Concept of Risk and Return

Sriram Rangarajan

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• OBSERVATION AND FORMAL RESEARCH both suggest that investment risk is as important to
investors as expected return. While we have theories about the relationship between risk and
expected return that would prevail in rational capital markets, there is no theory about the levels of
risk we should find in the marketplace.
• We can at best estimate from historical experience the level of risk that investors are likely to
confront. This situation is to be expected because prices of investment assets fluctuate in response
to news about the fortunes of corporations, as well as to macroeconomic developments.
• There is no theory about the frequency and importance of such events; hence we cannot
determine a “natural” level of risk. Compounding this difficulty is the fact that neither expected
returns nor risk are directly observable. We observe only realized rates of return.
• Moreover, in learning from an historical record, we face what has become known as the “black
swan” problem.1 No matter how long the historical record, there is never a guarantee that it
exhibits the worst (and best) that nature can throw at us in the future.
• We need essential tools for estimating expected returns and risk from the historical record and
consider implications for future investments.
• To begin with, we examine the interest rates and investments in safe assets and history of risk-free
investments.
• Develop and Use statistical tools for risky assets with scenario analysis of risky investments and the
data inputs necessary to conduct it.

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• INVESTMENT DECISIONS are influenced by various motives. Some people invest in a business to
acquire control and enjoy the prestige associated with it while others may want expensive cars,
villas to display their wealth, however, most investors are largely guided by the pecuniary motive of
earning a return on their investment.

• For earning returns investors have to almost invariably bear some risk. In general, risk and return
go hand in hand. While investors like returns they abhor/ hate risk. Investment decisions,
therefore, involve a tradeoff between risk and return. Since risk and return are central to
investment decisions, we must clearly understand what risk and return are and how they should be
measured.

• RETURN
• Return is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investing is about returns (after allowing for risk),
measurement of realised (historical) returns is necessary to assess how well the investment
manager has done. In addition, historical returns are often used as an important input in
estimating future (prospective) returns. The return of an investment consists of two components;

• CURRENT RETURN - The first component that often comes to mind when one is thinking about
return is the periodic cash flow (income), such as dividend or interest, generated by the
investment. Current return is measured as the periodic income in relation to the beginning price
of the investment.

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• Capital Return The second component of return is reflected in the price change called the capital
return—it is simply the price appreciation (or depreciation) divided by the beginning price of the
asset. For assets like equity stocks, the capital return predominates. Thus, the total return for any
security (or for that matter any asset) is defined as:
Total return = Current return + Capital return
• The current return can be zero or positive, whereas the capital return can be negative, zero, or
positive.

• RISK
• You cannot talk about investment return without talking about risk because investment decisions
invariably involve a trade-off between the two. Risk refers to the possibility that the actual
outcome of an investment will differ from its expected outcome. More specifically, most investors
are concerned about the actual outcome being less than the expected outcome. The wider the
range of possible outcomes, the greater the risk.

• SOURCES OF RISK - Risk emanates from several sources. The three major ones are: business risk,
interest rate risk, and market risk.

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• BUSINESS RISK - As a holder of corporate securities (equity shares or debentures), you are exposed
to the risk of poor business performance. This may be caused by a variety of factors like heightened
competition, emergence of new technologies, development of substitute products, shifts in
consumer preferences, inadequate supply of essential inputs, changes in governmental policies,
and so on. Often, of course, the principal factor may be inept and incompetent management. The
poor business performance definitely affects the interest of equity shareholders, who have a
residual claim on the income and wealth of the firm. It can also affect the interest of debenture
holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In
such a case, debenture holders face the prospect of default risk.

• INTEREST RATE RISK - The changes in interest rate have a bearing on the welfare of investors. As
the interest rate goes up, the market prices of existing fixed income securities fall, and vice versa.
This happens because the buyer of a fixed income security would not buy it at its par value or face
value if its fixed interest rate is lower than the prevailing interest rate on a similar security. For
example, a debenture that has a face value of Rs.100 and a fixed rate of 12 percent will sell at a
discount if the interest rate moves up from, say, 12 percent to 14 percent. While the changes in
interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices
too, albeit somewhat indirectly. The changes in the relative yields of debentures and equity shares
influence equity prices.

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• MARKET RISK –
• Even if the earning power of the corporate sector and the interest rate structure remain more or
less unchanged, prices of securities, equity shares in particular, tend to fluctuate.
• Many reasons may be attribute to this fluctuation, however, a major reason seems to be the
changing sentiment of the investors.
• There are periods when investors become bullish and their investment horizons lengthen.
Investor optimism, which may border on euphoria during such periods, drives share prices to
great heights. The buoyancy created in the wake of this development is pervasive, affecting
almost all the shares.
• On the other hand, when a wave of pessimism (which often is an exaggerated response to some
unfavourable political or economic development) sweeps the market, investors turn bearish and
myopic. Prices of equity shares register decline as fear and uncertainty pervade the market.
• The market tends to move in cycles. The cycles are caused by mass psychology. As John Train
explains: “The ebb and flow of mass emotion is quite regular: Panic is followed by relief, and
relief by optimism; then comes enthusiasm, then euphoria and rapture, then the bubble bursts,
and public feeling slides off again into concern, desperation, and finally a new panic.”
• One would expect large scale participation of institutions to dampen the price fluctuations in the
market. After all, institutional investors have core professional expertise to do fundamental
analysis and greater financial resources to act on fundamental analysis. However, nothing of this
kind has happened. On the contrary, price fluctuations seem to have become wider after the
arrival of institutional investors in larger numbers.

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• Why? Perhaps the institutions and their analysts have not displayed more prudence and rationality
than the general investing public and have succumbed in equal measure to the temptation to
speculate. As John Maynard Keynes had argued, factors that contribute to the volatility of the
market are not likely to diminish when expert professionals supposedly possessing better judgment
and knowledge compete in the market place. According to Keynes, even these people are
concerned with speculation (the activity of forecasting the psychology of the market) and not
enterprise (the activity of forecasting the prospective yield of assets over their whole life).

• TYPES OF RISK
• Modern portfolio theory looks at risk from a different perspective. It divides total risk as follows.
Total risk = Unique risk + Market risk
• The unique risk of a security represents that portion of its total risk which stems from firm-
specific factors like the development of a new product, a labour strike, or the emergence of a
new competitor. Events of this nature primarily affect the specific firm and not all firms in
general. Hence, the unique risk of a stock can be washed away by combining it with other stocks.
• In a diversified portfolio, unique risks of different stocks tend to cancel each other—a favourable
development in one firm may offset an adverse happening in another and vice versa. Hence,
unique risk is also referred to as diversifiable risk or unsystematic risk.
• The market risk of a security represents that portion of its risk which is attributable to economy-
wide factors like the growth rate of GDP, the level of government spending, money supply,
interest rate structure, and inflation rate. Since these factors affect all firms to a greater or lesser
degree, investors cannot avoid the risk arising from them, however diversified their portfolios
may be. Hence, it is also referred to as systematic risk (as it affects all securities) or non-
diversifiable risk. 7
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• Risk and Risk Premiums

• Holding-Period Returns
• You are considering investing in a stock-index fund. The fund currently sells for $100 per share.
With an investment horizon of 1 year, the realized rate of return on your investment will depend on
(a) the price per share at year’s end and (b) the cash dividends you will collect over the year.
• Suppose the price per share at year’s end is $110 and cash dividends over the year amount to $4.
The realized return, called the holding-period return, or HPR (in this case, the holding period is 1
year), is defined as

• HPR =

• We have HPR = =0.14 or 14%

• This definition of the HPR treats the dividend as paid at the end of the holding period. When
dividends are received earlier, the HPR should account for reinvestment income between the
receipt of the payment and the end of the holding period. The percent return from dividends is
called the dividend yield, and so dividend yield plus the rate of capital gains equals HPR.

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• Expected Return and Standard Deviation

• There is considerable uncertainty about the price of a share plus dividend income one year from
now, however, so you cannot be sure about your eventual HPR. We can quantify our beliefs about
the state of the market and the stock-index fund in terms of four possible scenarios, with
probabilities as presented in columns A through E of Spreadsheet (next slide). How can we evaluate
this probability distribution? To start, we will characterize probability distributions of rates of
return by their expected or mean return, E(r), and standard deviation, σ. The expected rate of
return is a probability-weighted average of the rates of return in each scenario. Calling p(s) the
probability of each scenario and r(s) the HPR in each scenario, where scenarios are labeled or
“indexed” by s, we write the expected return as
- Eq.1

• Applying this formula to the data in Spreadsheet (next slide), the expected rate of return on the
index fund is E(r) = (.25 × .31) + (.45 × .14) + [.25 × (− .0675)] + [.05 × (− .52)] = .0976

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The above spreadsheet shows that this sum can be evaluated easily in spreadsheet, using the
SUMPRODUCT function, which first calculates the products of a series of number pairs, and then sums
the products. Here, the number pair is the probability of each scenario and the rate of return.
The variance of the rate of return ( σ2) is a measure of volatility. It measures the dispersion of possible
outcomes around the expected value. Volatility is reflected in deviations of actual returns from the
mean return. In order to prevent positive deviations from canceling out with negative deviations, we
calculate the expected value of the squared deviations from the expected return. The higher the
dispersion of outcomes, the higher will be the average value of these squared deviations. Therefore,
variance is a natural measure of uncertainty. 10
 RISK AND RETURNS

• Symbolically,

• Hence, in our example

σ2 = .25(.31 − .0976)2 + .45 (.14 − .0976)2 + .25(− .0675 − .0976)2 + .05(− .52 − .0976)2 = .0380

• This value is calculated in cell G13 of the spreadsheet using the SUMPRODUCT function. When we
calculate variance, we square deviations from the mean and therefore change units. To get back to
original units, we calculate the standard deviation as the square root of variance. Standard
Deviation is calculated in cell G14 as

• What would trouble potential investors in the index fund is the downside risk of a crash or poor
market, not the upside potential of a good or excellent market. The standard deviation of the rate
of return does not distinguish between good or bad surprises; it treats both simply as deviations
from the mean. Still, as long as the probability distribution is more or less symmetric about the
mean, σ is a reasonable measure of risk. In the special case where we can assume that the
probability distribution is normal—represented by the well-known bell-shaped curve—E(r) and σ
completely characterize the distribution.

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• Excess Returns and Risk Premiums
• How much, if anything, would you invest in the index fund? First, you must ask how much of an expected
reward is offered for the risk involved in investing in stocks. We measure the reward as the difference
between the expected HPR on the index stock fund and the risk-free rate, that is, the rate you would earn
in risk-free assets such as T-bills, money market funds, or the bank. We call this difference the risk
premium on common stocks.
• Suppose Risk free rate is 4%. Expected return on Index fund is 9.76%, hence 9.76-4=5.76% is risk premium
per year.
• The difference in any particular period between the actual rate of return on a risky asset and the actual
risk free rate is called the excess return. Therefore, the risk premium is the expected value of the excess
return, and the standard deviation of the excess return is a measure of its risk. (See Spreadsheet in slide
10.)
• Notice that the risk premium on risky assets is a real quantity. The expected rate on a risky asset equals
the risk-free rate plus a risk premium.
• The degree to which investors are willing to commit funds to stocks depends on their risk aversion.
Investors are risk averse in the sense that, if the risk premium were zero, they would not invest any money
in stocks. In theory, there must always be a positive risk premium on stocks in order to induce risk-averse
investors to hold the existing supply of stocks instead of placing all their money in risk-free assets.
• Generally while evaluating the risk premium, the maturity of the risk-free rate should match the
investment horizon. Investors with long maturities will view the rate on long-term safe bonds as providing
the benchmark risk-free rate, which is the relevant risk-free rate. In practice, however, excess returns are
usually stated relative to one-month T-bill rates. This is because most discussions refer to short-term
investments.

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• Expected Returns and the Arithmetic Average
• When we use historical data, we treat each observation as an equally likely “scenario.” So if there
are n observations, we substitute equal probabilities of 1/n for each p (s) in Eq.1 (slide 9). The
expected return, E(r), is then estimated by the arithmetic average of the sample rates of return:

- Eq.2

= Arithmetic average of historic rates of return

• Arithmetic Average and Expected Return
• To illustrate, Spreadsheet (next slide) presents a (very short) time series of hypothetical holding
period returns for the S&P 500 index over a 5-year period.
• We treat each HPR of the n = 5 observations in the time series as an equally likely annual outcome
during the sample years and assign it an equal probability of 1/5, or 0.2.
• Column B in Spreadsheet therefore uses 0.2 as probabilities, and Column C shows the annual HPRs.
Applying Eq.2 (using Excel’s SUMPRODUCT function) to the time series in Spreadsheet
demonstrates that adding up the products of probability times HPR amounts to taking the
arithmetic average of the HPRs (compare cells C7 and C8).
• This illustrates the logic for the wide use of the arithmetic average in investments. If the time series
of historical returns fairly represents the true underlying probability distribution, then the
arithmetic average return from a historical period provides a forecast of the investment’s expected
future HPR.

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The Geometric (Time-Weighted) Average Return

• The arithmetic average provides an unbiased estimate of the expected future return. But what
does the time series tell us about the actual performance of a portfolio over the past sample
period?
• Column F in excel shows the investor’s “wealth index” from investing $1 in an S&P 500 index fund
at the beginning of the first year. Wealth in each year increases by the “gross return,” that is, by
the multiple (1 + HPR), shown in column E. The wealth index is the cumulative value of $1
invested at the beginning of the sample period. The value of the wealth index at the end of the
fifth year, $1.0275, is the terminal value of the $1 investment, which implies a 5-year holding-
period return of 2.75%.

** - https://exceljet.net/formula/standard-deviation-calculation

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• An intuitive measure of performance over the sample period is the (fixed) annual HPR that would
compound over the period to the same terminal value obtained from the sequence of actual returns
in the time series. Denote this rate by g, so that

• Practitioners call g the time-weighted (as opposed to dollar-weighted) average return to emphasize
that each past return receives an equal weight in the process of averaging. This distinction is
important because investment managers often experience significant changes in funds under
management as investors purchase or redeem shares. Rates of return obtained during periods when
the fund is large have a greater impact on final value than rates obtained when the fund is small.

• Notice that the geometric average return in excel (previous slide), 0.54%, is less than the arithmetic
average, 2.1%. The greater the volatility in rates of return, the greater the discrepancy between
arithmetic and geometric averages. If returns come from a normal distribution, the expected
difference is exactly half the variance of the distribution, that is,

[Geometric average] = E[Arithmetic average] − ½ σ2

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• Computation of Arithmetic and Geometric Mean of Annual Returns Provided by S&P CNX Nifty The
S&P CNX Nifty, commonly called Nifty, is a very popular stock market index in India. The data on
S&P CNX Nifty since December 1990 till December 2021 is given below;
Date S&P CNX Nifty % Annual Returns Date S&P CNX Nifty % Annual Returns

24-Dec-90 330.86 29-Dec-06 3966.40 39.83

24-Dec-91 558.63 68.84 31-Dec-07 6138.60 54.77
24-Dec-92 761.31 36.28 31-Dec-08 2959.15 -51.79
24-Dec-93 1042.59 36.95 31-Dec-09 5201.05 75.76
23-Dec-94 1182.28 13.40 31-Dec-10 6134.50 17.95
29-Dec-95 908.53 -23.15 30-Dec-11 4624.30 -24.62
31-Dec-96 899.10 -1.04 31-Dec-12 5905.10 27.70
31-Dec-97 1079.40 20.05 31-Dec-13 6304.00 6.76
31-Dec-98 884.25 -18.08 31-Dec-14 8282.70 31.39
30-Dec-99 1480.45 67.42 31-Dec-15 7946.35 -4.06
29-Dec-00 1263.55 -14.65 30-Dec-16 8185.80 3.01
31-Dec-01 1059.05 -16.18 29-Dec-17 10530.70 28.65
31-Dec-02 1093.50 3.25 31-Dec-18 10862.55 3.15
31-Dec-03 1879.75 71.90 31-Dec-19 12168.45 12.02
31-Dec-04 2080.50 10.68 31-Dec-20 13981.75 14.90
30-Dec-05 2836.55 36.34 31-Dec-21 17354.05 24.12
• The return for 1991 is (558.63/330.86) – 1 = 68.84%. The returns for the other years have been
calculated the same way. Given the annual returns during this period, we can calculate the
arithmetic mean and geometric mean:
• Arithmetic mean = (68.84 + ……. + 12.02 + 14.90 + 24.12 ) / 31 = 17.79%
• Geometric mean = (1.6884X1.3628 …… 1.0315X1.1202X1.1490X1.2412) 1/31 – 1 = 13.63%

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• CUMULATIVE WEALTH INDEX - A return measure like total return reflects changes in the level of
wealth. For some purposes it is more useful to measure the level of wealth (or price) rather than the
change in the level of wealth. To do this, we must measure the cumulative effect of returns over
time, given some stated initial amount, which is typically one rupee. The cumulative wealth index
captures the cumulative effect of total returns. It is calculated as follows:

CWIn = WI0 (1 + R1) (1 + R2) … (1 + Rn)

• Where CWIn is the cumulative wealth index at the end of n years, WI0 is the beginning index value
which is typically one rupee and Ri is the total return for year i ( i = 1, …n).
• To illustrate, consider a stock which earns the following returns over a five year period: R1 = 0.14, R2
= 0.12, R3 = –0.08, R4 = 0.25, and R5 = 0.02. The cumulative wealth index at the end of the five year
period, assuming a beginning index value of one rupee, is:
CWI5 = 1 (1.14) (1.12) (0.92) (1.25) (1.02) = 1.498
• Thus, one rupee invested at the beginning of year 1 would be worth Re. 1.498 at the end of year 5.
• You can use the values for the cumulative index to obtain the total return for a given period, using
the following equation:
Rn= -1

• where Rn is the total return for period n and CWI is the cumulative wealth index.

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• MEASURING HISTORICAL RISK –

• Risk refers to the possibility that the actual outcome of an investment will differ from the expected
outcome. Risk refers to variability or dispersion. If an asset’s return has no variability, it is riskless.
Suppose you are analysing the total return of an equity stock over a period of time. Apart from
knowing the mean return, you would also like to know about the variability in returns.

• VARIANCE AND STANDARD DEVIATION –

• In a layman’s language, Variance and Standard Deviation are the two important measurements in
statistics. Variance is a measure of how data points vary from the mean, whereas standard
deviation is the measure of the distribution of statistical data. The basic difference between
variance and the standard deviation is in their units. The standard deviation is represented in the
same units as the mean of data, while the variance is represented in squared units.

• The most commonly used measure of risk in finance is variance or its square root the standard
deviation. The variance and the standard deviation of a historical return series are defined as
follows:

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2
= *

=
• where is the variance of return, is the standard deviation of return, Ri is the return from the stock in
period i (i =1,…., n), is the arithmetic return, and n is the number of periods.
• To illustrate, consider the returns from a stock over a 6 year period: R 1 = 15%, R2 = 12%, R3 = 20%, R4
= –10%, R5 = 14%, and R6 = 9%. The variance and standard deviation of returns are calculated
below:

* Note that is divided by n – 1 not n. This is done technically to correct for the loss of one degree of freedom.

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• Looking at the above calculations, we find that:
• The differences between the various values and the mean value are squared.
• Values which are far away from the mean value have a much more impact on standard deviation
than values which are close to the mean value.
• The standard deviation is obtained as the square root of the average of squared deviations.
Standard deviation and the mean are measured in the same units and hence the two can be
directly compared.
• The choice between the two is solely a matter of convenience. Standard deviation is generally more
convenient as it is in the same units as the rate of return.
• However, when we talk about the proposition of risk attributable to same factor, it is generally less
confusing to work with variance.

• SPREADSHEET APPLICATION - A spreadsheet like Excel has many handy tools for calculation of
various financial functions. To calculate standard deviation of the returns given in the above
example, proceed as follows.

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• Open an Excel worksheet. It has rows numbered 1,2,3,4……… and columns labeled A,B,C,D,………….
Key in the given data viz. period and return in cells B1 to G2. To get the standard deviation in cell
G4, type the formula =STDEV(B2:G2) inside that cell and press enter. The built in function in Excel
automatically calculates the standard deviation and the value 10.45 appears in the cell.
Alternatively, you can first click on the cell G4 (also called selecting G4), type = and then click on the
menu item Insert. From the dialogue box that opens, first select ‘Function’ and out of the various
functions, select the ‘Financial’ function STDEV. An argument box opens wherein, in the space
provided, key in the data range B2 to G2 by typing B2:G2 or by just moving the cursor from B2 to
G2 and click on OK. If you wish to know the mean of the returns, type =AVERAGE(B2:G2) in cell G3
and press enter. The mean value automatically appears in cell G3.

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• The Reward-to-Volatility (Sharpe) Ratio

• Investors presumably are interested in the expected excess return they can earn by replacing T-bills
with a risky portfolio, as well as the risk they would thereby incur. Even if the T-bill rate is not
constant, we still know with certainty what nominal rate we will earn in any period if we purchase a
bill and hold it to maturity. Other investments typically entail accepting some risk in return for the
prospect of earning more than the safe T-bill rate. Investors price risky assets so that the risk
premium will be commensurate with the risk of that expected excess return, and hence it’s best to
measure risk by the standard deviation of excess, not total, returns.

• The importance of the trade-off between reward (the risk premium) and risk (as measured by
standard deviation or SD) suggests that we measure the attraction of a portfolio by the ratio of its
risk premium to the SD of its excess returns. This reward-to-volatility measure was first used
extensively by William Sharpe and hence is commonly known as the Sharpe ratio. It is widely used
to evaluate the performance of investment managers.

• Sharpe ratio =

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• CRITICISM OF VARIANCE (AND STANDARD DEVIATION) AS A MEASURE OF RISK - Though widely used in
finance, there are two criticisms of the use of variance as a measure of risk:
1. Variance considers all deviations, negative as well as positive. Investors, however, do not view positive
deviations unfavourably - in fact, they welcome it. Hence some researchers have argued that only negative
deviations should be considered while measuring risk.
• Markowitz, the father of portfolio theory, himself had recognised this limitation and suggested a measure
of downside risk called semi-variance. Semi-variance is calculated the way variance is calculated, except
that it considers only negative deviations. Markowitz, however, chose variance because analytically it can
be handled easily. Note that, as long as the returns are distributed symmetrically, variance is simply two
times semi-variance and it does not make any difference whether variance is used or semi-variance is
used.
2. When the probability distribution is not symmetrical around its expected value, variance alone does not
suffice. In addition to variance, the skewness of the distribution should also be used. Markowitz does not
consider skewness in developing portfolio theory. Proponents of the Markowitz model rely only on
variance on the grounds that the historical returns of stocks have been approximately symmetrical.

• RATIONALE FOR STANDARD DEVIATION - Notwithstanding the above criticisms, standard deviation is
commonly employed in finance as a measure of risk. Why? The principal reasons for using standard
deviation appear to be as follows:
• If a variable is normally distributed, its mean and standard deviation contain all the information about its
probability distribution. If the utility of money is represented by a quadratic function (a function
commonly suggested to represent diminishing marginal utility of wealth), then the expected utility is a
function of mean and standard deviation. Standard deviation is analytically more easily tractable

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• RISK AVERSION AND REQUIRED RETURNS – Lets play a hypothetical game where you are playing it.
There are -2- boxes one box contains ₹10,000 and the other box is empty. The host of the game doesn’t
tell you which box has ₹10,000 and which one is empty.
• You may choose one of the box and the content is yours. Initially you may hesitate as the difference
between 1 box and the other is ₹10,000, now sensing your hesitancy, the host offers you ₹3,000 if you
forfeit the option to open a box. You don’t accept his offer. He then raises it to ₹3,500. Now you feel
indifferent between a certain return of ₹3,500 and a risky (uncertain) expected return of ₹5,000. This
means that a certain amount of ₹3,500 provides you with the same satisfaction as a risky expected
value of ₹5,000. Thus your certainty equivalent (₹3,500) is less than the risky expected value (₹5,000).
• Empirical evidence suggests that most individuals, if placed in a similar situation, would have a certainty
equivalent which is less than the risky expected value. The relationship of a person’s certainty
equivalent to the expected monetary value of a risky investment defines his attitude toward risk.
• If the certainty equivalent is less than the expected value, the person is risk-averse; if the certainty
equivalent is equal to the expected value, the person is risk-neutral; finally, if the certainty equivalent is
more than the expected value, the person is risk-loving.
• In general, investors are risk-averse. This means that risky investments must offer higher expected
returns than less risky investments to induce people to invest in them. Remember, however, that we are
talking about expected returns; the actual return on a risky investment may well turn out to be less than
the actual return on a less risky investment.
• Put differently, risk and return go hand in hand. This indeed is a well-established empirical fact,
particularly over long periods of time. For example, the average annual rate of return and annual
standard deviations for Treasury bills, bonds, and common stocks in the US over a 75 year period (1926-
2000) as calculated by Ibbotson Associates have been as shown in next slide.
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• The Normal Distribution

• The bell-shaped normal distribution appears naturally in many applications. For example, the
heights and weights of newborns, the lifespans of many consumer items such as light bulbs, and
many standardized test scores are well described by the normal distribution. Variables that are the
end result of multiple random influences tend to exhibit a normal distribution, for example, the
error of a machine that aims to fill containers with exactly 1 gallon of liquid. By the same logic,
because rates of return are affected by a multiplicity of unanticipated factors, they also might be
expected to be at least approximately normally distributed.
• To see why the normal curve is “normal,” consider a newspaper stand that turns a profit of $100 on
a good day and breaks even on a bad day, with equal probabilities of .5. Thus, the mean daily profit
is $50 dollars. We can build a tree that compiles all the possible outcomes at the end of any period.
Here is an event tree showing outcomes after 2 days:

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• Notice that 2 days can produce three different outcomes and, in general, n days can produce n + 1
possible outcomes. The most likely 2-day outcome is “one good and one bad day,” which can
happen in two ways (first a good day, or first a bad day). The probability of this outcome is 0.5. Less
likely are the two extreme outcomes (both good days or both bad days) with probability 0.25 each.
What is the distribution of profits at the end of 200 days? There are 201 possible outcomes and,
again, the midrange outcomes are the most likely because there are more sequences that lead to
them. While only one sequence can result in 200 consecutive bad days, an enormous number of
sequences of good and bad days result in 100 good days and 100 bad days. Therefore, midrange
outcomes are far more likely than are either extremely good or extremely bad outcomes, just as
described by the familiar bell-shaped curve.

• Chart in (slide 28) shows a graph of the normal curve with mean of 10% and standard deviation of
20%. A smaller SD means that possible outcomes cluster more tightly around the mean, while a
higher SD implies more diffuse distributions. The likelihood of realizing any particular outcome
when sampling from a normal distribution is fully determined by the number of standard
deviations that separate that outcome from the mean. Put differently, the normal distribution is
completely characterized by two parameters, the mean and SD.

• Investment management is far more tractable when rates of return can be well approximated by
the normal distribution. First, the normal distribution is symmetric, that is, the probability of any
positive deviation above the mean is equal to that of a negative deviation of the same magnitude.

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Absent symmetry, the standard deviation is an incomplete measure of risk. Second, the normal
distribution belongs to a special family of distributions characterized as “stable” because of the
following property: When assets with normally distributed returns are mixed to construct a
portfolio, the portfolio return also is normally distributed. Third, scenario analysis is greatly
simplified when only two parameters (mean and SD) need to be estimated to obtain the
probabilities of future scenarios. Fourth, when constructing portfolios of securities, we must
account for the statistical dependence of returns across securities. Generally, such dependence is a
complex, multilayered relationship. But when securities are normally distributed, the statistical
relation between returns can be summarized with a single correlation coefficient.

• How closely must actual return distributions fit the normal curve to justify its use in investment
management? Clearly, the normal curve cannot be a perfect description of reality. For example,
actual returns cannot be less than −100%, which the normal distribution would not rule out. But
this does not mean that the normal curve cannot still be useful.

• A similar issue arises in many other contexts. For example, birth weight is typically evaluated in
comparison to a normal curve of newborn weights, although no baby is born with a negative
weight. The normal distribution still is useful here because the SD of the weight is small relative to
its mean, and the predicted likelihood of a negative weight would be too trivial to matter. In a
similar spirit, we must identify criteria to determine the adequacy of the normality assumption for
rates of return.

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• Value at Risk
• The value at risk (denoted VaR to distinguish it from Var, the abbreviation for variance) is the loss
corresponding to a very low percentile of the entire return distribution, for example, the 5th or 1st
percentile return. VaR is actually written into regulation of banks and closely watched by risk
managers. It is another name for the quantile of a distribution. The quantile, q, of a distribution is
the value below which lie q% of the possible values. Thus the median is q = 50th quantile.
Practitioners commonly estimate the 1% VaR, meaning that 99% of returns will exceed the VaR, and
1% of returns will be worse. Therefore, the 1% VaR may be viewed as the cut-off separating the 1%
worst-case future scenarios from the rest of the distribution.

• When portfolio returns are normally distributed, the VaR is fully determined by the mean and SD of
the distribution. Recalling that −2.33 is the first percentile of the standard normal distribution (with
mean = 0 and SD = 1), the VaR for a normal distribution is

VaR (1%, normal) = Mean − 2.33SD

• To obtain a sample estimate of VaR, we sort the observations from high to low. The VaR is the
return at the 1st percentile of the sample distribution

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• Lower Partial Standard Deviation and the Sortino Ratio

• The use of standard deviation as a measure of risk when the return distribution is non normal
presents two problems: (1) The asymmetry of the distribution suggests we should look at negative
outcomes separately, and (2) because an alternative to a risky portfolio is a risk-free investment, we
should look at deviations of returns from the risk-free rate rather than from the sample average,
that is, at negative excess returns.

• A risk measure that addresses these issues is the lower partial standard deviation (LPSD) of excess
returns, which is computed like the usual standard deviation, but using only “bad” returns.
Specifically, it uses only negative deviations from the risk-free rate (rather than negative deviations
from the sample average), squares those deviations to obtain an analog to variance, and then takes
the square root to obtain a “left-tail standard deviation.” The LPSD is therefore the square root of
the average squared deviation, conditional on a negative excess return. Notice that this measure
ignores the frequency of negative excess returns; that is, portfolios with the same average squared
negative excess returns will yield the same LPSD regardless of the relative frequency of negative
excess returns.

• Practitioners who replace standard deviation with this LPSD typically also replace the Sharpe ratio
(the ratio of average excess return to standard deviation) with the ratio of average excess returns to
LPSD. This variant on the Sharpe ratio is called the Sortino ratio.

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Thanks

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