Chapter 8

Risk and
Return

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All rights reserved.
 Risk and Return Fundamentals

• In most important business decisions there are two key

financial considerations: risk and return.
• Each financial decision presents certain risk and return
characteristics, and the combination of these
characteristics can increase or decrease a firm’s share
price.
• Analysts use different methods to quantify risk depending
on whether they are looking at a single asset or a
portfolio—a collection, or group, of assets.

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 Risk and Return Fundamentals:
Risk Defined
• Risk is a measure of the uncertainty surrounding the
return that an investment will earn or, more formally, the
variability of returns associated with a given asset.
• Return is the total gain or loss experienced on an
investment over a given period of time; calculated by
dividing the asset’s cash distributions during the period,
plus change in value, by its beginning-of-period
investment value.

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 Risk and Return Fundamentals:
Risk Defined (cont.)
The expression for calculating the total rate of return earned on any
asset over period t, rt, is commonly defined as

where
rt = actual, expected, or required rate of return during period t
Ct = cash (flow) received from the asset investment in the time
period t – 1 to t
Pt = price (value) of asset at time t
Pt – 1 = price (value) of asset at time t – 1

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 Risk and Return Fundamentals:
Risk Defined (cont.)
At the beginning of the year, Apple stock traded for $90.75 per share,
and Wal-Mart was valued at $55.33. During the year, Apple paid no
dividends, but Wal-Mart shareholders received dividends of $1.09 per
share. At the end of the year, Apple stock was worth $210.73 and
Wal-Mart sold for $52.84.
We can calculate the annual rate of return, r, for each stock.
Apple: ($0 + $210.73 – $90.75) ÷ $90.75 = 132.2%

Wal-Mart: ($1.09 + $52.84 – $55.33) ÷ $55.33 = –2.5%

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 Table 8.1 Historical Returns on
Selected Investments (1900–2009)

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 Risk and Return Fundamentals:
Risk Preferences
Economists use three categories to describe how investors
respond to risk.
– Risk averse is the attitude toward risk in which investors would
require an increased return as compensation for an increase in
risk.
– Risk-neutral is the attitude toward risk in which investors
choose the investment with the higher return regardless of its
risk.
– Risk-seeking is the attitude toward risk in which investors
prefer investments with greater risk even if they have lower
expected returns.

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 Risk of a Single Asset:
Risk Measurement
• Standard deviation (r) is the most common statistical indicator of
an asset’s risk; it measures the dispersion around the expected
value.
• Expected value of a return (r) is the average return that an
investment is expected to produce over time.

where
rj = return for the jth outcome
Prt = probability of occurrence of the jth outcome
n = number of outcomes considered

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 Table 8.3 Expected Values of
Returns for Assets A and B

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 Risk of a Single Asset:
Standard Deviation
The expression for the standard deviation of returns,
r, is

In general, the higher the standard deviation, the

greater the risk.

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 Table 8.4a The Calculation of the Standard
Deviation of the Returns for Assets A and B

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 Table 8.4b The Calculation of the Standard
Deviation of the Returns for Assets A and B

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 Table 8.5 Historical Returns and Standard Deviations on
Selected Investments (1900–2009)

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 Matter of Fact

All Stocks Are Not Created Equal

– Stocks are riskier than bonds, but are some stocks riskier than
others?
– A recent study examined the historical returns of large stocks
and small stocks and found that the average annual return on
large stocks from 1926-2009 was 11.8%, while small stocks
earned 16.7% per year on average.
– The higher returns on small stocks came with a cost, however.
– The standard deviation of small stock returns was a whopping
32.8%, whereas the standard deviation on large stocks was just
20.5%.

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 Risk of a Single Asset:
Coefficient of Variation
• The coefficient of variation, CV, is a measure of relative
dispersion that is useful in comparing the risks of assets
with differing expected returns.

• A higher coefficient of variation means that an investment

has more volatility relative to its expected return.

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 Risk of a Single Asset:
Coefficient of Variation (cont.)
Using the standard deviations (from Table 8.4) and
the expected returns (from Table 8.3) for assets A
and B to calculate the coefficients of variation yields
the following:
CVA = 1.41% ÷ 15% = 0.094
CVB = 5.66% ÷ 15% = 0.377

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 Personal Finance Example

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 Personal Finance Example
(cont.)
Assuming that the returns are equally probable:

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 Risk of a Portfolio

• In real-world situations, the risk of any single

investment would not be viewed independently of
other assets.
• New investments must be considered in light of
their impact on the risk and return of an investor’s
portfolio of assets.
• The financial manager’s goal is to create an
efficient portfolio, a portfolio that provides the
maximum return for a given level of risk.

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 Risk of a Portfolio: Portfolio
Return and Standard Deviation
The return on a portfolio is a weighted average of the
returns on the individual assets from which it is formed.

where
wj = proportion of the portfolio’s total
dollar value represented by asset j
rj = return on asset j

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 Risk of a Portfolio: Portfolio
Return and Standard Deviation
James purchases 100 shares of Wal-Mart at a price of $55
per share, so his total investment in Wal-Mart is $5,500. He
also buys 100 shares of Cisco Systems at $25 per share, so
the total investment in Cisco stock is $2,500.
– Combining these two holdings, James’ total portfolio is worth
$8,000.
– Of the total, 68.75% is invested in Wal-Mart ($5,500/$8,000)
and 31.25% is invested in Cisco Systems ($2,500/$8,000).
– Thus, w1 = 0.6875, w2 = 0.3125, and w1 + w2 = 1.0.

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 Table 8.6a Expected Return, Expected Value,
and Standard Deviation of Returns for
Portfolio XY

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 Table 8.6b Expected Return, Expected Value,
and Standard Deviation of Returns for
Portfolio XY

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 Risk of a Portfolio: Correlation

• Correlation is a statistical measure of the relationship between any

two series of numbers.
– Positively correlated describes two series that move in the same direction.
– Negatively correlated describes two series that move in opposite directions.
• The correlation coefficient is a measure of the degree of
correlation between two series.
– Perfectly positively correlated describes two positively correlated series
that have a correlation coefficient of +1.
– Perfectly negatively correlated describes two negatively correlated series
that have a correlation coefficient of –1.

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 Figure 8.4 Correlations

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 Risk of a Portfolio:
Diversification
• To reduce overall risk, it is best to diversify by combining,
or adding to the portfolio, assets that have the lowest
possible correlation.
• Combining assets that have a low correlation with each
other can reduce the overall variability of a portfolio’s
returns.
• The lower the correlation between portfolio assets, the
greater the risk reduction via diversification.
• Uncorrelated describes two series that lack any interaction
and therefore have a correlation coefficient close to zero.

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 Figure 8.5
Diversification

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 Table 8.7 Forecasted Returns, Expected Values,
and Standard Deviations for Assets X, Y, and Z
and Portfolios XY and XZ

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