Risk and Return

Why do you invest?

 Primarily to earn return on your money.

 However, only considering return maximisation is not enough. As an

investor you do not like too much of risk also.

 To facilitate this investment philosophy, it is important to analyse

securities and portfolios within a context of risk and return together.
Determinants of Required Rate of Return
 It is important to understand that required return on all investments change
over time.

 Selection process for an investor involves finding securities that provide a

rate of return that compensates you for:
◦ Time value of Money
◦ Expected Rate of Inflation
◦ Risk Involved

 Summarized as Real Risk free rate + Risk Premium

◦ Where RRFR = RFR – Inflation, Risk Premium is dependent on business
risk, financial risk, liquidity risk, exchange rate risk and country risk related
to a security
Risk Return Tradeoff
Risk
- Chance that investor may loose his
capital
- Chance that investor may not get the
desired return

Risk/Return Trade-off
- The greater risk accepted, the greater
must be the potential return for committing
funds to an uncertain outcome.
- Risk lover and risk averse investors
 Risk - Return Trade 0ff

Expected
Return

Futures
Options

Common
Stocks
Corporate
Bonds

Cash in
Bank

Risk
 What
securities
should be
held?

Investment
Decisions

How much
capital to
allocate to
each?
Investment Decisions

First step is estimation of risk and return for each

security over a forward holding period

This is Security Analysis

Return-risk estimates are compared on continuing

basis for allocation of funds

This is portfolio analysis, selection and management

Measures of Risk and Return
Security Returns
Elements of return
 Periodic Cash / Income – dividend / interest

 Capital Gain – Difference between the purchase and selling price

 Total Return (Abs) = Income +/- price change

 Total Return (%)

◦ Total Return (abs) / Purchase Price
Return Example
Income received on an investment plus any change in market price, usually
expressed as a percent of the beginning market price of the investment.

Dt + (Pt – Pt - 1 )
R=
Pt - 1
The stock price for Stock A was $10 per share 1 year ago. The stock is currently
trading at $9.50 per share and shareholders just received a $1 dividend. What return
was earned over the past year?
Different Measures of Returns

 Arithmetic Mean

 Geometric Mean
Historical Return and Risk
Historical Return and Risk
Year Security return(%)

2001 9

2002 6

2003 7

2004 10

2005 8

Mean Return R’= 40/5=8

Total Risk= Variance=(Standard Deviation)^2= (10)/4= 2.5
Standard Deviation= 1.58%
 Security Deviation =
Year
return(%) ri - m (ri - m)2
2001 9 1 1
2002 6 -2 4
2003 7 -1 1
2004 10 2 4
2005 8 0 0

Mean 8
return (m)= Sum= 10

Variance= 2.5

Std
Deviation= 1.58
 Concept of Probability
Expected Value
 Expected value is the benefit which an investor anticipates by investing his funds. It is the weighted average or the

mean of probability distribution of the possible future benefits that can be derived out of a scheme of investment.

The expected value is also known as the expected value of return on the portfolio when we talk in terms of a

portfolio.The formula for calculating expected value is:

Where, E(R) = Expected return

Pi = Probability of asset i

Ri =Return on asset i

n = Number of assets in the portfolio

 Return calculation using probabilities

Stock A Stock B
Return (%) Probability Outcome(%) Return (%) Probability Outcome (%)
7 0.05 .35 9 0.30 2.7
8 0.10 .80 10 0.40 4.0
9 0.20 1.80 11 0.30 3.3
10 0.30 3.00
11 0.20 2.20
12 0.10 1.20
13 0.05 0.65
1.00 10.00 1.00 10.00

Expected return is 10% for both the stocks.

Risk calculation using probabilities

 Formula - Standard Deviation = Sq Root of Σ [Ri – E(R)]2xPi

 Pi = Probability
 Ri = Possible Return
 E(R) = Expected Return
 Risk calculation using probabilities
Stock A Stock B
Return – Diff. Probabilit Diff * Prob. Return – Diff. Probability Diff * Prob.
Expected Squared y Expected Squared
Return Return
7 - 10 9 0.05 .45 9 - 10 1 0.30 0.30

Variance Variance
Standard Deviation Standard Deviation
 Risk calculation using probabilities
Stock A Stock B
Return – Diff. Probabilit Diff * Prob. Return – Diff. Probability Diff * Prob.
Expected Squared y Expected Squared
Return Return
7 - 10 9 0.05 .45 9 - 10 1 0.30 0.30
8 - 10 4 0.10 .40 10 - 10 0 0.40 0.00
9 - 10 1 0.20 .20 11 - 10 1 0.30 0.30
10 - 10 0 0.30 .00
11 - 10 1 0.20 .20
12 - 10 4 0.10 .40
13 - 10 9 0.05 .45

Variance 2.10 Variance 0.60

Standard Deviation 1.45 Standard Deviation 0.77
 Coefficient of Variation
 Coefficient of Variation refers to the statistical measure which helps in measuring
the dispersion of the various data points in the data series around mean and is
calculated by dividing the standard deviation by mean and multiplying the resultant
with 100.
Coefficient of Variation = Standard deviation / Mean
Coefficient of Variation

Concept of coefficient of variation allows an investor to assess the risk or

volatility in comparison to the amount of expected return from the investment.
Please keep in mind that lower the coefficient, better is the risk-return trade-
off.