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The Meaning and Measurement of Risk and Return

1) Expected returns come from future cash flows, not accounting profits. Diversifying investments across uncorrelated securities reduces risk. 2) There are two types of risk: unsystemic/diversifiable risk unique to individual firms, and systematic/nondiversifiable market risk that cannot be eliminated through diversification. 3) Beta is a measure of a stock's systematic risk relative to the market, calculated from the slope of the stock's returns against market returns. Diversifying across stocks reduces unsystemic risk but not systematic market risk.

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18 views

The Meaning and Measurement of Risk and Return

1) Expected returns come from future cash flows, not accounting profits. Diversifying investments across uncorrelated securities reduces risk. 2) There are two types of risk: unsystemic/diversifiable risk unique to individual firms, and systematic/nondiversifiable market risk that cannot be eliminated through diversification. 3) Beta is a measure of a stock's systematic risk relative to the market, calculated from the slope of the stock's returns against market returns. Diversifying across stocks reduces unsystemic risk but not systematic market risk.

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shraddha4311
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© Attribution Non-Commercial (BY-NC)
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Download as DOCX, PDF, TXT or read online on Scribd
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The Meaning and Measurement of Risk

and Return
Expected Return

The expected returns or benefits an investment generates come in the form of cash flow, not
accounting profits, is the relevant variable in measuring returns.

Continue to remember that future cash flows, not the reported earnings figure, determine the
investor's rate of return.

Risk

Risk is the potential variability in future cash flows. The wider the range of possible events
that can occur, the greater the risk.

If we diversify our investments across different securities rather than invest in only one stock,
the variability in the returns of our portfolio should decline.

The reduction in risk will occur if the stock returns within one portfolio do not move
precisely together over time-not correlated.The reduction occurs because some of the
volatility in the returns of a stock are unique to that security. The uniqueness of a single stock
tends to be countered by the uniqueness of another security. However, we should not expect
to eliminate all risk from our portfolio.

We can divide the total risk (total variability) of our portfolio into two types of risk:

1. Firm-specific or unsystemic risk

2. Market-related risk or systematic risk

Company-unique risk, also called diversifiable risk, in that it can be diversified away.

Market risk is nondiversifiable risk; it cannot be eliminated through diversification.

Measuring Market Risk

To clarify the idea of systematic risk, let's examine the relationship between the commoon
stock returns of Waste Management and the returns of the S&P 500 Index. The monthly
returns for Waste Management and fr the S&P Index for the last 12 mnths are in Table 1.1
below.

These monthly returns are called holding period returns and are calculated as followed:
K(t)= P(t)/P(t-1)-1

K(t)= the holding period return in month t for a particular firm like Waste
Management or for a portfolio such as the S&P500 Index.

P(t)= a firm's stock price or the S&P500 Index at the end of the month t

P(t-1)= the stock or portfolio price at the end of the previous month

When we have computed the averages of the returns for the 12 months, both for Waste
Management and the S&P 500, and the standard deviation for these returns.

The average monthly return for Waste Management and the S&P 500 Index are 1.16 percent
and 1.28 percent respectively. We also see Waste Management has experienced significantly
greater volatility of returns over the two years.

A standard deviation of 8.22 percent for Waste Management compared to 3.52 percent for the
S&P 500 Index.

It is also helpful to plot Waste Management's returns against the corresponding S&P 500
Index returns. See Figure 1

We then draw a line of "best fit" through the potted points, the slope of the line is 1.85. The
slope of this line of best fit, which we will call the characteristic line, tells us the average
movement in the stock price of Waste Management in response to a movement in the S&P
500 Index.

The slope of the characteristic line which is also called beta, is a measure of a stock's
systematic, or market risk. The slope of the line is merely the ratio of the rise of the line to the
run of the line.

From figure 1, we see the stock price of Waste Management on average changes 1.85
percent, compared to 1 percent for the average stock in the S&P 500 Index. A significantly
larger change than for most stocks in the market.

However, we do see a lot of fluctuation around the characteristic line. If we were to diversify
our holdings and own 20 stocks with betas of 1.85, we could eliminate the variation around
the line. We would remove almost all the volatility in returns, except for what is caused by
the general market, represented by the slope of the line.

If we plotted the returns of our 20 stock portofolio against the S&P 500 Index, the points in
our new graph would fit nicely along a straight line with a slope of 1.85. The new graph
would look like figure 2.

What if we were to diversify our portfolio with 8 stocks with betas of 1.0 and 12 stocks with
betas of 1.5. What would the beta of our portfolio become? The portfolio beta is the average
of the individual stock betas. The portfolio beta is a weighted average of the individual
security's betas, with the weight being equal to the proportion of the porfolio invested in each
security

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