portfolio is calculated from:

(i) return of single assets found in the portfolio

(ii) proportions (weights) of the single assets in the portfolio

The weight gives the ratio of a financial asset within the portfolio. (The weights of the assets in a
portfolio must add up to ONE)

The expected return of a portfolio is equal to the weighted average of expected returns of
individual financial assets found in the portfolio.

Expected rate of return of portfolio = E (Rport) = ∑ Wi E (Ri)

i=1

Where i represent the individual financial assets; the total number of financial assets in the
portfolio is equal to m. (m = 1, 2, 3, 4 …)

E (Ri) represents the expected returns of single/ individual assets.

Wi represents the weight of a single asset in the portfolio.

Example: Calculation of expected return for a portfolio, which is made up of four financial
products; according to the proportions given in the table below.

Expected Expected Return of

Weight Return Portfolio

Wi E (Ri) Wi * E (Ri)

0.20 0.10 0.02

0.30 0.11 0.033

0.30 0.12 0.036

0.20 0.13 0.026

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Expected return of portfolio = E (R port) = 0.02 + 0.033 + 0.036 + 0.026 = 0.1150 or 11.5%.

14.6 Risk of a 2-asset Portfolio

Read: Chapter Twelve, Page 333, Portfolio Variance- Book FCF,2nd European Ed.

Let us consider the following two 2 portfolios A and B and assume that same amount of money
is being invested in each asset

Portfolio A: made of stocks issued by two sugar companies (Expected Return: 15%)

Portfolio B: made of stocks issued by a bank and a sugar company (Expected Return 15 %)

An investor facing a choice between A and B must know which one is riskier before taking a
decision.

If bad weather conditions prevail (e.g. cyclone), the stock value and return of both sugar
companies will decrease; i.e. the overall value of portfolio A decreases. In portfolio B the return
of only one stock will be negatively affected by bad weather conditions, hence it will have a
lower decrease in value as compared to portfolio A. Portfolio A is therefore riskier than portfolio
B.

Portfolio A is riskier as the returns of assets found in portfolio A are more strongly related
(companies from same industry) than the returns of the assets found in portfolio B. The
relationship that exists between the returns of assets will be measured through covariance or
correlation coefficient.

14.6.1 Covariance
The direction (positive/ negative) in which returns are moving can be determined through
the covariance of returns which can be calculated as follows:
n
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Covariance (RA, RB) = CovAB = ∑ Ps [RAs – E (RA)] [RBs – E (RB)]

s= 1

Where s represents the different economic conditions that can be reached (ranging from 1 to n)

RAs and RBs represent the returns of assets A and B for different economic conditions

E (RA) and E (RB) represent the expected returns of assets A and B respectively.

The degree to which the returns of two assets are moving together or in opposite directions
cannot be estimated through the covariance. This is given by the correlation coefficient.
Through the comparison of correlation coefficients, the relationship between pairs of assets can
be compared.

14.6.2 Correlation Coefficient

The correlation coefficient between rates of return measures the degree of relationship
between the returns of two individual assets and can be calculated as follows:

Correlation coefficient (RA, RB) = rAB = CovAB/ σAσB

Where σA, σB are the standard deviations of the returns of financial products A and B.

The correlation coefficient can take values situated between +1 and -1.

When the correlation coefficient equals to:

+1: there is perfect positive relationship between the returns of two assets.

-1: there is perfect negative relationship between the returns of two assets.

0: it means that the returns of two single assets are independent (i.e. if return of asset A increases
then the return of asset B may increase/decrease/unchanged)

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In reality perfect negative or perfect positive correlation between the return of two assets do not
exist. The correlation coefficient between the returns of 2 assets will normally be inferior to +1
and superior to -1.

13.9.3 Standard deviation of a 2-asset portfolio

The standard deviation of the portfolio is calculated by considering the standard deviation of the
individual assets and the covariance/ correlation coefficient between the returns of the individual
assets.

Standard deviation of returns of portfolio (2 financial assets):

= σport = [WA2 σA2 + WB2 σB2 + 2 WAWB CovAB] 1/2

As CovAB = rAB σAσB,

then σport = [WA 2 σA2 + WB2 σB 2 + 2 WAWB rAB σAσB] 1/2

Example: calculation of the standard deviation of a portfolio with two assets

Two assets A and B offer the following expected returns and standard deviations. A portfolio is
made up of these two financial products in equal proportions (WA= WB = 0.5)

E (RA) = 0.4; E (RB) = 0.2 and σA = 0.1; σB = 0.05

(i) Calculate the expected return of the portfolio

(ii) For each of the following values of the correlation coefficient (rAB = 1; 0; -1); calculate
the standard deviation of the portfolio.

(a) Expected rate of return = E(Rport) = 0.5*0.4 + 0.5*0.2 = 0.3

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(b) Standard deviation:

(i) rAB = +1; σPORT = [0.52 * 0.12 + 0.52 *0.052 + 2*0.5*0.5*0.1*0.05*1]1/2 = 0.075 (inferior
to risk of asset B)
(ii) rAB = 0; σPORT = [0.52 * 0.12 + 0.52 *0.052 + 2*0.5*0.5*0.1*0.05*0]1/2 = 0.05590
(iii) rAB = -1; σPORT = [0.52 * 0.12 + 0.52 *0.052 + 2*0.5*0.5*0.1*0.05*-1]1/2 = 0.025

Remarks:

- It is observed that as the value of the correlation coefficient decreases (from +1 to -

1), the standard deviation of the portfolio decreases. (shows why it is important to
know the relationship between the returns of financial products when constituting a
portfolio)
- When correlation coefficient is low, the standard deviation of the portfolio should
normally be inferior to the standard deviations of the individual assets found in the
portfolio (0.025 < 0.1 < 0.05).

13.10 Diversification
Read: Chapter Twe;lve, Page 338, Diversification and Portfolio Risk- Book FCF,2nd
European Ed.

The risk of a portfolio can be divided into two parts: specific risk (diversifiable or unique risk)
and systematic risk (market risk or non-diversifiable).

Specific risk relates to the risk that a company and its competitors found within the same
industry may be facing. Company found within other industries will not be affected by the risk.
(E.g. bad weather: sugar industry; change in fiscal policy for manufacturing companies, etc)

By holding assets issued by companies from different industries, specific risk can be reduced.
Correlation coefficient between the returns of assets in different industries is low, this means that

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the returns of the assets move in opposite directions. The loss being generated by one asset will
be offset by gains being generated by other assets in the portfolio.

Systematic risk is due to changes operating in the market (macroeconomic factors), e.g. inflation
or interest rate, which will affect companies found within all industries. This risk cannot be
diversified through holding portfolios of assets.

When an investor diversifies his portfolio (it means that he holds a group of single assets), this
enables him to reduce specific risk. If a portfolio is well diversified only one type of risk caused
by general economic changes (systematic risk) would prevail.

Diversification is most effective (i.e. standard deviation is lowest) when the correlation
coefficient between the returns of assets tends towards -1.

13.11 Minimum variance portfolio

When setting up a portfolio with 2 assets (A & B), the investor can hold different weights of the
two assets in the portfolio. There is a set of weights (WA* & WB*) which will produce the lowest
value of standard deviation (minimum variance portfolio), for given values of standard deviation
for the individual assets and correlation coefficient between the returns of the assets.

Example:

E (RA) = 0.4; E (RB) = 0.2 and σA = 0.1; σB = 0.05; rAB = -0.3

WA WB σport E(Rport)

1 0 0,1 0,4

0,75 0,25 0,07224092 0,35

0,5 0,5 0,04873397 0,3

0,25 0,75 0,03832427 0,25

0 1 0,05 0,2

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σport = [WA 2 σA2 + WB2 σB 2 + 2 WAWB rAB σAσB] 1/2

WA + WB = 1 (express std. dev. only in terms of WA)

WB = 1 – WA

σport = [WA 2 σA2 + (1- WA) 2 σB 2 + 2 WA (1 – WA) rAB σAσB] ½

The weightage that gives the minimum variance portfolio is given by the formula:

* s B2 - rABs As B
WA =
s A2 2
+ s B - 2rABs As B

* 0.052 - (-0.3 * 0.1 * 0.05)

W =
A = 0.2581
0.12 + 0.052 - (2 * (-0.3) * 0.1 * 0.05)
WB* = 1 - WA* = 0.7419
E ( R *port ) = 0.2581 * 0.4 + 0.7419 * 0.2 = 0.25
s * port = [0.25812 * 0.12 + 0.7419 2 * 0.052 +
2 * 0.2581 * 0.7419 * 0.1 * 0.05 * (-0.3)]1/ 2 = 0.38

The risk of the portfolio which is measured by the standard deviation must also be evaluated. It
is also assumed that given the choice of different portfolios with identical expected returns, a
rational investor will opt for the one having the lowest level of risk.

13.11 ACTIVITIES

Activity 1
An investor is considering acquiring shares from Mercury Company and Venus Company. The
stocks of the two companies have the following possible returns:

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Mercury Company
Possible Rate of
Return Probability

-0.1 0.1

-0.05 0.05

0.1 0.2

0.2 0.65

Venus Company
Possible Rate of
Return Probability

-0.9 0.1

-0.4 0.05

-0.3875 0.2

0.5 0.65

(i) Calculate the expected rates of return of the stocks of Mercury Company and Venus
Company.
(ii) Explain which of the two stocks is riskier, without doing any calculations.
(iii) A rational investor will buy stocks from Mercury Company or Venus Company? Explain.

Activity 2
Two shares P & Q have the following expected returns, standard deviation and correlation:

E(Rp) = 20% E(Rq) = 16%

Std Dev.=25% Std dev.= 20%

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Corpq = -0.2

Calculate the portfolio expected return and risk if you decide to invest 60 % in P and the rest in
Q.

Activity 3
A portfolio consists of assets A and B, which possess the following expected return, risk and
weights.

Expected Standard
return/ Deviation/
Asset % % Weight

A 10 20 0.35

B 15 25 0.65

(i) What correlation between the two assets produces the maximum portfolio standard
deviation?
(ii) What correlation between the two assets produces the minimum portfolio standard
deviation?
For both parts (i) and (ii) of this question, show your calculations.

13.12 SUMMARY
1. There are different factors such as security, liquidity, risk and return and growth
prospects that affect investment decisions.
2. The two main determinants of investment are return and risk.
Dt + ( Pt - Pt -1 )
3. The return on a share can be calculated as follow: R =
Pt -1
4. The expected return an an individual asset is obtained as follows:
N
E ( Ri ) = åa it Rit , where
t =1

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i is security

a is the probability occurrence

Rt is the return for time t.

5. The risk on an individual investment is measured by the standard deviation. The square
of the standard deviation is the variance. The formula for the variance and standard deviation are:

Variance of rate of return (σ2) = ∑ Ps [Rs – E(R)] 2

s=1

6. Total risk is made up of specific risk and market risk. Specific risk can be made
eliminated via diversification. Market risk cannot be diversified.

7. An investor can reduce portfolio risk simply by holding instruments which are not
perfectly correlated.
8. A well-diversified portfolio eliminates (or considerably reduces) idiosyncratic risks. It
does not eliminate systematic risks, because, by definitions, all assets in the portfolio will suffer
from these risks.

13.13 SUGGESTED READINGS

· Fundamentals of Investments, G. J. Alexander, W. F. Sharpe & J. V. Bailey

· R. Brealey; S. Myers, Principles of Corporate Finance – 11th Ed.

· J. Rutterford ,1996, “Introduction to Stock Exchange Investment” Latest Edition

· Bailey, Jeffery V, and Alexander, Gordon J, and Sharpe, William “Fundamentals of
Investments”, Latest Ed., Prentice Hall, 2000

13.14 USEFUL LINKS

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For further reading, students are advised to consult the following links:

o www.stockexchangeofmauritius.com
o http://www.investopedia.com/walkthrough/corporate-finance/4/capital-
markets/risk-returns.aspx

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