The Returns and Risks from Investing

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The Returns and Risks from Investing. Chapter 6 Jones, Investments: Analysis and Management. 1. 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 - PowerPoint PPT Presentation

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  • The Returns and Risks from InvestingChapter 6Jones, Investments: Analysis and Management1

  • Asset ValuationFunction of both return and riskAt the center of security analysisHow should realized return and risk be measured?The realized risk-return tradeoff is based on the pastThe expected risk-return tradeoff is uncertain and may not occur2

  • Return ComponentsReturns 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 securityCapital Gain Or Loss: Price appreciation or depreciationThe change in price of the assetTotal Return =Yield +Price Change3

  • Risk SourcesInterest Rate RiskAffects market value and resale price Market RiskOverall market effectsInflation RiskPurchasing power variabilityBusiness RiskFinancial RiskTied to debt financingLiquidity Risktime and price concession required to sell securityExchange Rate RiskCountry RiskPotential change in degree of political stability4

  • Risk TypesTwo general types:Systematic (general) riskPervasive, affecting all securities, cannot be avoidedInterest rate or market or inflation risksNonsystematic (specific) riskUnique characteristics specific to a securityTotal Risk =General Risk +Specific Risk5

  • Measuring ReturnsTotal Return compares performance over time or across different securitiesTotal Return is a percentage relating all cash flows received during a given time period, denoted CFt +(PE - PB), to the start of period price, PB6

  • Measuring ReturnsTotal Return can be either positive or negativeWhen cumulating or compounding, negative returns are a problemA Return Relative solves the problem because it is always positive7

  • Measuring ReturnsTo measure the level of wealth created by an investment rather than the change in wealth, need to cumulate returns over timeCumulative Wealth Index, CWIn, over n periods, =8

  • Measuring International ReturnsInternational returns include any realized exchange rate changesIf foreign currency depreciates, returns lower in domestic currency termsTotal Return in domestic currency =9

  • Measures Describing a Return SeriesTR, RR, and CWI are useful for a given, single time periodWhat about summarizing returns over several time periods?Arithmetic mean and Geometric mean Arithmetic mean, or simply mean,10

  • Arithmetic Versus GeometricArithmetic mean does not measure the compound growth rate over timeDoes not capture the realized change in wealth over multiple periodsDoes capture typical return in a single periodGeometric mean reflects compound, cumulative returns over more than one period11

  • Geometric MeanGeometric 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, s12

  • Adjusting Returns for InflationReturns measures are not adjusted for inflationPurchasing power of investment may change over timeConsumer Price Index (CPI) is possible measure of inflation13

  • Measuring RiskRisk is the chance that the actual outcome is different than the expected outcomeStandard Deviation measures the deviation of returns from the mean14

  • Risk PremiumsPremium is additional return earned or expected for additional riskCalculated for any two asset classesEquity risk premium is the difference between stock and risk-free returnsBond default premium is the difference between the return on long term corporate bonds and long term government bonds15

  • Risk PremiumsEquity Risk Premium, ERP, =

    16

  • The Risk-Return RecordSince 1920, cumulative wealth indexes show stock returns dominate bond returnsStock standard deviations also exceed bond standard deviationsAnnual geometric mean return for the time period between December 1919 and December 1998 for the S&P 500 is 10.98% with standard deviation of 20.7%17

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