+ RATES OF RETURN: + RISKS AND RISK PREMIUM, + ASSET ALLOCATION ACROSS RISKY AND RISK-FREE ‘SECURITIES FORMULA OF HOLDING- (@ __ PerIop RETURN (HPR) HPR = (ENDING PRICE - BEGINNING PRICE + CASH DIVIDEND)/ BEGINNING PRICE RATES OF RETURNS EXAMPLE: ‘Suppose you are considering investing some of yout money, now all ‘the money earned over the investment period (price appreciation as well as dividends) per money invested. invested in a bank account, in a stock market index fund. The price of a share inthe fund is currently $100, and your time horizon is one ‘A key measure of investors! success is the rate at which their eat You expect the cath dividend during the year to be $4, so your funds have grown during the investment period : : ee : expected dividend yield is 4%. Holding-Period Return EA EXAMPL (HPR) Your HPR will depend on the price one year from now. The tata ing pv return (HP) of «share of stck depend nthe increase (oF decrease) in the price of the share over the investment period ‘Suppose your best guess is that it will be $110 per share. wl ton any Sven nc he sar at povided Then your capital gain will be $10, so your capital gains yield “4 sume thatthe dividends paid atthe end ofthe holding period Te the . isnt” that aves abe fctoed “cart a) depute pnb is $10/$100 = .10, or 10%. The total holding period rate of investment income between the receipt ofthe dividend andthe end of the eee retum is the sum of the dividend yield plus the capital gain yield, 4% + 10% = 14%._| Characteristics And Differences A) COMPUTATION: OF The Measurements. ceomeraic ‘Money. werctTeD Ending pice» $110 Teillustrate the measurements above, let ut Measuring Investment Returns over Multiple Periods ce} consider ABC Fund that starts with #1 millon ander management at the begining of the year. The holding period retum is 2 simple and unambiguous messure of investment return over a single patiad. Gut often you will be interested in vert | veor2 | Years average returns over longer periods of time, For example, you might want to ‘measure how well a mutual und has performed over the preceding five-year » = = riod, In thi cate, retum measurement is more ambiguou Ln . 1 os | 90 Arithmetic Measurement: Raz (el tx2+....txn)/n @ Measures of Performance Where: LARITHMETIC AVERAGE x1 +x2 +... + xn = portfolio returns for period n 2.GEOMETRIC AVERAGE 11 = number of periods 3.MONEY-WEIGHTED RETURN Ra = (.10+.25-.20+.25)/4 Ra=.10r 10%Arithmetic Measurement: The aithnetic average of the yealy retuns is just the sum of the yearly teturns vided by the runberof yes in the above example: (10 +25- 20 + 25/4 = 10%, Since this statistic ignores compounding, it does nt represent an equivalent, single ate forthe sr. The arithmetic average is uf, hough, becaue itis the best forecast of performance in future quarter, using this particular sample of historic tus. Geometric Measurement: Rg = [(1 #Rt) «(1-9 RO) (1 + RQ). «(16 Rl] Rr] /n= 1 where: ReRetun unt ofthe rumbers inthe series fg = [[1+.1) (1 +.25)x (1 = 20) *(1 + 259} 1/4-1 g = 0829 or 8.29% Geometric Measurement: The geometric average of the yearly returns is equal to the single per-period return that would give the same cumulative performance as the sequence of actual retuns. We calculate the geometric average by compounding the actual period-by-period returns and then finding the equivalent single per-period return. Money-Weighted Measurement: Yearo | Years [vez] Years 4 04 |-0.5) 80 To compute: eo = [Citta oC2/(1 BRYA. [CH/ 19} Were: 1a eral Rate of Retr ‘C= cashfows "=Count ofthe numbers inthe series “Therefore: 5-0.) -0.5/RR2 8/03 + R88) RR =437% RISK AND RISK PREMIUM RISK is any uncertainty with respect to your investments that has the potential to negatively affect your financial welfare. RISK PREMIUM is the investment return an asset is expected to yield in excess of risk-free rate of return.RISK EXAMPLE assume you have to choose between 2 different investments A and B: A is subject to a disrupting event with probability 0.01 with a related loss of 1000, while B is subject to a disrupting event with probability 0.02 with a loss of 800. RISK FORMULA AND CALCULATION Probability x Loss = Risk Risk(A) = 0.01 x 1000 = 10 Risk(B) = 0.02 x 800 = 16 RISK PREMUIM FORMULA Asset Return - Risk-Free Rate = Risk Premium RISK PREMUIM EXAMPLE Assume the risk-free rate is 8%. This means a riskless U.S. government treasury bond offers an annual f° return of 5%, Let's say an investor invests in the stock ‘of a company and that stock has an annual return of 7%. RISK PREMIUM COMPUTATION where: ‘The risk-free rate of - 5% fp Asset Retuin- 7% Risk Premium = Asset Return — Risk-Free Rate 2% = 7%- 5% Asset allocation Across Risky and Risk-free Securities bonds have been ker investments than investments in Treasury tock investments have bean eke til On the other hand, the fisher investments have offered higher average return ‘he most staightforward way to contr the kof the pot the fraction ofthe portfolio invested in Treasury bils and ot tmatht securities vraus sky astts, ‘hiss an example of an aset allocation choice,Most investment professionals consider asset allocation the most important part of portfolio construction. Consider this statement by John Bogle, made when he was the chairman of the Vanguard Group of Investment Companies Example: ‘toveiy Aes won mvt hd sane et he ing 8210900 iy sce, Say S10 inthe vpn S60 neta Ving 0 ner Pd 9400 ina meter ade Sond fond Th Yanga an ue ey fe at tne he Sn puree Pty ern! re Sond Fn 0) pain ‘Sponsors thigh tinged san Ty ce We hon tse ‘Sry porate nmap oon, wwe pril, Wn thn ge (Stone portsi punt, ee nme a vr xan has eng ‘Sdtanctroptn! Tchad overuse p ay pte The weight ofthe risky potola, P, nthe complete porto, including rik f 2s well a sky investments, is denoted by , and so the weight ofthe mone imatket ind is ¥ = 210,000/800,000 = 0.7 (sky asset, portoio P) 1 y = 90,000/300,000 = 0.5 (isk-troe assets) ‘The weights of the individual assets inthe complete portalio (C) are ‘Vanguard 113,400/00,000 = 0.378 Fidelity 96,600/200,00 Ready Assets F90,000/300,000 = 0.300, Pertflio © 800,000/300,000 = 1.000 ‘Suppose the investor cides to decrease risk by reducing the exposure to the risky portfolio from y 0.7 toy = 0.56. The risky portfolio would total only 0.66 X 200,000 = $148,000, requiring the eale of $42,000 of the original $210,000 ricky holzings, with the proceeds used to purchase more shares in Ready Assets Total holdings in the risk- ‘eee asset will increase to 300,000 (1 - 0.58)» $192,000 (the eriginalholeinge plu the ‘new contibution tothe money market fund: 0,000 + 42,000 = $182,00). The key point is that we leave the proportion of each asset inthe risky potioio Unchanged. Because the weights of Vanguard and Fidelity inthe risky pontfoo se 0.54 and 0.46 respectively, we sel. $4 X 42,000 » $2,680 of Vanguard and 0.46 X 42,000 = $19,920 of Fidelity. Alter the sale, the proportions ofeach und inthe risky portfolio are urchange. Wy = 113.400 = 22,280 = 0.54 (vanguard) 210,000 42,000 WIG 26,400 = 19.320 = 0.46 (deity 20,000 ~ 42,000 ‘The Risk-Free Asset The power to tax and control the noney supply lets the government, and only the government, issue default-ree bonds. The default-fee guarantee by itself is not sufficient to make the bonds risk-free in real ‘teims, since inflation affects the purchasing power of the proceeds from an investment in T-bills. The only risk-free asset in real terms would be a price-indexed government bond. All the money market instruments are virtually immune to interest rate risk (unexpected fluctuations in the price of a bond due to changes in market interest rates) because of their short maturities, and all are fairly safe in terms of default or credit risk. ‘Money market mutual funds hold, for the most part, three types of securi + Treasury bill + bank certificates of deposit (CDs) + commercial paper. + The instruments differ slightly in their default risk. The yields to maturity on CDs and commercial paper, for identical maturities, are always slightly higher than those of T-bills.