Chapter 6

THE MEANING AND MEASUREMENT OF RISK AND RETURN.

People play the stock market to WIN. In order to win you must become knowledgeable

to play the stock market and know if an investment is worth the risk.

Unfortunately, people rely on tips and hunches from brokers which often ends with

disappointing results. Knowledge and experience is the key for success in making

money in the stock market (Fontanills & Gentile, 2001).

With over 10,000 stocks and 3000 options selecting a winning and successful stock like

the next Google or Microsoft is not easy but armed with the right knowledge on how to

select well managed firms, will go a long way for you to be winner in the market.

Let us discover several knowledge points and understand what risk is and what

diversification means.

pg 172

Principle of finance #1

The Risk - Return Trade-Off - We Won't take on additional risk unless we expect to be

compensated with additional return.

EXPECTED RETURN DEFINED AND MEASURED

The expected benefits, or returns, an investment generated comes in the forms of cash

flow.

http://finance.yahoo.com/q/cf?s=IBM&annual

(The future cash flows, not reported earnings, determine the investor's rate of return).

Principle of finance #3 Cash - not profits - is king.

pg 174

RISK DEFINED AND MEASURED

Risk means different things to different people. Risk in this chapter only refers to the

potential variability in future cash flows.

The wider range of possibilities that can occur, the greater the risk.

The square root of the weighted average

Keown et.al p. 176 (2008)

Pg 175

Keown et.al p. 175 (2008)

pg 179

RATES OF RETURN: THE INVESTOR'S EXPERIENCE

Keown et.al (2008)

pg 180

Unsystematic - The risk is unique to the firm such as a strike, unfavorable litigation,

or a natural catastrophe that can be eliminated through diversification.

Systematic - Risks that affect most investments. (interest rate changes and consumer

prices (inflation). It may not be possible to eliminate systematic risks through

diversification, it can be reduced by adding utilities and blue chip securities which

historically have slow changing prices.

Nominal Rate of Return - This is the rate that you will see most often; the published

rates. Say you see a sign "CD investments at 5%. " If you invest $100 at 5% return for 1

year from now can calculate this at $100 x .05% = $105 in addition you may receive a

dividend of $5. $105 + $5 = $110

Real rate of Return - "Real Rates of Return", reflects the impact of inflation. Using

the example above: If the interest rate is 3% the total return would be $110 - $3 = $107

pg. 184

Watch video on beta

http://www.youtube.com/watch?v=W1f7tLTGJwY

Beta - Greek letter 'ß' to represent beta.

measures the average relationship between a stock's returns and the market's return

(Keoen tl, 2008). In other words how does an individual stock's price compare to the

overall market. The beta number is calculated for you. The S&P 500 (an index of 500

large-cap common stocks that trade on the NYSE Euronext (includes the NYSE) and

the NASDAQ OMX (National Association of Securities Dealers Automated Quotations)

is assigned a beta of 1. Stocks with a beta rating that is greater than 1 is considered to

have more risk. A stock with a beta rating of less than 1 is considered to be of less risk.

Stocks with greater beta rating of 1 has more risk and it should return more reward. A

stock of less than beta 1 should return a lower reward.

http://stocks.about.com/gi/o.htm?zi=1/XJ&zTi=1&sdn=stocks&cdn=money&tm=1669

&gps=27_981_948_1264&f=21&su=p649.3.336.ip_&tt=2&bt=0&bts=0&zu=http%3A/

/www.investor.reuters.com/StockEntry.aspx%3Ftarget%3D/stocks

http://stocks.about.com/gi/o.htm?zi=1/XJ&zTi=1&sdn=stocks&cdn=money&tm=1669

&gps=27_981_948_1264&f=21&su=p649.3.336.ip_&tt=2&bt=0&bts=0&zu=http%3A/

/www.investor.reuters.com/StockEntry.aspx%3Ftarget%3D/stocks

Additional facts on beta

beta is based on historical data and not future projections

beta does not take into account new business products

beta is a good ratio for short term or long term decision-making, where volatility

knowledge is important.

beta is a single method to measure value stock and careful consideration of other firms

fundamentals will allow a better picture of the overall firms potential.

http://stocks.about.com/od/evaluatingstocks/a/beta120904.htm

Stock Beta Calculation of 0 - Basically, cash has a beta of 0. In other words, regardless of

which way the market moves, the value of cash remains unchanged (given no inflation).

http://www.stockbetacalculation.com/

rf = The risk-free interest rate is the interest rate the investor would expect to receive from a risk-free investment. Typically, US Treasury Bills are used for US dollars and German Government bills are used for the Euro.

ß = A stock beta is used to mathematically describe the relationship between the movements of an individual stock versus the market itself. Investors can use a stock's beta to measure the risk of a security versus the market.

http://www.money-zine.com/Investing/Stocks/Stock-Beta-and-Volatility/

If the required rate of return is 13% The risk free rate is 5% Market risk premium is 10% What is this firm's beta?

RoR = Rf +b(mkt premium)

.13 - .05 + b (.10)

= beta = .8

MEASURING THE MARKET RISK

Pg 181

See book

pg 187

RISK AND DIVERSIFICATION

On the broad sense diversification means not placing all our eggs in one basket. It means purchasing different investments that all have the expectation based on analysis that they will go up in value over the long term. For instance bonds. stocks, and real-estate do not change value together at the same time but over time we could expect them to gain value. This concept of having a mixture of investments is called diversification.

When we chart our investments showing the return versus risk we use for risk a mathematical formula called standard deviation which means the volatility such as how far it deviates from the average. We will discover that by mixing stocks, bonds, and real estate together we are over time creating more return for lower risks.

Diversifying among different kinds of assets is called "asset allocation".

MUTUAL FUNDS

Own a part of 100's of stocks, professionally managed, and the advantage of the diversification as the money is pooled across many stocks.

Types of mutual funds (pools of money that is invested in a certain area of stocks).

Stocks could be US SP 500 stocks, Government bonds, emerging stocks or bonds.

The performance can be measured against the US 500 funds to see if it is better or worse than the index.

Generally $1000, 2000, 3000 investments are required.

pg 190

THE INVESTOR'S REQUIRED RATE OF RETURN

Investor's minimum rate of return or required rate of return.

We invest in an investment with the intent to obtain a return that will make it worthwhile.

Expressed as;

K= Krf + Krp

K = the investor's rate of return

Krf = the risk free rate of return

Krp = the risk premium

risk-free of return - (generally the Treasury rate) has the opportunity cost and the interest rate cost but no risk cost.

the risk premium - the additional premium we must add for assuming the risk.

GROUP WORK

Stock Market Info & Research.

http://research.scottrade.com/public/stocks/snapshot/snapshot.asp?symbol=c

References

Fontanills, G. & Gentile, T. (2001). The stock market course. John Wiley & Sons, Inc. Danvers, MA.

Keown, A., Keown, A., Martin, J., Petty, J., & Scott, D. (2008). Foundations of Finance. Upper Saddle River: Pearson Prentice Hall.