Return Example

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?
R = $1.00 + ($9.50 - $10.00) = 5%
$10.00
Rule #1
 No investment should be undertaken unless the expected rate of return is high enough to compensate the
investor for the perceived risk of the investment.
 “Your expected rate of return is your threshold”
Expected Rate of Return
 The weighted average of outcomes
Determining Expected Return (Discrete or Sample Distribution)
If you are given a probability, then it is discrete
If no probability, then it is population or continuous

Rule #2
The tighter the probability distribution of the expected future returns, the smaller the risk of a given investment

Basic Foods is tighter compared to sales.com. That

means basic food is less risky as compared to sale.com.
How to measure the tightness of the distribution?
 Through STANDARD DEVIATION (measurement of the tightness); it is a risk measure
 The symbol for which is σ, pronounced “sigma”
Rule #3
The smaller the standard deviation, the tighter the probability distribution, and, accordingly, the less risky the
stock.
How do we choose between two investments if one has a higher expected return but the other has a lower
standard deviation?
 Use coefficient of variation (CV), which is the standard deviation divided by the expected return.

Rule #4
The lower the coefficient of variation, the better.
Consider this!
Project X Project Y
Expected Return 60% 8%
Standard Deviation 15% 3%
Coefficient of Variation 0.25 0.375
If we will use the criteria of expected return, we will choose project x because it has higher expected return
If we will use the criteria of standard deviation, we will choose project y because we need to choose the lower
risk
If we will use the criteria of coefficient of variation, we will choose project x because it has a lower coefficient
of variation
Another Example – Solve it!
Given the following expected returns and standard deviations of assets B, M, Q, and D, which asset should the
prudent financial manager select?
Asset Expected Return Standard Deviation
B 10% 5%
M 16% 10%
Q 14% 9%
D 12% 8%
a) Asset B
b) Asset M
c) Asset Q
d) Asset D