Transcript The Returns and Risks From Investing

Chapter 6
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons
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
Function of both return and risk
◦ At the center of security analysis

Historical risk-return relationships useful
indicators
◦ No guarantee future will be like the past
◦ Also no reason to assume that relative relationships
will be much different in the future than they are
now
◦ Especially useful in the long-run
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
Returns consist of two elements:
◦ Yield
 Periodic cash flows such as interest or dividends
 Measures return relative to purchase or current price
◦ Capital gain (loss)
 The change in price of the asset


Total Return =Yield + Price Change
Investors sometimes focus only on yield
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

For comparing 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
CFt  (PE  PB )
TR 
PB
6-4

Total Return can be either positive or negative
◦ When cumulating or compounding, negative returns
are problem

A Return Relative solves the problem because
it is always positive
CFt  PE
RR 
 1  TR
PB
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

To measure return in dollars and reflect
compounding returns over a time period,
given a specific initial investment, use
Cumulative Wealth Index
Cumulative Wealth Index, CWIn, over n
periods =
WI0( 1  TR1)( 1  TR2 )...( 1  TRn )
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
International investments subject to
exchange rate risk
◦ When you buy a foreign asset, you must use the
foreign currency, so you must first exchange home
currency
◦ If foreign currency depreciates, returns lower in
domestic currency terms

Total Return in domestic currency =
End Val. of For.Curr. 

RR  Begin Val. of For.Curr.  1


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

TR, RR, and CWI are useful for a given, single
time period
What about summarizing returns over several
time periods?
Arithmetic mean, or simply mean,
X
X 
n
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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
Over multiple periods, the geometric mean
shows the true average compound growth
rate
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Defined as the n-th root of the product of n
return relatives minus one, or G =
( 1  TR1 )( 1  TR2 )...( 1  TRn )1/n  1
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
Return measures are nominal, i.e., are not
adjusted for inflation
◦ Purchasing power of investment may change over
time
◦ Nominal return = real return + expected inflation
rate
◦ Consumer Price Index (CPI) is possible measure of
inflation
1  TR 
TRIA 
1
1  CPI 
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Risk



Risk and return are opposite sides of the
same coin
Risk is the chance that the actual outcome
from an investment will differ from the
expected outcome
Investors willing to assume large risks may
gain large returns, but they may also lose
money
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
Interest Rate Risk

◦ Affects income return

Market Risk
◦ Tied to debt financing

◦ Recession, war, etc.


Liquidity Risk
◦ Marketability of
security in secondary
market
Inflation Risk
◦ Purchasing power
variability
Financial Risk

Currency Risk
◦ Exchange Rate Risk
Business Risk

Country Risk
◦ Political stability
613
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
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Risk arises from variability of outcomes
Variance and standard deviation measure
variability
Standard Deviation is simply the square root
of the variance
2 1/ 2
  X  X 

s


n

1


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Returns for Major Asset Classes
200
Spread in Returns for Major Asset Classes, 1962-2011
-60
Inflation
Treasury
bills
Corporate
bonds
Treasury
bonds
S&P 500
Small
stocks

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 issuer

Total Risk = General Risk + Specific Risk
616
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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
◦ Stocks versus Treasury bills
◦ Stocks versus Treasury bonds
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
Equity Risk Premium, ERP, =




1
TR


CS
1


1
RF







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

From 1926 - 2010, geometric average annual
return was 9.6% for S&P 500
Arithmetic mean was 11.4%
Standard deviation was 19.9%
Smaller common stocks show greater risks
and returns than large common stocks in that
period
T-bills showed lowest risk and return
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Cumulative Wealth Indexes

Cumulative wealth index can be decomposed
into
◦ Dividend component: cumulative dividend yield
(CDY)
◦ Price change component: (CPC)
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