Risk & Return

Lecture 6
Business Finance
 Outline

Calculating the expected return, standard deviation & variance.

Arithmetic & Geometric average returns

What’s Beta(β)?

Portfolio Management

Diversification

Risk: Systematic & Unsystematic.

 Risk & Return
“Risk and Return, you can’t have one without the other”
What’s Risk?
Risk - the possibility of earning a negative, or less than expected, return.

What do we mean by ”earning a negative return”?

It is the case where an investor’s principal is less than it was when they initiated the investment.
 Calculating Rate of Return
𝐄𝐧𝐝 𝐕𝐚𝐥𝐮𝐞 − 𝐁𝐞𝐠𝐢𝐧𝐢𝐧𝐠 𝐕𝐚𝐥𝐮𝐞
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐧 =
𝐁𝐞𝐠𝐢𝐧𝐢𝐧𝐠 𝐕𝐚𝐥𝐮𝐞

Example: Suppose you buy 10 shares of stock for $1,000. The stock pays no dividends and at the
end of 1 year you sell the stock for $1,100. What is your rate of return?
𝟏𝟏𝟎𝟎 − 𝟏𝟎𝟎𝟎
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐫𝐞𝐭𝐮𝐫𝐧 = = 𝟎. 𝟏𝟎 = 𝟏𝟎%
𝟏𝟎𝟎𝟎
 Risk
• Risk is the probability that you end up with a lower rate of return than expected.
Stand-alone risk is the risk of an individual asset.
Portfolio risk is the risk of all of your portfolio.
Market risk is the risk of the entire market
Market bubbles
Pandemics
Wars
Crisis such as oil crisis
Central banks announcements
What’s a portfolio ?
A portfolio is the a collection of your investments.
 Risk & Return
When you invest your money in the stock market, a bond, or a savings account, you expect that
over time your account will grow in value.

However, most investments have some risk that the portfolio will grow in value and some risk
that it will decline in value.
In this lecture, we will look at how to evaluate risk and how to use that evaluation:
1. Analyze the risk level of your investment portfolio.
2. Determine the risk of an individual investment.
 Evaluating Risk through probability
distributions
How can we evaluate the risk?
1. We can evaluate risk using probability distributions.
• What’s a probability distribution?
A probability distribution is a set of possible outcomes and the probability that those
outcomes occur.
We will use probability distributions to calculate the expected return of a series of
possible outcomes:
𝑛

𝐸 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟 = 𝑝1 𝑟1 + 𝑝2 𝑟2 + 𝑝3 𝑟3 + ⋯ + 𝑝𝑛 𝑟𝑛 = 𝑝𝑖 𝑟𝑖
𝑖=1
Where:
𝑝𝑖 : is a the probability an event occurs (𝑝𝑖 must sum to 1).
𝑟𝑖 : is the outcome of a specific event.
 Expected Returns
Let’s Suppose that you predicted the below mentioned returns for stocks “X” & “Y” in
three situations of the economy, BOOM, NORMAL, and RECESSION. What are your
expected returns?
Situation Probability “X” “Y”
BOOM 0.3 0.15 0.25
NORMAL 0.5 0.1 0.2
RECESSION ? 0.02 0.01
1. what’s the probability of recession?
1 − 0.3 − 0.5 = 0.2
2. Calculating the expected return:
𝑅𝑥 = 0.3 0.15 + 0.5 0.1 + 0.2(0.02)= 0.099 or 9.9%
𝑅𝑌 = 0.3 0.25 + 0.5 0.2 + 0.2(0.01)=0.177 or 17.7%
Now, let’s suppose that the risk-free rate is 4%. In this case, what is the risk premium?
Stock “X”: 9.9 – 4 = 5.9%
Stock “y”: 17.7 – 4 = 13.7%
 Evaluating Risk
The expected return:
𝐸 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝑟 = 0.3 0.37 + 0.4 0.11 + 0.3 −0.15 = 0.11 = 11%
The standard deviation:
SD = (0.37 − 0.11)2 . 0.3 + (0.11 − 0.11)2 . 0.4 + (−0.15 − 0.11)2 . 0.3 = 0.201 = 20.1%
 Normal distribution

Stock market returns typically follow a normal distribution.

We are calculating an estimate for the expected return, 𝑟.
Thus, we are not able to state with certainty that we will get a specific value.
Yet, the normal distribution will help us to get a range for which provide us more certainty to our
expected return.
 This Figure draws two different normally distributed curves
Which of the two returns for hypothetical returns A and B.
is more risky? There is more risk associated with investing in the asset that
provides the returns modeled by return B
 Evaluating Risk
What do “Variance” & “Standard Deviation” stand for?
They both measure the volatility of returns. They measure dispersion from the mean.
How to evaluate it?
Standard deviation is another measure of dispersion that helps quantify risk parameters for
individual.
The more widely spread out the set of possible outcomes are, the greater the risk.
𝑛

𝑺𝑫 = (𝑟 − 𝑟)2 × 𝜌𝑖
𝑖=1

Variance measures the dispersion around a mean, which is used as a proxy for risk. The
larger the variance, the more dispersion is present which means that there is more risk is
present.
𝑛

𝜎2 = (𝑟 − 𝑟)2 × 𝜌𝑖
𝑖=1
The standard deviation is the square root of the variance.
 Evaluating Risk
What are the variance & standard deviation for each stock using same ?
Let’s Suppose that you predicted the below mentioned returns for stocks “X” & “Y” in three
situations of the economy, BOOM, NORMAL, and RECESSION. What are your expected returns?

𝒏
𝑺𝑫 = 𝒊=𝟏(𝒓 − 𝑟)𝟐 × 𝑝𝑖

Stock “X”:
𝝈𝟐 = 0.3(0.15 − 0.099)2 +0.5(0.10 − 0.099)2 +0.2(0.02 − 0.099)2 = 0.002029
𝝈 = 𝟒. 𝟓%
Stock ‘Y”:
𝝈𝟐 = 0.3(0.25 − 0.177)2 +0.5(0.20 − 0.177)2 +0.2(0.01 − 0.177)2 = 0.007441
𝝈 = 𝟖. 𝟔𝟑%
 2. Historical data
Sometimes, we can predict “the immediate future” by using the “immediate past”.
Immediate past is relative, which means that it can be the last 30 minutes, the last 30 hours, days
or years.
So, we calculate the arithmetic average of previous returns.
We can use historical data to figure out:
The average rate of return
The average standard deviation
The average correlation between two stocks
Historical Returns
Historical Returns
 Historical data
Average Rate of Return
To calculate the average rate of return:
𝑛
𝑟𝑡 + 𝑟𝑡−1 + 𝑟𝑡−2 + ⋯ + 𝑟𝑡−𝑛 𝑡=1 𝑟𝑡
𝑟= =
𝑛 𝑛
Historical Standard Deviation
To calculate the historical standard deviation:
𝑛
(𝑟𝑡 − 𝑟)2 +(𝑟𝑡−1 − 𝑟)2 + ⋯ + (𝑟𝑡−𝑛 − 𝑟)2 𝑡=1(𝑟𝑛− 𝑟 )2
σ= =
𝑛−1 𝑛−1
Historical Correlation
𝑟𝑥,𝑡 − 𝑟𝑥 𝑟𝑦,𝑡 − 𝑟𝑦 + 𝑟𝑥,𝑡−1 − 𝑟𝑥 𝑟𝑦,𝑡−1 − 𝑟𝑦 + ⋯ + (𝑟𝑥,𝑡−𝑛 − 𝑟𝑥 )(𝑟𝑦,𝑡−𝑛 − 𝑟𝑦 )
ρx,y =
SD 𝑥 . SD 𝑦 (𝑛 − 1)
𝑛
𝑡=1( 𝑟𝑥,𝑡−𝑛 − 𝑟𝑥 )(𝑟𝑦,𝑡−𝑛 − 𝑟𝑦 )
ρx,y =
SD 𝑥 . SD 𝑦 (𝑛 − 1)
𝜌 𝑖𝑠 𝑎𝑙𝑤𝑎𝑦𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 − 1 𝑎𝑛𝑑 1.
A negative ρ means that the two stocks tend to move in opposite direction
A positive ρ means that the two stocks tend to move in the same direction
 Historical data
Average Rate of Return :
Arithmetic Vs. Geometric
Arithmetic return:
𝑛
𝑟𝑡 + 𝑟𝑡−1 + 𝑟𝑡−2 + ⋯ + 𝑟𝑡−𝑛 𝑡=1 𝑟𝑡
𝑟= =
𝑛 𝑛
r is the average return, t is an individual time period, and T is the total number of time periods in
the average.
The arithmetic average of past returns might be useful in determining an expected return for any
given year, yet it does not include the effects of compounding.
Geometric average : it computes the annual growth rate that assumes compounding took place
in every period.
1 𝑁
𝑁

𝐶𝐴𝐺𝑅 = (1 + 𝑟𝑡 ) −1
𝑡=1
 Historical data
Example: Suppose that you invest $1,000 and you earn the following three returns over the next
three years: 5%, 10%, and 15%.

1 𝑁
𝑁

𝐶𝐴𝐺𝑅 = (1 + 𝑟𝑡 ) − 1 = *(1.05)(1.10)(1.15)+1 3 −1 = 0.0993

𝑡=1

This shows that earning 5% in the first year, 10% in the second year, and 15% in the third year is
the same as earning 9.93% a year for three years.
 Portfolio Management
Portfolio return : a weighted average return of all securities in a portfolio.
Diversification: the process of investing in securities in different industries to reduce
the risk of the entire portfolio.
Systematic (Non-Diversifiable) and Unsystematic (Diversifiable) Risk
Diversifiable risk: also known as unsystematic risk, is the risk associated with an
individual company’s stock price decline irrespective of the market.
Non-diversifiable risk :Also known as systematic, or market risk, this is the risk that
something causes the entire market to drop in price.
• Total risk is measured by the standard deviation and The systematic risk is
measured by beta.
 Portfolio
• Investors try to increase the expected return on their portfolios & to reduce the
standard deviation of that return.
• The portfolio that gives the highest expected return for a given standard deviation
& the lowest standard deviation for a given expected return is called “efficient
portfolio”.
• The marginal contribution of a stock to a portfolio risk is measured by its sensitivity
to changes in the value of the portfolio and is measured by β.
• CAPM is a model of risk & return and it states that each security’s expected risk
premium should increase in proportion to its β. However, even if the CAPM is used
widely, the relationship between the returns & β is not as strong as CAPM predicts
it . Thus, there may be some other factors that explain the returns.
• Efficient Market Hypothesis (EMH): A hypothesis which states that all information
is already included within stock prices, which makes it impossible to earn excess
returns.
 Portfolio Management

Portfolio Return
A portfolio is a collection of assets.
Some of the assets in your portfolio will have more weight than others
Some stocks will have a higher value than others and therefore will make up a higher
percentage of the total value of your portfolio
To calculate the weight of each stock:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘
𝜔𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
To calculate the weighted return of a portfolio:
𝑛

𝑟𝑝 = 𝜔1 𝑟1 + 𝜔2 𝑟2 + ⋯ + 𝜔𝑛 𝑟𝑛 = 𝜔𝑖 𝑟𝑖
𝑖=1
Where,
𝜔𝑖 is the weight for stock 𝑖.
𝑟𝑖 is the average annual return for stock 𝑖.
Diversification
 Example: Suppose this is your portfolio that is worth
Portfolio $10,000:
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘
Management 𝜔𝑖 =
𝑇𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
2,900
𝜔𝐴𝑝𝑝𝑙𝑒 = 10,000 = 0.29=29%
4,430
𝜔𝐺𝑜𝑜𝑔𝑙𝑒 = 10,000 = 0.443=44.3%
Stock Value Return
520
Apple $2,900 15% 𝜔𝑁𝑖𝑘𝑒 = 10,000 = 0.0520=5.22%
Google $4,430 17% 950
𝜔𝐹𝑜𝑟𝑑 = 10,000 = 0.095=9.5%
Nike $520 6%
1,200
Ford $950 5% 𝜔𝑃𝑓𝑖𝑧𝑒𝑟 = 10,000 = 0.12=12%
Pfizer $1,200 8% A chance in the value of Nike’s stock will have a much
smaller impact on the total value of the portfolio than a
Total $10,000 change in the value of Google or Apple.
𝑟𝑝 = 𝜔1 𝑟1 + 𝜔2 𝑟2 + ⋯ + 𝜔𝑛 𝑟𝑛
𝑟𝑝 = 0.29 × 0.15 + 0.443 × 0.17 + 0.052 × 0.06
+ 0.095 × 0.05 + 0.12 × 0.08
𝒓𝒑 = 0.13564 or 13.564%
 Portfolio Diversification
Diversification is the process of investing in different industries to reduce the risk of
your entire portfolio.
The goal is to have a collection of investments that that cancel each others stand-
alone risk out.
Recall from earlier that there is market risk, which is out of our control.
Historical Data :
If you own 1 stock, the average standard deviation of returns is near 50% .
By owning 10 stocks that are randomly selected from various industries, the standard
deviation of returns drops to around 24% .
By owning 40 stocks that are randomly selected from various industries, the standard
deviation drops to about 20%.
Adding more than 40 stocks may make the standard deviation drop slightly more, but
not much more.
Research shows that with proper diversification, a portfolio can get a standard
deviation of about 20%, which we consider the standard deviation of the market .
 Portfolio
The portfolio beta tells us the risk of the entire portfolio relative to the market:
𝑛
𝛽𝑝 = 𝜔1 𝛽1 + 𝜔2 𝛽2 + ⋯ + 𝜔𝑛 𝛽𝑛 = 𝑖=1 𝜔𝑖 𝛽𝑖
We want to be as close to 1 as possible.
Standard Deviation of the Portfolio :
𝜎𝑝 = 𝛽𝑝 𝜎𝑀
If βp = 1, then 𝜎𝑝 = 𝜎𝑀 and the portfolio is perfectly diversified = 1, then 𝜎𝑝 = 𝜎𝑀 and the
portfolio is perfectly diversified.
 Capital Asset Pricing Model (CAPM)
“The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how
to measure risk and the relation between expected return and risk.”
We want to know how much risk each stock contributes to a portfolio.
We can measure this by calculating the Beta of each stock.
𝜎𝑖
𝛽𝑖 = . 𝜌𝑖,𝑀
𝜎𝑀
Where,
𝜎𝑖 : is the standard deviation of stock 𝑖.
𝜎𝑀 : is the standard deviation of the market (𝜎𝑀 :=0.20).
𝜌𝑖,𝑀 : is the correlation between returns of stock i and the returns of the market.
By making some substitutions, we can rewrite the equation for 𝛽𝑖 to be.
𝑛
𝑡=1(𝑟𝑥,𝑛 − 𝑟𝑥 )(𝑟𝑚,𝑛 − 𝑟𝑚 )
𝛽𝑖 =
𝜎𝑀 2 (𝑛 − 1)
Interpreting Beta:
If 𝛽𝑖 < 1, a stock is less risky relative to the market.
If 𝛽𝑖 = 1, then the stock has equal risk to the market.
If 𝛽𝑖 > 1, then the stock is more risky relative to the market.
Because each stock has a different weight in a portfolio, we want to calculate the portfolio beta
 The Security Market Line (SML)
Equation 𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝑟𝑀 − 𝑟𝑓 can be used to graph the security market line (SML). The
SML captures the tradeoff between expected return and systematic risk as measured by β.
The SML gives us the rate of return that is required by investors to be adequately
compensated for the level of risk of the investment.
Why do we care about the required rate of return?
If analysts are able to forecast the expected return of a stock and find that the expected
return is greater than the required return, that could mean the stock is undervalued. the
CAPM model states that the expected return for a given security is a function of the market
risk premium, the risk-free rate, and a stock’s riskiness relative to the overall portfolio of
risky assets (which we will now call the market).
𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝑟𝑀 − 𝑟𝑓
Where,
𝑟𝑓 :is the risk-free rate
𝛽𝑖 is the beta of stock 𝑖.
𝑟𝑀 :is the expected return of the market.
𝑟𝑀 − 𝑟𝑓 : is know as the Risk Premium of the Market, 𝑅𝑃 𝑀 .
 The Security Market Line (SML)
Example: Suppose that investors expect the market to earn an 11% rate of return over the
next year and the yield on 3-month US Treasury Bill is 6%. What would be required rate of
return be for the following stocks:
1. A low-risk stock 𝛽𝐿 = 0.5
2. An average-risk stock, 𝛽𝐴 = 1.0
3. A high-risk stock, 𝛽𝐻 = 2.0
Applying the SML equation 𝒓𝒊 = 𝒓𝒇 + 𝜷𝒊 𝒓𝑴 − 𝒓𝒇 𝒘𝒆 𝒌𝒏𝒐𝒘 that investors will require
(expect) the company to earn: for instance 𝒓𝑳 = 8.5% to compensate them for accepting
the implied level of systematic risk.
𝑟𝐿 = .06 + 0.5(0.11 − 0.06) = 0.085 = 8.5%
𝑟𝐴 = .06 + 1.0(0.11 − 0.06) = 0.11 = 11.0%
𝑟𝐻 = .06 + 2.0(0.11 − 0.06) = 0.16 = 16.0%
We can also use the SML to compare two stocks that have the same beta
Stocks above the SML are undervalued.
Stocks below the SML are overvalued.
 The Security Market Line (SML)
Using the values from the example, we can plot the Security Market Line:
Beta and the expected return of the
stocks of some companies
 Efficient Market Hypothesis
The efficient market hypothesis (EMH) states that all known information about investment
securities is already included in the prices of those securities. Which implies that no amount of
analysis can give you an edge over “the market”.
Forms of the Efficient Market Hypothesis
Weak Form: Suggests that all past information is included in the prices of the securities.
Fundamental analysis of securities can give you information to produce returns above market
averages in the short term. Yet, this fundamental analysis does not give you a long-term
advantage. Also, the technical analysis will not work .
Semi-Strong Form: This form states that neither fundamental analysis nor technical analysis can
give you an advantage. In addition to that, This form states that new information is instantly
included in securities prices.
Strong Form: All information, both public and private, is included in the securities prices. Thus, no
investor can gain advantage over the market as a whole.
Those who “win” are lucky; those who “lose” are unlucky.
Empirical studies suggest the market is weakly efficient but not strongly efficient.
 Behavioral Finance
Behavioral finance is the field that analyzes why individuals do not act
rationally.
By rationality means violating some preference ordering or make a choice
that selects an option with the lower expected value.
 Resources
Mainly:
Introduction to Business Finance: Techniques & Tools. Jeffrey S. Smith, Ph.D.
Department of Economics and Business Virginia Military Institute
Extra:
Brealey, Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance, 13th
edition (McGraw‐Hill Irwin, 2020).
Lecture Notes of:
https://timmurrayecon.com/wp-content/uploads/2022/07/Business-Finance-Lecture-
Notes-June-2022.pdf