Chapter

1
A Brief History of Risk and Return

Fundamentals
of InvestmentsValuation & Management
second edition
Charles J. Corrado Bradford D. Jordan

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 1-2

Who Wants To Be A Millionaire?

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A Brief History of Risk and Return

Our goal in this chapter is to see
Goal what financial market history can tell
us about risk and return.
 Two key observations emerge.
 There is a reward for bearing risk, and at least on
average, that reward has been substantial.
 Greater rewards are accompanied by

greater risks.

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Returns
Total dollar return
The return on an investment measured in
dollars that accounts for all cash flows and
capital gains or losses.

Example
Total dollar return = Dividend + Capital gain
on stock income (or loss)

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Returns
Total percent return
The return on an investment measured as a %
of the originally invested sum that accounts for
all cash flows and capital gains or losses.
It is the return for each dollar invested.

Example
Percent return = Dividend + Capital gains
on stock yield yield
or Total dollar return .

Beginning stock price

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Returns
Example: Calculating Returns
 Suppose you invested $1,000 in a stock at $25 per
share. After one year, the price increases to $35. For
each share, you also received $2 in dividends.
 Dividend yield = $2 / $25 = 8%
 Capital gains yield = ($35 – $25) / $25 = 40%
 Total percentage return = 8% + 40% = 48%
 Total dollar return = 48% of $1,000 = $480
 At the end of the year, the value of your $1,000
investment is $1,480.
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Work the Web

 For more information on investments,
check out:
http://www.investorama.com

 For more information on common

stocks, check out:
http://finance.yahoo.com
http://www.nyse.com
http://www.sec.gov

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The Historical Record:

A First Look

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The Historical Record:

A Longer Range Look

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The Historical Record: A Closer Look

Figure 1.3

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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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The Historical Record: A Closer Look

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Work the Web

 To learn more about global market

history, visit:
http://www.globalfindata.com

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Average Returns: The First Lesson

 Average annual =  yearly returns

return number of years

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Average Returns: The First Lesson

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Average Returns: The First Lesson

Risk-free rate
The rate of return on a riskless investment.

Risk premium
The extra return on a risky asset over the
risk-free rate; the reward for bearing risk.

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Average Returns: The First Lesson

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Average Returns: The First Lesson

The First Lesson
 There is a reward, on average, for bearing risk.

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Return Variability: The Second Lesson

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Return Variability: The Second Lesson

Variance
A common measure of volatility.
Standard deviation
The square root of the variance.
Normal distribution
A symmetric, bell-shaped frequency
distribution that is completely defined by its
average and standard deviation.
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Return Variability: The Second Lesson

Variance of return
R  R 
N
2
i
Var  R   σ 
2 i 1
N 1
where N is the number of returns

Standard deviation of return

SD R   σ  Var  R 
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Return Variability: The Second Lesson

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Return Variability: The Second Lesson

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Work the Web

 For an easy-to-read review of basic

statistics, see:
http://www.robertniles.com/stats/

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Return Variability: The Second Lesson

The Second Lesson
 The greater the potential reward, the greater
the risk.

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Return Variability: The Second Lesson

Top 12 One-Day Percentage Changes in the

Dow Jones Industrial Average

October 19, 1987 - 22.6 % March 14, 1907 - 8.3 %

October 28, 1929 - 12.8 October 26, 1987 - 8.0
October 29, 1929 - 11.7 July 21, 1933 - 7.8
November 6, 1929 - 9.9 October 18, 1937 - 7.7
December 18, 1899 - 8.7 February 1, 1917 - 7.2
August 12, 1932 - 8.4 October 27, 1997 - 7.2

Source:
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Risk and Return

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Risk and Return

 The risk-free rate represents compensation for
just waiting. So, it is often called the time
value of money.
 If we are willing to bear risk, then we can
expect to earn a risk premium, at least on
average.
 Further, the more risk we are willing to bear,
the greater is that risk premium.

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A Look Ahead
This text focuses exclusively on
financial assets: stocks, bonds, options,
and futures.
 We will learn how to value different assets and
make informed, intelligent decisions about the
associated risks.
 We will also discuss different trading
mechanisms and the way different markets
function.
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 1 - 32

Chapter Review
 Returns
 Dollar Returns
 Percentage Returns

 The Historical Record

 A First Look
 A Longer Range Look

 A Closer Look

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Chapter Review
 Average Returns: The First Lesson
 Calculating Average Returns
 Average Returns: The Historical Record

 Risk Premiums

 The First Lesson

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Chapter Review
 Return Variability: The Second Lesson
 Frequency Distributions and Variability
 The Historical Variance and Standard Deviation

 The Historical Record

 Normal Distribution

 The Second Lesson

 Risk and Return

 The Risk-Return Trade-Off
 A Look Ahead

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