DAVAO ORIENTAL STATE COLLEGE

OF SCIENCE AND TECHNOLOGY

INVESTMENT AND PORTFOLIO MANAGEMENT

FM 131 | 1st Semester SY 2020-2021
Return and Risk
 Components of Return
Income
Income may take the form of dividends from stocks or mutual funds or interest
received on bonds. For our purposes, an investment’s income is the cash that
investors periodically receive as a result of owning the investment.

Capital Gains (or Losses)

The second dimension of return focuses on the change in an investment’s market
value.
The amount by which the proceeds from the sale of an investment exceed its
original purchase price is a capital gain.
If an investment sells for less than its original purchase price, a capital loss results.
 Components of Return

We can calculate the capital gain or loss of the investments shown in Table 4.1. Investment A
experiences a capital gain of $100 (i.e., $1,100 sale price -$1,000 purchase price) over the
one-year period. Investment B, on the other hand, earned a $40 capital loss because the sale
price of $960 is $40 less than the $1,000 purchase price.
 Components of Return

Table 4.2 shows the total return for investments A and B over the year. Investment
A earns a $180 total return, compared to just $80 earned by investment B.
 Historical Performance
Most people recognize that future performance is
not guaranteed by past performance, but past data
often provide a meaningful basis for future
expectations. A common practice in the investment
world is to look closely at the historical record when
formulating expectations about the future.
Consider the data for ExxonMobil Corporation presented in Table 4.3. ExxonMobil
paid dividends every year from 2005 through 2014. ExxonMobil’s stock price
generally rose during this decade, starting at $51.26 and ending at $92.45. Despite
the overall upward trend, the company’s stock price fell in 2008 and 2009 (largely
due to the Great Recession and the corresponding drop in oil prices), and it
declined again in 2014 (largely due to a rapid increase in the supply of oil and
shrinking worldwide demand for oil).

Two aspects of these data are important. First, we can determine the annual total
return generated by this investment over the past 10 years. The average annual
total return earned by ExxonMobil’s shareholders (column 6) over this period was
9.6%, performance that put ExxonMobil ahead of many other stocks for the same
period. Second, observe that there was considerable variation in ExxonMobil’s
return from one year to the next. The firm’s best year was 2006, during which its
investors earned a total return of 38.7%. But in 2008,
ExxonMobil’s worst year, shareholders lost 13.1%.
 Expected Return
In the final analysis, of course, it’s the future that
matters when we make investment decisions.
Therefore an investment’s expected return is a vital
measure of its performance. It’s what you think the
investment will earn in the future that determines
what you should be willing to pay for it.
 Level of Return
The level of return achieved or expected from an investment will depend on a
variety of factors. The key factors are internal characteristics and external forces.

Internal Characteristics Certain characteristics of an investment affect its return.

For investments issued by companies, the important characteristics include things
such as the type of investment (e.g., stocks or bonds), the quality of the firm’s
management, and whether the firm finances its operations with debt or equity.

External Forces External forces such as Federal Reserve actions, recessions,

wars, and political events may also affect an investment’s return. None of these
are under the control of the issuer of the investment, and investments react
differently to these forces.
 The Time Value of Money
The phrase the time value of money refers to the fact that it is generally
better to receive cash sooner rather than later.

For example, consider two investments, A and B. Investment A will pay

you $100 next year and $100 the year after that. Investment B pays you
$200 in two years. Assume that neither investment has any risk, meaning
that you are certain that you will receive these cash payments. Clearly
both investments pay $200 over two years, but investment A is preferable
because you can reinvest the $100 you receive in the first year to earn
more interest the second year. You should always consider time value of
money principles when making investment decisions.
 Computational Aids for Use in Time Value of Money
Calculations
The phrase the time value of money refers to the fact that it is generally
better to receive cash sooner rather than later.

For example, consider two investments, A and B. Investment A will pay

you $100 next year and $100 the year after that. Investment B pays you
$200 in two years. Assume that neither investment has any risk, meaning
that you are certain that you will receive these cash payments. Clearly
both investments pay $200 over two years, but investment A is preferable
because you can reinvest the $100 you receive in the first year to earn
more interest the second year. You should always consider time value of
money principles when making investment decisions.
 Determining a Satisfactory Investment
You can use time value of money techniques to determine whether an
investment’s return is satisfactory given the investment’s cost.

The three possible cost–benefit relationships and their interpretations follow:

1. If the present value of the benefits equals the cost, you would earn a rate of
return equal to the discount rate.
2. If the present value of benefits exceeds the cost, you would earn a rate of
return greater than the discount rate.
3. If the present value of benefits is less than the cost, you would earn a rate of
return less than the discount rate.
 Real, Risk-Free, and Required Returns
Inflation and Returns
The nominal rate of return on an investment is the return that the investment earns
expressed in current dollars. For example, if you put $50 into an investment that promises to
pay 3% interest, at the end of the year you will have $51.50 (the initial $50 plus a $1.50
return). Your nominal return is 3%, but this does not necessarily mean that you are better off
financially at the end of the year because the nominal return does not take into account the
effects of inflation
The real rate of return on an investment measures the increase in purchasing power that
the investment provides. In our continuing example, the real rate of return is 0% even
though the nominal rate of return is 3%.

In dollar terms, by investing $50 you increased your wealth by 3% to $51.50, but in terms of
purchasing power you are no better off because you can only buy the same amount of
goods that you could have bought before you made the investment. In mathematical terms,
the real rate of return is approximately equal to the nominal rateof return minus the inflation
rate.
 Risk and Returns
Investors are generally risk averse, meaning that they do not like risk and
will only take risk when they expect compensation for doing so. The
greater the risk associated with any particular investment, the greater the
return that investors will require to make that investment. The rate of
return that fully compensates for an investment’s risk is called the
required return. Note that the required return is a kind of forecast. If an
investor expects an investment to earn a return equal to or greater than
the required return, the investor will want to buy the investment. However,
the return that an investment actually earns can be quite different from the
investor’s required return.
 Real, Risk-Free, and Required Returns
The required return on any investment j consists of three components: the real rate of return, an
expected inflation premium, and a risk premium, as noted in Equation 4.1. The expected
inflation premium represents the rate of inflation expected over an investment’s life.
Real, Risk-Free, and Required Returns
Real, Risk-Free, and Required Returns
 Understanding Return Components
Earlier in this chapter we identified the two components of
investment return: income and capital gains (or losses). The
income received by the investor during the investment period
is a realized return. Capital gains and losses, on the other
hand, are realized only when the investor sells an asset at
the end of the investment period. Until the sale occurs, the
capital gain or loss is called a paper return or an unrealized
return.
 Holding Period Return
The holding period is the period of time over which one
wishes to measure the return on an investment. When
comparing returns, be sure to use holding periods of the
same length. For example, comparing the return on a stock
over a six-month period with the return on a bond over a one-
year period could result in a poor investment decision. To
avoid this problem, be sure you define the holding period. It is
common practice to annualize the holding period and use
that as a standard.
 Computing the Holding Period Return
The holding period return (HPR) is the total return
earned from holding an investment for a specified
time (the holding period). Analysts typically use the
HPR with holding periods of one year or less. It
represents the sum of income and capital gains (or
losses) achieved over the holding period, divided by
the beginning investment value (market price).
Computing the Holding Period Return
Computing the Holding Period Return
Computing the Holding Period Return
 Using the HPR in Investment Decisions
The holding period return is easy to use in making
investment decisions. It measures an investment’s
return (including both the income and capital gains
components) relative to the investment’s initial cost,
and in so doing makes it easier to compare the
performance of investments that may differ greatly in
terms of the amount of money required from an
investor.
 The Internal Rate of Return
For investments with holding periods greater than one year, an alternative
way to define a satisfactory investment is in terms of the annual rate of
return it earns. Why do we need an alternative to the HPR? Because the
HPR calculation fails to fully account for the time value of money, and the
HPRs for competing investments are not always comparable. Instead,
sophisticated investors prefer to use a present value–based measure,
called the internal rate of return (IRR), to determine the annual rate of
return earned on investments held for longer than one year. An
investment’s IRR is the discount rate that equates the investment’s cost to
the present value of the benefits that it provides for the investor.
 IRR for a Single Cash Flow
Some investments, such as U.S. savings bonds, stocks paying
no dividends, and zero-coupon bonds, provide no periodic
income. Instead, investors pay a lump sum up front to
purchase these investments, and in return investors expect to
receive a single, future cash flow when they sell the
investment or when the investment matures. The IRR on such
an investment is easy to calculate using a financial calculator
or an Excel spreadsheet.
 Example
Assume you wish to find the IRR on an investment
that costs $1,000 today and will pay you $1,400 in
five years. To compute the IRR for this investment on
a financial calculator, you treat the investment’s cost
as a present value, PV, and the investment’s payoff
as a future value, FV. Using the inputs shown at the
left, you can verify that the IRR is 6.96%.
Example
 IRR for a Stream of Income
Investments such as income-oriented stocks and
bonds typically provide the investor with an income
stream. The IRR on an investment that pays income
periodically is the discount rate that equates the
present value of the investment’s cash flows to its
current price.
IRR for a Stream of Income
IRR for a Stream of Income
IRR for a Stream of Income
Interest on Interest: The Critical Assumption
The IRR is a measure of the return that an
investment provides, but the IRR calculation
contains a subtle assumption. That
assumption is that the investor can reinvest
all of the income that the investment
provides, and that the return earned on
reinvested income equals the return on the
original investment.
Interest on Interest: The Critical Assumption
Suppose you buy a $1,000 U.S. Treasury bond that
pays 8% annual interest ($80) over its 20-year life.
Each year you receive $80, and at maturity you get
the $1,000 principal back. To earn an 8% IRR on
this investment, you must be able to reinvest the
$80 annual interest income for the remaining 20-
year life at the same annual rate of return of 8%.
 Interest on Interest: The Critical Assumption
Figure 4.1 shows the elements of return on this investment to demonstrate the
point. If you don’t reinvest the interest income of $80 per year, you’ll end up
earning an IRR of about 4.9%. You’ll have $2,600—the $1,000 principal plus
$1,600 in interest ($80 per year for 20 years)—at the end of 20 years. (The IRR
on a single cash flow of $1,000 today that will be worth $2,600 in 20 years is
about 4.9%.) Alternatively, if you reinvest each $80 annual interest payment, and
if those reinvestment payments earn an 8% return from the time that they are
received until the end of the bond’s 20-year life, then at the end of 20 years you’ll
have $4,661—the $1,000 principal plus the $3,661 future value of the $80
interest payments reinvested at 8%. (The IRR on a single cash flow of $1,000
today that will be worth $4,661 in 20 years is 8%.) Figure 4.1 shows that this
investment’s future value is $2,061 greater ($4,661-$2,600) with interest
payments reinvested compared to the case when interest payments are not
reinvested.
Risk: The Other Side of the Coin
Risk is the uncertainty surrounding the actual return that an
investment will generate. The risk associated with a given
investment is directly related to its expected return. In general, the
greater the investment’s risk, the higher the expected return it
must offer to attract investors. Riskier investments should provide
higher returns. Otherwise, what incentive is there for an investor to
risk his or her money? This relationship between risk and return is
called the risk-return tradeoff. In general, investors want to
obtain the highest possible return for the level of risk that they are
willing to take.
Business Risk
Sources of Risk
The degree of uncertainty associated with an investment’s earnings and the
investment’s ability to pay the returns (interest, principal, dividends) that investors
expect.
Financial Risk
Many firms raise money both by issuing common stock to investors and by
borrowing money. When firms borrow money, they commit themselves to make
future interest and principal payments, and those payments are generally not
linked to a firm’s profits but are instead fixed according to a contract between the
firm and its lender.
Purchasing Power Risk
The chance that unanticipated changes in price levels (inflation or deflation) will
adversely affect investment returns is purchasing power risk. Specifically, this
risk is the chance that an unexpected increase in prices (inflation) will reduce
purchasing power (the goods and services that can be purchased with a dollar).
Interest Rate Risk
Sources of Risk
Securities are especially affected by interest rate risk. This is particularly true for those
securities that offer purchasers a fixed periodic return. Interest rate risk is the chance that
changes in interest rates will adversely affect a security’s value. The interest rate changes
themselves result from changes in the general relationship between the supply of and the
demand for money.
Liquidity Risk
The risk of not being able to sell (or liquidate) an investment quickly without reducing its
price.
Tax Risk
The chance that Congress will make unfavorable changes in tax laws.
Event Risk
Occurs when something happens to a company that has a sudden and substantial impact
on its financial condition.
Market Risk
The risk that investment returns will decline because of factors that affect the broader
market, not just one company or one investment.
 Risk of a Single Asset
Standard Deviation: An Absolute Measure of Risk
One indicator of an asset’s risk is the standard deviation, s.
It measures the dispersion (variation) of returns around an asset’s average or
expected return. The formula is
Risk of a Single Asset
Regardless of the country, the
general pattern is clear: Investments
with higher average returns have
higher standard deviations. Because
higher standard deviations are
associated with greater risk, the
historical data confirm the existence
of a positive relationship between
risk and return. That relationship
reflects the fact that market
participants require higher returns as
compensation for greater risk.
 Assessing Risk
Risk-Return Characteristics of Alternative Investments
 Assessing Risk
An Acceptable Level of Risk
Individuals differ in the amount of risk that they are willing to bear and the return that they
require as compensation for bearing that risk.

• For risk-indifferent (or risk-neutral) investors, the required return does not change as risk
changes. For example, in Figure 4.3, the horizontal blue line indicates that the risk-
indifferent investor will accept the same return even if an investment’s risk increases from
x1 to x2.
• For risk-averse investors, the required return increases with risk. Because they do not
like risk, these investors require higher expected returns to compensate them for taking
greater risk. In Figure 4.3, the preferences of risk-averse investors are depicted by the
upward sloping green line.
• For the risk-seeking investor, the required return decreases as risk increases. These
investors simply enjoy the thrill of taking a risk, so they willingly give up some return to take
more risk, as indicated by the downward sloping red line in Figure 4.3.
Assessing Risk
 Steps in the Decision Process: Combining Return and Risk
When you are deciding among alternative investments, you should take the following steps to
combine return and risk.
• Using historical or projected return data, estimate the expected return over a given holding
period. Be sure that your estimate of an investment’s expected return takes into account the
time value of money.
• Using historical or projected return data, assess the risk associated with the investment. You
can assess an investment’s risk by making a subjective judgment, by calculating the standard
deviation of an investment’s returns, or by using one of the more sophisticated methods that
we discuss elsewhere.
• Evaluate the risk-return characteristics of each investment option to make sure that the return
that you expect is reasonable given the risk that you are taking. If other investments with lower
levels of risk provide equal or greater expected returns, or if other investments with the same
level of risk provide higher returns, the investment is not acceptable.
• Select the investments that offer the highest returns associated with the level of risk you are
willing to take. As long as you get the highest expected return for your acceptable level of risk,
you have made a ―good investment.‖