CHAPTER 5

PORTFOLIO RISK AND RETURN: PART I

Presenter
Venue
Date
RETURN ON FINANCIAL ASSETS

Total Return

Periodic Capital Gain

Income or Loss
 HOLDING PERIOD RETURN
A holding period return is the return from
holding an asset for a single specified period of
time.
Pt  Pt 1  Dt Pt  Pt 1 Dt
R  
Pt 1 Pt 1 Pt 1
 Capital gain  Dividendyield

105  100 2
R   5%  2%  7%
100 100
 HOLDING PERIOD RETURNS

What is the 3-year holding period return if the

annual returns are 7%, 9%, and –5%?

R   1  R1   1  R2   1  R3    1
  1  .07  (1  .09 )(1  .05)   1  .1080  10 .80 %
 AVERAGE RETURNS

Average
returns

Arithmetic Geometric Money-

or mean mean weighted
return return return
 ARITHMETIC OR MEAN RETURN

The arithmetic or mean return is the simple

average of all holding period returns.

Ri1  Ri 2  RiT 1  RiT 1 T

Ri    Rit
T T t 1

 50%  35%  27%

Ri   4%
3
 GEOMETRIC MEAN RETURN

The geometric mean return accounts for the

compounding of returns.

RGi  T 1 Ri1  1 Ri2  1 RiT1  1 RiT  1

T
 T 1 Rit  1
t 1

RGi  3 (1 .50)  (1 .35)  (1 .27) 1  5.0%

 ANNUALIZED RETURN
rannual  1  rperiod   1
c

c : number of periods in a year

Weekly return of 0.20%:

rannual  (1 0.002) 1  .1095 10.95%

52

18-month return of 20%:

2
rannual  (1  0.20) 3  1  0.1292  12.92%
 NOMINAL RETURNS AND REAL RETURNS

(1 r)  1  rrF   (1   )  (1 RP)  (1  0.03)  (1 0.02)  (1  0.05)

r  10.313%
1 rreal   1 rrF   (1 RP)  (1 0.03)  (1 0.05)
rreal  8.15%
1 rreal   (1 r)  (1  )  (1 0.10313)  (1 0.02)
rreal  8.15%
 EXAMPLE 5-4 RETURN AND RISK OF A TWO-
ASSET PORTFOLIO

Assume that as a U.S. investor, you decide to hold a

portfolio with 80 percent invested in the S&P 500 U.S.
stock index and the remaining 20 percent in the MSCI
Emerging Markets index. The expected return is 9.93
percent for the S&P 500 and 18.20 percent for the
Emerging Markets index. The risk (standard deviation) is
16.21 percent for the S&P 500 and 33.11 percent for the
Emerging Markets index. What will be the portfolio’s
expected return and risk given that the covariance
between the S&P 500 and the Emerging Markets index is
0.0050?
 EXAMPLE 5-4 RETURN AND RISK OF A TWO-
ASSET PORTFOLIO (CONTINUED)

RP  w1 R1  w2 R2   0.80  0.0993   0.20  0.1820

 0.1158  11 .58%

 P2  w12 12  w22 22  2 w1w2Cov R1 , R2 

   
 0.802  0.16212  0.202  0.33112  ( 2  0.80  0.20  0.0050)
 0.02281

 P  w12 12  w22 22  2 w1w2Cov R1 , R2 

 0.02281  0.1510  15.10%
 EXAMPLE 5-4 RETURN AND RISK OF A TWO-
ASSET PORTFOLIO (CONTINUED)
Expected Portfolio Return E (Rp)

20%
𝜌 = 0.093
Emerging
Markets
Portfolio
10%
S&P 500

10% 20% 30%

Standard Deviation of Portfolio p

IMPORTANT ASSUMPTIONS OF MEAN-
VARIANCE ANALYSIS

Mean-variance
analysis

Returns are
normally
distributed

Markets are
informationally and
operationally
efficient
 EXHIBIT 5-9 HISTOGRAM OF U.S. LARGE
COMPANY STOCK RETURNS, 1926-2008

2006
Violations of the 2004
2000 2007 1988 2003 1997
normality assumption: 1990 2005 1986 1999 1995
1981 1994 1979 1998 1991
skewness and 1977 1993 1972 1996 1989
kurtosis. 1969 1992 1971 1983 1985
1962 1987 1968 1982 1980
1953 1984 1965 1976 1975
1946 1978 1964 1967 1955
2001 1940 1970 1959 1963 1950
1973 1939 1960 1952 1961 1945
2002 1966 1934 1956 1949 1951 1938 1958
2008 1974 1957 1932 1948 1944 1943 1936 1935 1954
1931 1937 1939 1941 1929 1947 1926 1942 1927 1928 1933

–60 –50 –40 –30 –20 –10 0 10 20 30 40 50 60 70

 UTILITY THEORY
Expected
Variance or
return
risk
1
U  E (r )  A 2

Utility of an Measure of
investment risk
tolerance or
risk aversion
 INDIFFERENCE CURVES
High Moderate Low
E(Ri) Utility Utility Utility
An indifference
1 2 3
curve plots the
bx combination of
Expected Return

risk-return pairs
a x x c
that an investor
would accept to
maintain a given
level of utility.

0 σi
Standard Deviation
 THE CAPITAL ALLOCATION LINE (CAL)

E(Rp)
CAL

E(Ri)

Equation of the CAL :

E  Ri   R f
E  RP   R f  P
i
Rf

σp
σi
 EXHIBIT 5-15 PORTFOLIO SELECTION FOR TWO
INVESTORS WITH VARIOUS LEVELS OF RISK AVERSION

E(Rp) Indifference Curves

Capital Allocation
Portfolio Return

A=2 Line
x
k

A=4
x
j

0 σp
Portfolio Standard Deviation
CORRELATION AND PORTFOLIO RISK

Correlation between assets in the portfolio

Portfolio risk
EXHIBIT 5-17 RELATIONSHIP BETWEEN
RISK AND RETURN

ρ = .2
14
E (Rp)
Expected Portfolio Return

ρ = −1
11 ρ=1

ρ = .5
8

5 10 15 20 25

Standard Deviation of Portfolio p

AVENUES FOR DIVERSIFICATION
Diversify with
asset classes
Buy
insurance

Diversify with
index funds

Evaluate
assets
Diversify
among
countries
 EXHIBIT 5-22 MINIMUM-VARIANCE
FRONTIER

E(Rp) Efficient Frontier

X A B
D
Portfolio Expected Return

C Minimum-Variance
Frontier
Global
Minimum-
Variance
Portfolio (Z)

0 σ
Portfolio Standard Deviation
EXHIBIT 5-23 CAPITAL ALLOCATION LINE
AND OPTIMAL RISKY PORTFOLIO

CAL(P) is
CAL(P)
Y Efficient Frontier
the optimal
X CAL(A) of Risky Assets capital
allocation
P
line and
E(Rp)

Optimal Risky portfolio P

A Portfolio
is the
optimal
Rf
risky
σp
portfolio.
Portfolio Standard Deviation
 EXHIBIT 5-25 OPTIMAL INVESTOR
PORTFOLIO

CAL(P)
E(Rp) Indifference curve
Given the
investor’s
Efficient frontier
of risky assets
indifference
curve,
Expected return (%)

C P
A Optimal risky
portfolio portfolio C on
CAL(P) is the
Rf
optimal
Optimal investor
portfolio portfolio.

0 σp
Standard deviation (%)
 SUMMARY

• Different approaches for determining return

• Risk measures for individual assets and portfolios
• Market evidence on the risk-return tradeoff
• Correlation and portfolio risk
• The risk-free asset and the optimal risky portfolio
• Utility theory and the optimal investor portfolio