The Returns and Risks From Investing Chapter 6

The Returns and Risks From Investing Chapter 6 Charles P. Jones, Investments: Analysis and Management, Twelfth Edition, John Wiley & Sons 61

Asset Valuation 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 62

Return Components 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 63

Measuring Returns 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 6 -4

Measuring Returns 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 6 -5

Measuring Returns To measure return in dollars and reflect compounding returns over a time period, given a specific initial investment, use Cumulative Wealth Index, CWIn, over n periods = 66

Measuring International Returns 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 = 67

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, or simply mean, 68

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 Over multiple periods, the geometric mean shows the true average compound growth rate 69

Geometric Mean Defined as the n-th root of the product of n return relatives minus one, or G = 610

Adjusting Returns for Inflation 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 611

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 612

Interest Rate Risk Market Risk ◦ Affects income return ◦ 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

Measuring Risk arises from variability of outcomes Variance and standard deviation measure variability Standard Deviation is simply the square root of the variance 614

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

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 issuer Total Risk = General Risk + Specific Risk 616

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 ◦ Stocks versus Treasury bills ◦ Stocks versus Treasury bonds 617

Risk Premiums Equity Risk Premium, ERP, = 618

The Risk-Return Record 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 619

Cumulative Wealth Indexes Cumulative wealth index can be decomposed into ◦ Dividend component: cumulative dividend yield (CDY) ◦ Price change component: (CPC) 620

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