Chapter 2

Risk and Return

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reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Risk and Return (1 of 2)

“All I ask is for the chance to prove that

money can’t make me happy.’’
– Spike Milligan

© McGraw-Hill Education. 1-2

 Risk and Return (2 of 2)

• Our goal in this chapter is to see what financial

market history can tell us about risk and return.
• There are two key observations:
– First, there is a substantial reward, on average, for
bearing risk.
– Second, greater risks accompany greater returns.
• The single most important fact to understand
about investments: Risk and Return go together.

© McGraw-Hill Education. 1-3

 Learning Objectives

To become a wise investor (maybe even one

with too much money), you need to know:
1. How to calculate the return on an investment
using different methods.
2. The historical returns on various important types
of investments.
3. The historical risks of various important types of
investments.
4. The relationship between risk and return.

© McGraw-Hill Education. 1-4

 Example I: Who Wants To Be A
Millionaire?
• You can retire with One Million Dollars (or
more).
• How? Suppose:
– You invest $300 per month.
– Your investments earn 9% per year.
– You decide to take advantage of deferring
taxes on your investments.
• It will take you about 36.25 years. Hmm. Too
long.

© McGraw-Hill Education. 1-5

 Example II: Who Wants To Be A
Millionaire? (1 of 2)
• Instead, suppose:
– You invest $500 per month.
– Your investments earn 12% per year
– you decide to take advantage of deferring
taxes on your investments
• It will take you 25.5 years.

© McGraw-Hill Education. 1-6

 Example II: Who Wants To Be A
Millionaire? (2 of 2)
• Realistic?
– $250 is about the size of a new car payment,
and perhaps your employer will kick in $250
per month
– Over the last 90 years, the S&P 500 Index
return was about 12%
Try this calculator:
cgi.money.cnn.com/tools/millionaire/million
aire.html

© McGraw-Hill Education. 1-7

 Dollar Returns

• Total dollar return is the return on an

investment measured in dollars, accounting
for all interim cash flows and capital gains or
losses.
• Example:
Total Dollar Return on a Stock = Dividend
Income + Capital Gain (or Loss)

© McGraw-Hill Education. 1-8

 Percent Returns

• Total percent return is the return on an investment

measured as a percentage of the original investment.
• The total percent return is the return for each dollar
invested.
• Example, you buy a share of stock:

Dividend Income  Capital Gain  or Loss

Percent Return on a Stock 
Beginning Stock Price
or
Total Dollar Return on a Stock
Percent Return 
Beginning Stock Price i.e., Beginning Investment

© McGraw-Hill Education. 1-9

 Example 1.1: Concannon Plastics
Calculating Total Dollar and Total
Percent Returns (1 of 2)
• Suppose you invested $1,400 in a stock with a
share price of $35.
• After one year, the stock price per share is $49.
• Also, for each share, you received a $1.40
dividend.
• What was your total dollar return?
– $1,400 / $35 = 40 shares
– Capital gain: 40 shares times $14 = $560
– Dividends: 40 shares times $1.40 = $56
– Total Dollar Return is $560 + $56 = $616

© McGraw-Hill Education. 1-10

 Example 1.1: Concannon Plastics
Calculating Total Dollar and Total
Percent Returns (2 of 2)
• What was your total percent return?
– Dividend yield = $1.40 / $35 = 4%
– Capital gain yield = ($49 – $35) / $35 = 40%
– Total percentage return = 4% + 40% = 44%
Note that $616 divided by $1,400 is 44%.

© McGraw-Hill Education. 1-11

 Annualizing Returns, I (1 of 2)

• You buy some shares of Johnson & Johnson (JNJ)

at $60 per share. Three years later, you sell
these shares for $64.50 per share. You received
no dividends. What is your return? What is your
annualized return?
• Return:
Pt 1 – Pt  Pt   $64.50 - $60  $60  .0750  7.50%

• This return is the holding period percentage

return.

© McGraw-Hill Education. 1-12

 Annualizing Returns, I (2 of 2)

• Effective Annual Return (EAR): The return

on an investment expressed on an
“annualized” basis.
• Key Question: What is the number of
holding periods in a year?

© McGraw-Hill Education. 1-13

 Annualizing Returns, II

1  EAR  1  holding period percentage return

m

m = the number of holding periods in a year.

In this example, the holding period is three years.
So, each year contains = 1/3 of this 3-year holding
period.
Therefore:
1  EAR  1  .0750
13
 1.0244.
So, EAR = .0244 or 2.44%.
Note: (1.0244) × (1.0244) × (1.0244) = 1.075

© McGraw-Hill Education. 1-14

A $1 Investment in Different Types of
Portfolios, 1926—2015

© McGraw-Hill Education. 1-15

Financial Market History, 1801-2015

© McGraw-Hill Education. 1-16

The Historical Record: Total Returns
on Large-Company Stocks

© McGraw-Hill Education. 1-17

The Historical Record: Total Returns
on Small-Company Stock

© McGraw-Hill Education. 1-18

The Historical Record: Total Returns
on Long-term U.S. Bonds

© McGraw-Hill Education. 1-19

The Historical Record: Total Returns
on U.S. T-bills

© McGraw-Hill Education. 1-20

The Historical Record: Inflation

© McGraw-Hill Education. 1-21

Historical Average Returns (1 of 2)

• A useful number to help us summarize historical

financial data is the simple, or arithmetic average.
• Using the data in Table 1.1, if you add up the
returns for large-company stocks from 1926
through 2015, you get about 1,067 percent.
• Because there are 90 returns, the average return
is about 11.9%. How do you use this number?
• If you are making a guess about the size of the
return for a year selected at random, your best
guess is 11.9%.

© McGraw-Hill Education. 1-22

Historical Average Returns (2 of 2)

• The formula for the historical average return is:

n

 yearly return
Historical Average Return  i 1
n

This formula says: Starting with the first one,

add up each yearly return   says" sum"
and divide by the number of years, n

© McGraw-Hill Education. 1-23

 Average Annual Returns for Five
Portfolios and Inflation, 1926—2015
Investment Average Return

Large-company stocks 11.9%

Small-company stocks 17.5

Long-term corporate bonds 6.5

Long-term government bonds 6.2

U.S. Treasury bills 3.6

Inflation 3.0

© McGraw-Hill Education. 1-24

2008: The Bear Growled and
Investors Howled

© McGraw-Hill Education. 1-25

 World Stock Market Capitalization

2015: Amount 2014: Amount

Region/Country 2015: Percent 2014: Percent
(in trillions) (in trillions)
United States $ 25.1 37.4% $26.3 38.7%
Canada 1.6 2.4 2.1 3.1
Americas, excluding U.S.
1.3 1.9 1.9 2.8
and Canada
Japan 4.9 7.3 4.4 6.5
Asia-Pacific, excluding
18.3 27.3 16.7 24.6
Japan
United Kingdom 3.9 5.8 4.0 5.9
Germany 1.7 2.5 1.7 2.5
Europe, Africa, Middle
East, excluding United 10.3 15.4 10.9 16.0
Kingdom and Germany
Total $67.1   $68.0  

More than one third of the value of tradable stock is in

the U.S.

© McGraw-Hill Education. 1-26

 Average Annual Returns and Risk
Premiums for Five Portfolios, 1926—
2015
Investment Average Return Risk Premium

Large-company stocks 11.9% 8.3%

Small-company stocks 17.5 13.9

Long-term corporate bonds 6.5 2.9

Long-term government bonds 6.2 2.6

U.S. Treasury bills 3.6 0.0

© McGraw-Hill Education. 1-27

Average Returns: The First Lesson
(1 of 2)
• Risk-free rate: The rate of return on a
riskless, i.e., certain investment.
• Risk premium: The extra return on a risky
asset over the risk-free rate; i.e., the reward
for bearing risk.
• The First Lesson: There is a reward, on
average, for bearing risk.

© McGraw-Hill Education. 1-28

Average Returns: The First Lesson
(2 of 2)
• By looking at Table 1.4, we can see the risk
premium earned by large-company stocks was
8.3%!
– Is 8.3% a good estimate of future risk
premium?
– The opinion of 226 financial economists: 7.0%.
– Any estimate involves assumptions about the
future risk environment and the risk aversion of
future investors.

© McGraw-Hill Education. 1-29

 Why Does a Risk Premium Exist?

• Modern investment theory centers on this question.

• Therefore, we will examine this question many
times in the chapters ahead.
• We can examine part of this question, however, by
looking at the dispersion, or spread, of historical
returns.
• We use two statistical concepts to study this
dispersion, or variability: variance and standard
deviation.
• The Second Lesson: The greater the potential
reward, the greater the risk.

© McGraw-Hill Education. 1-30

 Return Variability Review and
Concepts (1 of 2)
• Variance is a common measure of return
dispersion. Sometimes, return dispersion is
also call variability.
• Standard deviation is the square root of the
variance.
– Sometimes the square root is called volatility.
– Standard Deviation is handy because it is in the
same "units" as the average.

© McGraw-Hill Education. 1-31

 Return Variability Review and
Concepts (2 of 2)
• Normal distribution: A symmetric, bell-
shaped frequency distribution that can be
described with only an average and a standard
deviation
Does a normal distribution describe asset
returns?

© McGraw-Hill Education. 1-32

Frequency Distribution of Returns on
Common Stocks, 1926—2015

© McGraw-Hill Education. 1-33

 Return Variability: The Statistical
Tools (1 of 2)
• The formula for return variance is ("n" is the
number of returns):

 R 
N 2

i R
VAR R   σ 2  i 1
N1

• Sometimes, it is useful to use the standard

deviation, which is related to variance like this:
SDR     VAR R 

© McGraw-Hill Education. 1-34

 Return Variability: The Statistical
Tools (2 of 2)
• The variance formula says: Starting with the
first return, subtract the average return from
it and then square the result. Continue to do
so for all “N” returns. Add them all up
  says" sum".
Then, divide by N – 1.

© McGraw-Hill Education. 1-35

 Example: Calculating Historical
Variance and Standard Deviation
Let’s use data from Table 1.1 for Large-Company Stocks.
The spreadsheet below shows us how to calculate the
average, the variance, and the standard deviation (the
long way…).
(4) (5)
(1) (2) (3)
Difference: Squared:
Year Return Average Return:
(2) - (3) (4) × (4)
2012 0.1600 0.1587 0.0013 0.0000
2013 0.3239 0.1587 0.1653 0.0273
2014 0.1369 0.1587 -0.0218 0.0005
2015 0.0138 0.1587 -0.01449 0.0210
Sum: 0.6346 0.0000 0.0488
Average: 0.1587 Variance: 0.01625
Standard Deviation: 0.12749

© McGraw-Hill Education. 1-36

Historical Returns, Standard
Deviations, and Frequency
Distributions: 1926—2015

© McGraw-Hill Education. 1-37

The Normal Distribution and Large
Company Stock Returns

© McGraw-Hill Education. 1-38

Good Times for the Dow Jones Index

Point Percentage
Date Index Level Rank Date Index Level
Increase Increase

2008-10-13 9,387.61 936.42 1 1933-03-15 62.10 15.3%

2008-10-28 9,065.12 889.35 2 1931-10-06 99.34 14.9%

2015-08-26 16,285.51 619.07 3 1929-10-30 258.47 12.3%

2008-11-13 8,835.25 552.59 4 1931-06-22 145.82 11.9%

2000-03-16 10,630.61 499.19 5 1932-09-21 75.16 11.4%

03-23-2009 7,775.86 497.48 6 2008-10-13 9,387.61 11.1%

2008-11-21 8,046.42 494.13 7 2008-10-28 9,065.12 10.9%

2011-11-30 12,045.68 490.05 8 1987-10-21 2,027.85 10.1%

2002-07-24 8,191.29 488.95 9 1932-08-03 58.22 9.5%

2008-09-30 10,850.66 485.21 10 1939-09-05 148.12 9.5%

© McGraw-Hill Education. 1-39

Bad Times for the Dow Jones Index

Point Percentage
Date Index Level Rank Date Index Level
Decrease Decrease

2008-09-29 10,365.45 -777.68 1 1987-10-19 1,738.74 -22.6%

2008-10-15 8,577.91 -733.08 2 1914-12-14 56.76 -20.5%

2001-09-17 8,920.70 -684.81 3 1929-10-28 260.64 -13.5%

2008-12-01 8,149.09 -679.95 4 1899-12-18 58.27 -12.0%

2008-10-09 8,579.19 -678.91 5 1929-10-29 230.07 -11.7%

2011-08-08 10,809.85 -634.76 6 1931-10-05 86.48 -10.7%

2000-04-14 10,305.78 -617.77 7 1929-11-06 232.13 -9.9%

1997-10-27 7,161.14 -544.26 8 1932-08-12 63.11 -8.4%

2015-08-24 15,871.35 -588.40 9 1907-03-14 76.23 -8.3%

2015-08-21 16,459.75 -530.94 10 1932-01-04 71.59 -8.1%

© McGraw-Hill Education. 1-40

 Arithmetic Averages versus
Geometric Averages (1 of 2)
• The arithmetic average return answers the
question: “What was your return in an average
year over a particular period?”
• The geometric average return answers the
question: “What was your average compound
return per year over a particular period?”
• When should you use the arithmetic average and
when should you use the geometric average?
• First, we need to learn how to calculate a
geometric average.

© McGraw-Hill Education. 1-41

 Arithmetic Averages versus
Geometric Averages (2 of 2)
• The arithmetic average tells you what you earned
in a typical year.
• The geometric average tells you what you actually
earned per year on average, compounded annually.
• When we talk about average returns, we
generally are talking about arithmetic average
returns.
• For the purpose of forecasting future returns:
– The arithmetic average is probably "too high"
for long forecasts.
– The geometric average is probably "too low"
for short forecasts.
© McGraw-Hill Education. 1-42
Example: Calculating a Geometric
Average Return
• Let’s use large-company stock data from Table 1.1 for
2012-2015.
• Here’s how to calculate a geometric average return.

Year Percent Return One Plus Return Compounded Return:

2012 16.00% 1.1600 1.1600

2013 32.39% 1.3239 1.5357

2014 13.69% 1.1369 1.7460

2015 1.38% 1.0138 1.7701

(1.7235)^(1/4): 1.1534

Geometric Average Return: 15.34%

© McGraw-Hill Education. 1-43

 Geometric versus Arithmetic
Averages, 1926—2015
Geometric Arithmetic Standard
Series
Mean Mean Deviation

Large-company stocks 9.9% 11.9% 20.0%

Small-company stocks 11.9 17.5 36.3

Long-term corporate bonds 6.3 6.5 7.0

Long-term government bonds 5.5 6.2 12.5

Intermediate-term government bonds 5.3 5.5 8.1

U.S. Treasury bills 3.5 3.6 3.2

Inflation 2.9 3.0 4.1

© McGraw-Hill Education. 1-44

Dollar-Weighted Average Returns, I

• There is a hidden assumption we make when

we calculate arithmetic returns and geometric
returns.
• The hidden assumption is that we assume that
the investor makes only an initial investment.
• Clearly, many investors make deposits or
withdrawals through time.
• How do we calculate returns in these cases?

© McGraw-Hill Education. 1-45

Dollar-Weighted Average Returns, II
(1 of 2)
• You had returns of 10% in year one and -5%
in year two.
• If you only make an initial investment at the
start of year one:
– The arithmetic average return is 2.50%.
– The geometric average return is 2.23%.

© McGraw-Hill Education. 1-46

Dollar-Weighted Average Returns, II
(2 of 2)
• Suppose you makes a $1,000 initial investment
and a $4,000 additional investment at the
beginning of year two.
– At the end of year one, the initial investment grows
to $1,100.
– At the start of year two, your account has $5,100.
– At the end of year two, your account balance is
$4,845.
– You have invested $5,000, but your account value is
only $4,845.
• So, the (positive) arithmetic and geometric
returns are not correct.
© McGraw-Hill Education. 1-47
Dollar-Weighted Average Returns and
IRR

© McGraw-Hill Education. 1-48

 Risk and Return

• The risk-free rate represents compensation for

just waiting.
• Therefore, this is often called the time value
of money.
• First Lesson, Restated: If we are willing to
bear risk, then we can expect to earn a risk
premium, at least on average.
• Second Lesson, Restated: Further, the
more risk we are willing to bear, the greater
the expected risk premium.

© McGraw-Hill Education. 1-49

Historical Risk and Return Trade-Off

© McGraw-Hill Education. 1-50

 A Look Ahead

• This textbook focuses exclusively on financial

assets: stocks, bonds, options, and futures.
• You will learn how to value different assets
and make informed, intelligent decisions about
the associated risks.
• You will also learn about different trading
mechanisms and the way that different
markets function.

© McGraw-Hill Education. 1-51

 Useful Internet Sites

• finance.yahoo.com (reference for a terrific

financial web site)
• www.globalfinancialdata.com (reference
for historical financial market data—not free)
• www.robertniles.com/stats/ (reference
for easy to read statistics review)
• jmdinvestments.blogspot.com (reference
for recent financial information)

© McGraw-Hill Education. 1-52

 Chapter Review, I

• We Calculate Returns Using Several Methods

• The Historical Record
– A First Look
– A Longer Range Look
– A Closer Look
• Average Returns: The First Lesson
– Calculating Average Returns
– Average Returns: The Historical Record
– Risk Premiums

© McGraw-Hill Education. 1-53

 Chapter Review, II

• Return Variability: The Second Lesson

– Frequency Distributions and Variability
– The Historical Variance and Standard Deviation
– The Historical Record
– Normal Distribution
• Arithmetic Returns versus Geometric Returns
• Dollar Weighted Average Returns
• The Risk-Return Trade-Off

© McGraw-Hill Education. 1-54

 End of Presentation

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No
1-55
reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.