Magnus Dahlquist

Summer 2021

Risk and Return

Copyright © Magnus Dahlquist. All rights reserved.

Outline
1. Risk and risk measures.

2. Historical perspective of returns.

3. Portfolios of assets.

4. Diversification.

5. Mean-variance analysis.

6. Concluding comments.

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1. Risk and risk measures
• Two questions:
– What is risk?
– How can risk be measured?

• Risk measures:
– Volatility / standard deviation.
– Beta (duration, delta, etc.).
– Etc.

• These measures all quantify the uncertainty of future returns.

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2. Historical perspective of returns
• Illustrate with the USA.

• Three asset classes: Bills, bonds, and stocks.

• Annual USD returns:

– Nominal terms.
– Real terms.

• Sample periods: 1900–2020 and 1980–2020.

• Source: Dimson et al. (2002, 2014), and my updates and assumptions.

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2a. Return summary statistics

Mean Standard Deviation

Bills Bonds Stocks Bills Bonds Stocks
1900–2020
Nominal 3.7 5.2 11.6 2.8 8.7 19.5
Real 0.9 2.4 8.7 4.5 10.1 19.8
1980–2020
Nominal 4.2 9.3 13.2 3.6 12.3 16.5
Real 1.1 6.1 9.9 2.4 12.4 16.1
Means and standard deviations for USD returns in nominal as well as real terms over the periods 1900-2020 and 1980-2020 (annualized, in %).
Source: Dimson et al. (2002, 2014), and my updates and assumptions.

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 Value of one dollar invested (nominal terms)

100,000
Source: Dimson et al. (2002, 2014), and my updates and assumptions.
80,927

Bills
Value of one dollar invested (nominal terms)

10,000 Bonds
Stocks

1,000
319

100 78

10

0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030

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 Value of one dollar invested (real terms)

100,000
Source: Dimson et al. (2002, 2014), and my updates and assumptions.
Bills
Value of one dollar invested (real terms)

10,000 Bonds
Stocks 2,678
1,000

100

10 11

3
1

0
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 2030

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2b. Some comments
• The nominal US market return has been about 12% with a standard
deviation of about 20% (other developed markets have had similar
means but often higher standard deviations and emerging markets,
for shorter sample periods, higher means and standard deviations).

• Bills and bonds have had lower average returns, but also substantially
lower standard deviations.

• In general: Large variation in mean returns across assets.

• We want to understand expected returns.

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2c. Individual shares and the market: A paradox?
• The mean nominal return in a stock market has been about
12% with a standard deviation in the range 20%–25%.

• The mean return on a typical individual stock has also been about
12% but with a standard deviation in the range 50%–60%.

• That is, the mean market return and a typical mean return on an
individual stock have been about the same, but the volatility on the
typical stock has been much higher.

• We want to understand diversification.

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3. Portfolios of assets
• We will consider risk and return for a portfolio of two assets (it gives
us all intuition, which helps us understand cases with many assets).
• Consider a portfolio of two risky assets:
– The returns are R1 and R2 (think: 1 = “stocks” and 2 = “bonds”).
– The weights of the two assets are w1 and w2 (with w1 + w2 = 1).
– The portfolio return is:
RP = w1R1 + w2R2

• Let the weights be between 0% and 100% (see Appendix B1 and B2

for more advanced material on selling short and buying on margin).
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3a. Expected portfolio return and variance
• The expected return on the portfolio is:
E(RP) = w1E(R1) + w2E(R2)

• The variance of the portfolio is:

Var(RP) = w1w1Var(R1) + w2w2Var(R2) + 2w1w2Cov(R1,R2)

• Note that:

Std(RP) = Var(RP) and Cov(R1,R2) = Std(R1)×Std(R2)×Corr(R1,R2)

• Consider a numerical example and develop intuition from figures.

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3a. Expected portfolio return and variance (cont’d)
• Consider a portfolio of 50% stocks (6% mean and 20% standard
deviation) and 50% bonds (2% mean and 10% standard deviation),
where the correlation between bonds and stocks is 30%.
• Portfolio mean:
E(RP) = 0.5×0.06 + 0.5×0.02 = 0.04 = 4%

• Portfolio variance and standard deviation are:

Var(RP) = 0.52×0.202 + 0.52×0.102+2×0.5×0.5×0.20×0.10×0.30 = 0.0155
Std(RP) = 0.0155 = 0.1245 = 12.45%

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 Two-asset case, mean

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Source: Author's assumptions and calculations.

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Asset 1
Mean (annualized, %)

2
Asset 2

0
-0.5 0.0 0.5 1.0 1.5
Weight in asset 1

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 Two-asset case, standard deviation

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Source: Author's assumptions and calculations.

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Standard deviation (annualized, %)

Asset 1

15

10
Asset 2
Correlation = -1
5 Correlation = 0
Correlation = +1

0
-0.5 0.0 0.5 1.0 1.5
Weight in asset 1

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 Two-asset case, mean and standard deviation

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Source: Author's assumptions and calculations.

Correlation = -1
Correlation = 0
6 Correlation = +1
Asset 1
Mean (annualized, %)

2
Asset 2

0
0 5 10 15 20 25
Standard deviation (annualized, %)

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3b. Importance of correlations
• When Corr(R1,R2) = 1, the portfolio standard deviation is a weighted
average of individual asset standard deviations.

• When –1 ≤ Corr(R1,R2) < 1:

– The standard deviation of a portfolio of two assets is less than the
weighted average of the standard deviations of the individual
assets (diversification principle).
– The lower correlation, the better diversification benefits.

• Optional exercise: See Excel file PORTFOLIORISK.XLS.

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4. Diversification
• When assets are not perfectly correlated, portfolios of assets have
lower variance than individual assets.
– Power of diversification: The variance of a single asset has little
effect on the variance of a portfolio of many assets.
– Limit of diversification: The variance of a portfolio with many
assets cannot fall below the common movements in the market.

• Hence, the lower the correlation, the lower the variance.

• “Don’t put all your eggs into one basket.”

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 Portfolio diversification

50
Source: Author's assumptions and calculations.

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Standard deviation (annualized, %)

30

Unique risk
20

Common risk

10

0
0 5 10 15 20 25 30
Number of stocks in portfolio

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4. Diversification (cont’d)
• The variance of a portfolio can be divided into:
Total risk = Common risk + Unique risk

Also known as: Also known as:

• Systematic risk. • Nonsystematic risk.
• Market risk. • Asset- or firm-specific risk.
• Non-diversifiable risk. • Diversifiable risk.
• Idiosyncratic risk.
• Optional exercise: See Excel file DIVERSIFICATION.XLS.
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5. Mean-variance analysis
• Asset allocation: How much to invest in different assets.

• Risk-averse investors:
– Do not participate in “fair gambles.”
– Require higher expected return on riskier investments.

• We will develop a framework for understanding a tradeoff between:

– Expected return (captured by the mean).
– Risk (captured by the variance).

• We will do the analysis in figures (while developing intuition).

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5a. An illustration of mean-variance analysis
• Consider allocation to risk-free cash, bonds, and stocks.

• Assume the (rounded) means and variances/covariances of annual

real returns for US bonds and stocks from 1900 to 2020 guide us for
representing the distribution of future returns; later we also assume
that cash offers a risk-free return equal to 1% on an annual basis.
[We will discuss these assumptions later.]

• Source: Dimson et al. (2002, 2014) and my updates.

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 Means and standard deviations

8
Author's assumptions and calculations.

6
Expected return (% per year)

Stocks

2
Bonds

Cash
0
0 5 10 15 20 25
Standard deviation (% per year)

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 Mean-standard deviation frontier

8
Author's assumptions and calculations.

6
Expected return (% per year)

Stocks

2
Bonds

Cash
0
0 5 10 15 20 25
Standard deviation (% per year)

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 Tangency portfolio and capital allocation

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Author's assumptions and calculations.
Expected return (% per year)

6 Tangency
portfolio Stocks

Best mix of bonds and

stocks
4

The line is the Capital

2 Allocation Line (CAL):
Bonds - The intercept of the line
is the risk-free rate.
- The slope of the line
Cash
is the Sharpe ratio.
0
0 5 10 15 20 25
Standard deviation (% per year)

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 Risk tolerance and capital allocation line

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Author's assumptions and calculations.
Aggressive
investor
6
Expected return (% per year)

Stocks
Moderate
investor Best mix of bonds and
stocks
4

Conservative
investor

2
Bonds

Cash
0
0 5 10 15 20 25
Standard deviation (% per year)

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5b. Identify and main takeaways
• Identify:
– Risk-free asset (different from risky assets):
o No standard deviation.
o No correlation with risky assets.
– Optimal portfolio and Sharpe ratio.

• Main takeaways:
– Take more (less) risk by holding proportionally more (less) of the
risky-assets portfolio (aka two-fund separation).
– The risk tolerance determines the final allocation.
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6. Concluding comments
• We want to understand expected returns and risks on individual
assets as well as on portfolios of assets and the tradeoffs.

• Important concepts:
– Diversification.
– Covariance risk.

• They are useful in investment management as well as corporate

finance and will later help us understand the cost of capital (our “r”).

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Appendix
Appendix A1: Selling short (w < 0)
• Goal is to benefit from a decline in the price of an asset (here a stock):
– Borrow shares of the stock (from another investor).
– Sell the shares (in the market).
– Later buy the shares back (hopefully at a lower price).
– Return the shares (to the lender).

• While waiting for the right time to cover the short position, the short
seller pays interest to the lender of the borrowed security and is also
responsible for dividends to the lender.
• There are several institutional details related to this.
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Appendix A2: Buying on margin
• Basic idea:
– Use only a portion of the proceeds for an investment.
– Borrow remaining component.
– Effectively gives leverage.

• There are also several institutional details related to this..

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 Thanks!

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