Part-IV

Investments Management
 The Investment Environment
Questions to be answered:
• What is an investment?
• Why do individuals invest?
• What are the types of risk?
• How do we measure the rate of return and the
risk involved in an investment accurately?
• How are risk and return relates?
•
 Introduction
• What do you do with your Income?
• An economist says when people earn a dollar; they
do one of two things with it: They either consume it
or save it.
• A person consumes a dollar by spending it on
something like a shoes, clothing, food, etc.

• People also spent some of their money

involuntarily because they must pay tax;

• A person saves a dollar by somehow putting it

aside for consumption at a later period of time.
 Con’t…
• Therefore Income can be what is spent for current
consumption or saved for the future consumption.

• Savings are generated when a person or an

organization abstains from present consumption for
a future use.

• The person saving a part of income tries to find a

temporary repository for his savings until they are
required to finance his future expenditure. This
results in investment.
 What is an Investment?
• Therefore, investment may be defined as “a current
commitment of funds made in the expectation of
some positive rate of return in the future “.

• In other words investment involves employment of

funds with the aim of achieving additional income
or growth values.
o The essential quality of investment is that it involves
waiting for a reward.
 Con’t…
• An investment is the current commitment of
dollars for a period of time in order to derive
future payments that will compensate the
investor for:
 (1) the time the funds are committed,
 (2) the expected rate of inflation, and
(3) the uncertainty of the future payments.

• The “investor” can be an individual, a government,

a pension fund, or a corporation.
 Con’t…
• Expectation of return is an essential element of
investment.
 Since the return is expected to be realized in the
future, there is a possibility that the return
actually realized is lower than the return
expected to be realized.

• This possibility of variation in the actual return is

known as investment risk. Thus, every investment
involves return and risk.
 Investment Alternatives
• Money Market • Equity Securities:
Securities:
– Stocks
– Treasury Bill
• Derivative Securities:
– Negotiable CDs
– Options
• Fixed-Income
Securities: – Future Contracts
– Bonds – Swaps
– Asset-Backed
Securities
The Investment Process
The investment process involves a series of activities leading to the
purchase of securities or other investment alternatives. It can be divided
in to five stages.
Investment Process

1. Investment Policy 2. Analysis 3. Valuation

 Investible
funds  Market  Intrinsic value
 Objectives  Industry  Future value
 Knowledge  Company

4. Portfolio Construction 5. Portfolio

Evaluation
 Diversification
 Selection and  Appraisal
allocation  Revision

Figure 1.1: the investment process

1. Investment Policy
• An investor before processing in to investment
formulates the policy for the systematic functioning.
The essential ingredients of the policy are:

• Availability of investible funds: the fund may be

generated through savings or from borrowings.
– If the funds are borrowed, the investor has to be extra
careful in the selection of alternative investments. The
return should be higher than the interest he pays.
• Objectives: Another step in the investment
management process, setting investment objectives,
begins with a thorough analysis of the investment
objectives of the entity whose funds are being
managed.
 Con’t…
• These entities can be classified as individual
investors and institutional investors.

• The objectives of an individual investor may be to:

• Accumulate funds to purchase a home or other major
acquisitions,
• Have sufficient funds to be able to retire at a specified
age, or
• Accumulate funds to pay for college tuition for children.
An individual investor may engage the
2. Security Analyses
• After formulating the investment policy, the securities to be
bought have to be scrutinized through the economy, industry
and company analysis.
• Economy Analysis: the performance of a company
depends on the performance of the economy.
• If the economy is booming, income rises, demand for
goods and services increase, and hence the industries
and companies in general tend to be prosperous.

• On the other hand if the economy is in recession, the

performance of companies would be generally bad. Hence,
investors should analyze those variables in the economy
which affect the performance of the company in which
they intend to invest.
Con’t…
 Industry Analyses: the industries that contribute to the
output of the major segments of the economy vary in
their growth rates and their overall contribution to the
economic activity.
• Some industries, for example the IT industry grow faster
and are expected to continue in their growth.
• The economic significance and growth potential of the
industry have to be analyzed.
 Company analysis: The company’s earnings,
profitability, operating efficiency, capital structure, and
management has to be screened.
Con’t…
• These factors have direct bearing on the stock prices
and the return of the investors.

• Appreciation of the stock value is a function of the

performance of the company.
3. Valuation
• Valuation: The process of determining the current worth
of an asset.
• Valuation helps investors to determine the return
and risk expected from an investment

• Intrinsic value of the share is measured through the

book value of the share and price earnings ratio.

• The stock market analyses have developed many

advanced models to value shares.
Con’t…
• The real worth of the share is compared with the
market price and then the investment decisions are
made.

• Future value: Future value of securities could be

estimated by using simple statistical techniques,
like trend analysis. The analysis of the historical
behavior of the price enables the investor to predict
the future value.
 4. Portfolio Constructions
• Selecting a portfolio strategy that is consistent with the
investment objectives and investment policy guidelines of
the client or institution is the other step in the investment
management process.

• A portfolio is a combination of securities. The portfolio is

constructed in such a manner to meet the investor’s goals
and objectives.
• The investor tries to get maximum return with minimum
risk. Towards the end, the investor diversifies his portfolio
and allocates funds among the securities.
• Diversification: the main objective of diversification is
the reduction of risk in the loss of capital income.
Con’t…
• A diversified portfolio is comparatively less risky than
holding a single portfolio.
• There are several ways to diversify a portfolio.
– Debt and equity diversification
– Industry diversification
– Company diversification\
• Based on the diversification level, industry and
company analysis, securities have to be selected.
Funds are allocated for the selected securities.
Selection of securities and allocation of funds leads
the construction of a portfolio.
Con’t…
• Therefore objectives should be framed on the premises
of the:
 Required rate of return,
 Need for regularity of income,
 Risk perception and
 Need for liquidity.
• The risk takers objective is to earn high rate of
return in the form of capital appreciation, where as
the primary objective of the risk averse is the safety
of the principal.
• Knowledge: the knowledge about the investment
alternatives and markets play a key role in the
policy formulation.
5. Measuring and Evaluating Performance
• The measurement and evaluation of investment
performance is the last step in the investment
management process.
• The portfolio has to be managed efficiently. The efficient
management calls for evaluation of a portfolio.
• Appraisal: the return and risk performance of the security
vary from time to time.
• The variability in returns is measured and compared. The
developments in the economy, industry and relevant
companies from which the stocks are bought have to be
appraised. The appraisal warns the loss and steps can be
taken to avoid such losses.
 Constraints of investments
• Several factors affect the construction of a
portfolio. These include:
– Investors risk tolerance
– Liquidity
– The goals of the investor,
– The risks involved,
– The taxes that will be imposed on any gain, and
– A knowledge of the available opportunities and
alternative investments.

21
Con’t…
 Investors Risk Tolerance
• Investors are classified in to 3 based on their risk tolerance:
i. Risk averse (Avoider): Most people do not like risk—they are risk
averse. Does this mean a risk averse person will not take on risk?
No—they will take on risk if they feel they are compensated for it.
ii. A risk neutral person is indifferent toward risk. Risk neutral
persons do not need compensation for bearing risk.
iii.A risk taker (lover) person likes risk—someone even willing to pay
to take on risk.
Con’t…
– Liquidity
• Vary between investors depending upon age, employment,
tax status, etc.
• Planned vacation expenses and house down payment are
some of the liquidity needs.
Time Horizon
• Influences liquidity needs and risk tolerance
• Longer investment horizons generally requires less
liquidity and more risk tolerance

• The length of time the investment will be at work is

critical to proper asset allocation.
– In the long run, daily fluctuations in security values do
not matter

– The long-term growth of earnings is important in the

long-run

24
 Tax Situation
• Taxes are the largest component of trading costs
for many investors
– Federal, state, and local taxes can exceed 50 percent
combined
• Investors may avoid taxable bonds and stocks with a high
dividend yield
• Fund managers should carefully consider the sale of a
stock, resulting in a realized (taxable) capital gain

25
 Liquidity Needs
• Some portfolios must produce a steady
stream of income to the owner or to a set of
beneficiaries
– The manager must ensure the required funds
are available in a timely fashion

26
 Legal Considerations
• Some types of investment portfolios face a
legal list of eligible assets
– E.g., restricted to investment-grade bonds or a
minimum payout ratio of fund assets to
maintain tax-exempt status

27
Measuring of Risk and Return
“Two Sides of the Investment Coin”.
 What is Uncertainty ?
• Whenever you make a financing or investment decision,
there is some uncertainty about the outcome.
• Uncertainty means not knowing exactly what will
happen in the future.
• There is uncertainty in most everything we do as
financial managers, because no one knows precisely
what changes will occur in such things as
– tax laws,
– consumer demand,
– interest rates, or
– the economy, etc.
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29
Con’t….
 Benjamin Franklin pointed out:
“In this world nothing can be said to be certain,
except death and taxes”.

• Though the terms “risk” and “uncertainty” are often

used to mean the same thing, there is a distinction
between them.
• Uncertainty is not knowing what’s going to happen.

• Risk is how we characterize how much uncertainty exists:

The greater the uncertainty, the greater the risk.
–Risk is the degree of uncertainty.
07/19/23 30
 Risk Analysis

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31
Risk --- What is this?
• Consider the two cases.
  1) Mr. Ramesh has put his money in National Bank of Ethiopia
(NBE) bond where he is going to get 12% p.a.. He is really happy
with the rate of return. Will he have sleepless nights, if the
economy goes into recession?. Of course no.
 2) Mr. Ramesh is very bullish with the stock market and invests
money into equity diversified fund with the expectation that he
will get 12% return. Will he have sleepless nights if economy
goes into deep recession, and now he feels that he may get
negative returns of say 5-7%? Of course yes.

• In the second situation, he has a fear, which is the result of huge

difference in his expected return and the actual return, which he
may get. This difference itself is the risk that he bears. Does he
face this kind of difference in the first situation? No. So there is
no risk.
What is risk ?
• Literally risk is defined as “exposing to danger or
hazard”.
 Which is perceived as negative terms.

 In finance,
• Risk refers to the likelihood that we will receive
a return on an investment that is different from
the return we expected to make.

• Risk is the probability or likelihood that actual

results (rates of return) deviates from expected
returns. 21 - 33
Con’t…
• Thus, risk includes not only the bad outcomes
(returns that are lower than expected), but also good
outcomes (returns that are higher than expected).

• In fact, we can refer to the former as downside risk

and the latter as upside risk.
 What is Risk ?
• Chinese Symbol for Risk: The first symbol is the
symbol for “danger” while the second is the symbol for
“opportunity”, making risk a mix of danger and
opportunity.

• Hence, risk is both bad outcomes and good outcomes.

 Sources of Risk

07/19/23
36
 Sources of Risk Con’t…
Business Risk:
• Uncertainty of income flows caused by the
nature of a firm’s business.

• Sales volatility and operating leverage

determine the level of business risk.

07/19/23
37
 Source of risk Con’t…
Financial Risk
• Uncertainty caused by the use of debt financing.
(Level of Financial Leverage)

• Borrowing requires fixed payments which must

be paid ahead of payments to stockholders.

• The use of debt increases uncertainty of

stockholder income and causes an increase in the
stock’s risk premium.
07/19/23
38
 Source of Risk Con’t…
Liquidity Risk
• Uncertainty is introduced by the secondary
market for an investment.
– How long will it take to convert an investment
into cash?
– How certain is the price that will be received?

07/19/23
39
 Source of Risk Con’t…
• Exchange Rate Risk:
• Uncertainty of return is introduced by acquiring
securities denominated in a currency different
from that of the investor.

• Changes in exchange rates affect the investors

return when converting an investment back into
the “home” currency.
07/19/23
40
 Source of Risk Con’t…
• Country Risk:
• Political risk is the uncertainty of returns caused by the
possibility of a major change in the political or economic
environment in a country.

• Individuals who invest in countries that have unstable

political-economic systems must include a country risk-
premium when determining their required rate of return

07/19/23
41
 Source of Risk Con’t…
 Interest rate risk is the chance that changes in
interest rates will adversely affect a security’s
value.

 Purchasing Power Risk refers to the chance that

changing price levels (inflation or deflation) will
adversely affect investment returns.

07/19/23
42
 Classification of Risk:
Diversifiable and Non-diversifiable Risk
• Although there are many reasons why actual returns
may differ from expected returns, we can group the
reasons into two categories:
A. Market wide/Systematic Risk and
B. Firm-specific/ Unsystematic Risk.

• The risks that arise from firm-specific actions affect one

or a few investments, while the risks arising from
market wide reasons affect many or all investments.
• This distinction is critical to the way we assess risk in
finance.
Con’t…
1) Systematic risk - The risk inherent to the entire market or
entire market segments, not just a particular stock or industry is
known as systematic risk.
 This is also known as:
• Un-diversifiable risk" or "market risk” or “uncontrollable risk. “

• Interest rates, inflation, economic policies, recession,

wars, etc all represent sources of systematic risk because
they affect the entire market and cannot be avoided
through diversification.

• This risk can’t be mitigated through diversification, only through

hedging or by using the correct asset allocation strategy..
Con’t…
• What is 'Asset Allocation:
• Asset allocation is an investment strategy that aims to
balance risk and reward by apportioning a portfolio's
assets according to an individual's goals, risk tolerance
 and investment horizon.

• The three main asset classes - equities, fixed-income,

and cash and equivalents - have different levels of risk
and return, so each will behave differently over time.
 Examples of Systematic Risk
46

07/19/23 46
Con’t…
• 2) Unsystematic Risk – The risk which is specific to
a company or industry is known as unsystematic
risk.
• This risk can be reduced through appropriate
diversification. This is also known as "specific
risk", "diversifiable risk" or "residual risk“ or “
controllable risk.
• Examples of unsystematic risk:
– Employees strike
– Key person leaving
 Examples of Unsystematic Risk
48

07/19/23 48
How is Unsystematic Risk
Reduced?
 Con’t…
• Activity-1
• Why Diversification Reduces or Eliminates
Firm-Specific Risk: Give an Intuitive
Explanation!
Quantification of Returns and Risk 
 Measuring of Return:
• If you buy an asset of any sort, your gain (loss) from that
investment is called the return on your investment. This
return will usually have two components:
• Current return – It is the periodic cash inflow in the form of interest or
dividend.
• Capital return --- It represents change in the price of asset.
–  Thus Total Return = Current Return + Capital Return

• Thus; return is nothing but the reward for undertaking investment.

Assessment of historical returns is must to know the performance of the
fund manager. This also helps as an important input to estimate future
returns.
• The current return can be zero or positive, whereas capital
return can be zero, positive or negative.
Con’t…
1. Calculation of Historical Returns (Ex post):
Single period return:
• Example: Suppose, at the beginning of the year, the stock for a
company was selling for $37 per share. If you had bought 100
shares, you would have a total out-lay of $3700. Suppose, over the
year, the stock paid a dividend of $1.85per share. By the end of the
year, then, you would have received income of:
– Dividend Income interms of dollar = $1.85 x 100= $185
Con’t…
• Also, suppose that the value of the stock has risen to $40.33 per
share by the end of the year. Your 100 shares are now worth $4,033,
so you have a capital gain of:
Capital gain = ($40.33 - $37) x 100 = $333

• Therefore, the total return of on your investment is the sum of the

dividend and the capital gain.
Total dollar return = dividend income + capital gain (loss)
= $185 + $333 = $ 518

• Notice that, if you sold the stock at the end of the year, the total
amount of cash you would have would equal your initial
investment plus total return. Then, total cash if the stock is sold
is :
Con’t….
• Total cash = initial investment + total return
$ 3700 + $ 518 = $ 4,218
• As a check, notice that this is the same as the proceeds from
the sale of the stock plus the dividends:
• Proceeds from stock sale + dividends = $40.33 x 100 + 185= $ 4,218
• Although expressing returns in dollars is easy, two
problems arise:
 (1) to make a meaningful judgment about the return, you need
to know the scale (size) of the investment;
 A $100 return on a $100 investment is a great return
(assuming the investment is held for 1 year), but a $100
return on a $10,000 investment would be a poor return.
 The question is, how much do we get for each dollar we
invest?
Con’t…
 (2) You also need to know the timing of the return;
a $100 return on a $100 investment is a great return
if it occurs after 1 year, but the same dollar return
after 20 years is not very good.

• The solution to these scale and timing problems

is to express investment results as rates of return,
or percentage returns.
Con’t…
• Basic Terms:
• Dividend yield: The annual stock dividend as a
percentage of the initial stock price.

• Capital gains yield: The change in stock price as

a percentage of the initial stock price.

• Total percent return: The return on an investment

measured as a percentage that accounts for all cash
flows and capital gains or losses.
 Con’t….
• It is usually more convenient to summarize information
about returns in percentage terms, rather than in dollar
terms, because that way your return does not depend on
how much you actually invest.

• To answer this question, let Pt be the price of the stock at

the beginning of the year and let D t+1be the dividend
paid on the stock during the year.

• In the example above, the price at the beginning of the

year was $37 per share and the dividend paid during the
year on each share was $1.85. Therefore, dividend yield
is:
Con’t…
• Dividend yield= D t/ Pt-1
= $1.85/37 = .05= 5%, this implies that for each dollar we
invest, we get five cents in dividends.
• The second component of the return from investment is the capital gains
yield. This is calculated as the change in the price during the year (the
capital gain) divided by the beginning price:
• Capital gains yield = (P t –Pt-1)/ Pt-1
• = (40.33 -37)/37 = .09= 9%. This means that per dollar
we invest, we get nine cents in capital gain. Putting it together, per dollar
invested, we get 5 cents in dividends and nine cents in capital gains: so
we get a total of 14 cents. Our percentage return is 14%.
• Simply, the total percentage return of an investment can be calculated as:

•  The rate of return = ((Pt +Dt- Pt-1) / Pt-1) × 100 = ((40.33+1.85--37) / 37) × 100 = 14%

• Total Percentage return =

Dividend paid at end of period + Change in market value over period
Beginning market value
= $1.85 + (40.33 – 37)/ 37 = 5.18/37 = .14 = 14%
In general;
Cont’t…
Con’t…
Quantification of Returns and Risk 
2. Quantification of Historical Risk
o As it has already been mentioned, risk is nothing
but possibility that actual outcome of investment
will differ from expected outcome of investment.

o To measure this deviation, statistical tools like

Variance and standard deviations are used.

o Variance is the square of standard deviation.

o So let’s see the basic behind usage of standard
deviation to measure the risk and also the way to
calculate it.
Con’t…
• The variance essentially measures the average
squared difference between the actual returns and
the average return.

• The bigger this number is, the more the actual

returns tend to differ from the average return.

• Also, the larger the variance or standard deviation

is, the more spread out the returns will be.
Con’t…
• The way we will calculate the variance and standard
deviation will depend on the specific situation.
• In this section, we are looking at historical returns;

• If we were examining estimated future returns, then

the procedure would be different from the risk of
historical returns. We describe this procedure in the
next topic.

• So the variance can now be calculated by dividing the

sum of the squared deviations, by the number of returns
less 1.
Con’t…
Example
Measuring the Expected Return and Risk of a Single Asset

3)Calculation of Expected Return (EX ANTE)

When we talk about expectations, we talk about
probability.
The future or expected return of a security is uncertain;
however it is possible to describe the future returns
statistically as a probability distribution.
The mean of this distribution is the expected return.

The expected return of the investment is the

probability weighted average of all the possible
returns.
Con’t….
 If the possible returns are denoted by Xi and
the related probabilities are P(Xi), expected
return may be represented as and can be
calculated as:
= Σ Xi P (Xi).
• It is the sum of the products of possible returns with
their respective probabilities. Consider the example
below.
Con’t…
• Expected value of return for asset, E(Ri) : Expected rate of
return is the return expected to be realized from an investment.
– R = p1r1 + p2r2……+ pnrn
where,
p1,p2…. pn = is the probability of the ith out come.
r1, r2..... rn = is the ith possible out come (return).
n = number of outcomes considered
or

E(Ri) =  (Rj x Prj) 

Where Rj = return for the jth outcome
Prj = probability of occurrence of the jth outcome

21 - 70
Con’t…
• Example: Mr. X is considering the possible rates of return
(dividend yield plus capital gain or loss) that he might earn
next year on a $10,000 investment in the stock of either
Alpha Company or Beta Company. The rates of return
probability distributions for the two companies are shown
here under:
State of the Probability of the Rate of return if the state occurs
economy state
Alpha Co Beta Co.

Boom 0.35 20% 24%

Normal 0.40 15% 12%

Recession 0.25 5% 8%
Required: compute the expected rate of return on each company’s stock.
Solution
• E(Ri) = (Rj x Prj)
• E(Ralpha) = (0.35*20) + (0.4*15) + (0.25 *5)
E(Ralpha) = 7 + 6 + 1.25 = 14.25%
• E(RBeta) = (0.35 * 24) + (0.4 * 12) + (0.25 * 8)
E(RBeta) = 8.4 + 4.8 + 2 = 15.2%
Calculation of Expected Risk
• Standard deviation (S.D) is the most common statistical
indicator of an asset’s risk (stand alone risk).
• S.D measures the variability of a set of observations.
• The larger the standard deviation, the higher the
probability that returns will be far below the expected
return.
• Coefficient of variation is an alternative measure of
stand-alone risk.
Con’t…
• Standard deviation is indicator of risk asset (an
absolute measure of risk) of that asset’s expected
return, σ (Ri), which measures the dispersion
around its expected value. This can be calculated
using equation below:
σ (Ri) = √  [R j - E(Ri) ]2 x Pr j
• Steps to calculate the σ or sigma:
1. Calculate the expected rate of return:
Expected rate of return, E(Ri) = (Rj x Prj) 
2. Subtract the expected rate of return (E(R ) ) from each
i

possible outcome (ri) to obtain a set of deviations

about E(Ri), Deviationi = ri − E(Ri)
Con’t…
3. Square each deviation
Deviationi = (ri − E(Ri))2
4. Multiply the squared deviations by the probability
of occurrence for its related outcome.
Pi(ri − E(Ri) )2
5. Sum these products to obtain the variance of the
probability distribution:
6.

21 - 75
Determining Standard Deviation
(Risk Measure)

n
 =  ( Ri - R )2( Pi )
i=1

Standard Deviation,
Deviation , is a statistical measure of
the variability of a distribution around its mean.
It is the square root of variance.
Note, this is for a discrete distribution.

21 - 76
How to Determine the Expected Return and
Standard Deviation

Stock BW
Ri Pi (Ri)(Pi)
The
-.15 .10 -.015 expected
-.03 .20 -.006 return, R,
.09 .40 .036 for Stock
BW is .09
.21 .20 .042
or 9%
.33 .10 .033
Sum 1.00 .090
21 - 77
How to Determine the Expected Return and
Standard Deviation

Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576
-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
21 - 78
 MEASURING EXPECTED (EX ANTE)
RETURN AND RISK
EXPECTED RATE OF RETURN
n
E (R) = pi Ri
i=1
STANDARD DEVIATION OF RETURN
 = [ pi (Ri - E(R) )2]

Bharat Foods Stock

i. State of the
Economy pi Ri piRi Ri-E(R) (Ri-E(R))2 pi(Ri-E(R))2
1. Boom 0.30 16 4.8 4.5 20.25 6.075
2. Normal 0.50 11 5.5 -0.5 0.25 0.125
3. Recession 0.20 6 1.2 -5.5 30.25 6.050
E(R ) = piRi = 11.5 pi(Ri –E(R))2 =12.25
σ = [pi(Ri-E(R))2]1/2 = (12.25)1/2 = 3.5%
 Comments on Standard Deviation as a
Measure of Risk
• Standard deviation (σi) measures total, or stand-
alone, risk.
• The larger σi is, the lower the probability that actual
returns will be closer to expected returns.
• Larger σi is associated with a wider probability
distribution of returns.

• The larger standard deviation (σi) indicates a

greater variation of returns and thus a greater
chance that the expected return will not be realized.
• The larger the Standard deviation (σi), the higher
the risk, because Standard deviation (σi), 21is- 80 a
 Coefficient of Variation: A Relative Measure of Risk

• If conditions for two or more investment alternatives are not

similar—that is, if there are major differences in the expected
rates of return or standard deviation—it is necessary to use a
measure of relative variability to indicate risk per unit of
expected return.
• A widely used relative measure of risk is the coefficient of
variation (CV), calculated as follows:

• Formula for CV is:

Coefficient of Variation = Standard Deviation
Average or Expected Return 
CV = σ (Ri)
E(Ri)
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Coefficient of Variation con’t…
• The coefficient of variation is a useful measure
of risk when we are comparing the investment
alternatives which have
– (i) same standard deviations but different expected values, or
– (ii) different standard deviations but same expected values, or
– (iii) different standard deviations and different expected
values.

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 Expected Risk and Preference

• While both products have the same expected value, they differ in
the distribution of possible outcomes. When we calculate the
standard deviation around the expected value, we see that Product
B has a larger standard deviation.

• The larger standard deviation for Product B tells us that Product B

has more risk than Product A since its possible outcomes are more
distant more from its expected value.
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 Con’t…
• Which product investment do you prefer, A or B? Most
people would choose A since it provides the same
expected return with less risk.

• Most people do not like risk—they are risk averse. Does

this mean a risk averse person will not take on risk? No
—they will take on risk if they
feel they are compensated for it. i.e.

 Risk Averse – describes an investor who requires

greater return in exchange for greater risk.
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Con’t…
• A risk-averse investor will choose among investments
with the equal rates of return, the investment with
lowest standard deviation and among investments with
equal risk they would prefer the one with higher return.

• A risk neutral person is indifferent toward risk. Risk

neutral persons do not need compensation for bearing
risk.
– A risk-neutral investor does not consider risk,
and would always prefer investments with
higher returns.

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 Con’t…
• Risk Seeking (Risk Taker) – describes an investor who
will accept a lower return in exchange for greater risk. i.e

• A risk-seeking investor likes investments with

higher risk irrespective of the rates of return. In
reality, most (if not all) investors are risk-averse.

• Are there such people? Yes. Consider people who

play the state lotteries, where the expected value
is always negative:
– The expected value of the winnings is less than
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AND
HAVE A NICE DAY!