The Returns and Risks from Investing

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The Returns and Risks from Investing
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Asset Valuation

• Function of both return and risk
• At the center of security analysis
• How should realized return and risk be measured?
• The realized risk-return tradeoff is based on the
  past
• The expected risk-return tradeoff is uncertain
  and may not occur
• Value of any asset is theoretically the present
  value of the future expected flows.

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Return Components

• Returns consist of two elements
• Yield Periodic cash flows such as interest or
  dividends (income return)
• Yield measures relate income return to a price
  for the security
• Capital Gain Or Loss Price appreciation or
  depreciation
• The change in price of the asset
• Total Return Yield Price Change

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Risk Sources

• Interest Rate Risk
• Affects market value and resale price
  
• Market Risk
• Overall market effects
• Inflation Risk
• Purchasing power variability
• Business Risk

• Financial Risk
• Tied to debt financing
• Liquidity Risk
• time and price concession required to sell
  security
• Exchange Rate Risk
• Country Risk
• Potential change in degree of political stability

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Risk Types

• Two general types
• Systematic (general) risk
• Pervasive, affecting all securities, cannot be
  avoided
• Interest rate or market or inflation risks
• Nonsystematic (specific) risk
• Unique characteristics specific to a security
• Total Risk General Risk Specific Risk

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Measuring Return

• Real Risk-Free Rate of Return
• The rate of return that could be earned in a
  perfect world where all outcomes are know and
  certain where there was no risk
• Historically, this amount has remained relatively
  stable at 1 to 2
• Expected Inflation Premium
• The average rate of inflation expected in the
  future
• Inflation has average 3.1 per year since 1925

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Measuring Return

• Risk-free Rate
• The rate of return that can be earned on a
  risk-free investment
• The sum of the real rate of return and the
  expected inflation premium
• The most common risk-free investment is
  considered to be the 3-month U.S. Treasury Bill

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Measuring Return

• Risk Premium
• Additional return an investor requires on an
  investment to compensate for higher risks based
  upon issue and issuer characteristics
• Issue characteristics are the type, maturity and
  features
• Issuer characteristics are industry and company
  factors

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Measuring Return

• Required Return
• The rate of return an investor must earn on an
  investment to be fully compensated for its risk

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Measuring Returns--Historical

• Total Return
• Relative Return
• Cumulative Wealth Index

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Measuring ReturnsTotal Return

• Total Return compares performance over time or
  across different securities
• Total Return is a percentage relating all cash
  flows received during a given time period,
  denoted CFt (PE - PB), to the start of period
  price, PB

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Measuring ReturnsRelative Return

• Total Return can be either positive or negative
• When cumulating or compounding, negative returns
  are a problem
• A Return Relative solves the problem because it
  is always positive

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Measuring ReturnsCumulative Wealth Index

• To measure the level of wealth created by an
  investment rather than the change in wealth, need
  to cumulate returns over time
• Cumulative Wealth Index, CWIn, over n periods,

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Measures Describing a Return Series

• TR, RR, and CWI are useful for a given, single
  time period.
• What about summarizing returns over several time
  periods?
• Arithmetic mean and Geometric mean
• Arithmetic mean, or simply mean,

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Arithmetic Versus Geometric

• Arithmetic mean does not measure the compound
  growth rate over time.
• Does not capture the realized change in wealth
  over multiple periods.
• Does capture typical return in a single period.
• Geometric mean reflects compound, cumulative
  returns over more than one period.

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Geometric Mean

• Geometric mean defined as the n-th root of the
  product of n return relatives minus one or G
• Difference between Geometric mean and Arithmetic
  mean depends on the variability of returns,

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Adjusting Returns for Inflation

• Returns measures are not adjusted for inflation
• Purchasing power of investment may change over
  time
• Consumer Price Index (CPI) is possible measure of
  inflation

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Risk MeasuresHistorical
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Measuring Risk

• Risk is the chance that the actual outcome is
  different than the expected outcome
• Standard Deviation measures the deviation of
  returns from the mean

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Risk Premiums

• Premium is additional return earned or expected
  for additional risk
• Calculated for any two asset classes
• Equity risk premium is the difference between
  stock and risk-free returns
• Bond default premium is the difference between
  the return on long term corporate bonds and long
  term government bonds

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Risk Premiums

• Equity Risk Premium, ERP,

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RISK, RETURN AND INVESTMENT SELECTION

• COEFFICIENT OF VARIATION
• IT IS A STATISTICAL MEASURE OF THE RISK/RETURN
  TRADE-OFF OFFERED BY AN INVESTMENT
• CV COEFFICIENT OF VARIATION
• SD STANDARD DEVIATION
• AM ARITHMETIC MEAN OF RETURNS

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HISTORICAL RETURNS

• NOMINAL RETURNS 1926-1999

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HISTORICAL RETURNS

• REAL RETURNS 1926-1999

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Return on Portfolio
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Portfolio Standard Deviation
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Covariance
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Portfolio SD given Covariance
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Portfolio Variance usingCorrelation Coefficient
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Using HPR in Investment Decisions

• Advantages of Holding Period Return
• Easy to calculate
• Easy to understand
• Considers current income and growth
• Disadvantages of Holding Period Return
• Does not consider time value of money
• Rate may be inaccurate if time period if longer
  than one year

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Risk

• Risk-Return Tradeoff is the relationship between
  risk and return, in which investments with more
  risk should provide higher returns, and vice
  versa
• Risk is the chance that the actual return from an
  investment may differ from what is expected

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Sources of Risk

• Business Risk
• Exchange Risk
• Financial Risk
• Purchasing Power Risk
• Interest Rate Risk
• Liquidity Risk
• Tax Risk
• Market Risk
• Event Risk

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Business Risk

• The degree of uncertainty associated with an
  investments earnings and the investments
  ability to pay the returns owed investors
• Types of Investments Affected
• Common stocks
• Preferred stocks
• Examples of Business Risk
• Decline in company profits or market share
• Bad management decisions

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Currency Exchange Risk

• The risk caused by the varying exchange rates
  between the currencies of two countries
• Types of Investments Affected
• International stocks or ADRs
• International bonds
• Examples of Currency Exchange Risk
• U.S. dollar gets stronger against foreign
  currency, reducing value of foreign investment

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Financial Risk

• The degree of uncertainty attributable to the mix
  of debt and equity used to finance a business
  the larger the proportion of debt financing, the
  greater this risk
• Types of Investments Affected
• Common stocks
• Corporate bonds
• Examples of Financial Risk
• Company cant get additional loans for growth or
  to fund operations
• Company defaults on bonds

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Purchasing Power Risk

• The chance that changing price levels (inflation
  or deflation) will adversely affect investment
  returns
• Types of Investments Affected
• Bonds (fixed income)
• Certificates of deposit
• Examples of Purchasing Power Risk
• Movie that was 8.00 last year is 9.00 this year

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Interest Rate Risk

• The chance that changes in interest rates will
  adversely affect a securitys value
• Types of Investments Affected
• Bonds (fixed income)
• Preferred stocks
• Examples of Interest Rate Risk
• Market values of existing bonds decrease as
  market interest rates increase
• Income from an investment is reinvested at a
  lower interest rate than the original rate

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Liquidity Risk

• The risk of not being able to liquidate an
  investment conveniently and at a reasonable price
• Types of Investments Affected
• Some small company stocks
• Real estate
• Examples of Liquidity Risk
• The price of a house has to be lowered for a
  quick sale

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Tax Risk

• The chance that Congress will make unfavorable
  changes in tax laws, driving down the after-tax
  returns and market values of certain investments
• Types of Investments Affected
• Municipal bonds
• Real estate
• Examples of Tax Risk
• Lower tax rates reduce the tax benefit of
  municipal bond interest
• Limits on deductions from real estate losses

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Market Risk

• The risk of decline in investment returns because
  of market factors independent of the given
  investment
• Types of Investments Affected
• All types of investments
• Examples of Market Risk
• Stock market decline on bad news
• Political upheaval
• Changes in economic conditions

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Event Risk

• Event Risk come from an unexpected event that has
  a significant and unusually immediate effect on
  the underlying value of an investment
• Types of Investments Affected
• All types of investments
• Examples of Event Risk
• Decrease in value of insurance company stock
  after a major hurricane
• Decrease in value of real estate after a major
  earthquake

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Measures of Risk Single Asset

• Standard deviation is a statistic used to measure
  the dispersion (variation) of returns around an
  assets average or expected return
• Coefficient of variation is a statistic used to
  measure the relative dispersion of an assets
  returns it is useful in comparing the risk of
  assets with differing average or expected returns
• Higher values for both indicate higher risk

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Acceptable Levels of Risk Depend Upon the
Individual Investor

• Risk-indifferent describes an investor who does
  not require a change in return as compensation
  for greater risk
• Risk-averse describes an investor who requires
  greater return in exchange for greater risk
• Risk-seeking describes an investor who will
  accept a lower return in exchange for greater risk

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Figure 4.5 Risk Preferences
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Steps in the Decision ProcessCombining Return
and Risk

• Estimate the expected return using present value
  methods and historical/projected return rates
• Assess the risk of the investment by looking at
  historical/projected returns using standard
  deviation or coefficient of variation of returns
• Evaluate the risk-return of each investment
  alternative to make sure the return is reasonable
  given the level of risk
• Select the investment vehicles that offer the
  highest expected returns associated with the
  level of risk you are willing to accept