Risk and Return

2
The value of an investment of $1 in
1900
$100,000
1900
$10,000
,
Common Stock
US Govt Bonds
14,276
$1,000
(
l
o
g

s
c
a
l
e
)
US Govt Bonds
T-Bills
$100
o
l
l
a
r
s

(
241
71
$10
D
o
$1
0
0 0
2
0
3
0
4
0
5
0
6
0
7
0
8
0
9
0
0
0 0
8
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
Start of Year
2
0
0
3
The real value of an investment of $1 in
1900
Real Returns
1900
$1,000
E i i
581
$100
s
c
a
l
e
)
Equities
Bonds
Bills
l
a
r
s

(
l
o
g

$10
D
o
l
l
9.85
2 87
$1
0 9 9 9 9 9 9 9 9 9 9
2.87
8
1
9
0
0
1
9
0
9
1
9
1
9
1
9
2
9
1
9
3
9
1
9
4
9
1
9
5
9
1
9
6
9
1
9
7
9
1
9
8
9
1
9
9
9
Start of Year
2
0
0
8
Start of Year
4
Hi t i l t 1926 2007 Historical returns: 1926-2007
Average Standard
Series Annual Return Deviation Distribution
Large Company Stocks 12.3% 20.0%
Small Company Stocks 17.1 32.6 p y
Long-Term Corporate Bonds 6.2 8.4
Long-Term Government Bonds 5.8 9.2
U.S. Treasury Bills 3.8 3.1 y
Inflation 3.1 4.2
Source: Stocks Bonds Bills and Inflation 2008 Yearbook Ibbotson Associates Inc Chicago (annually updates work by
90% + 90% 0%
Source: Stocks, Bonds, Bills, and Inflation 2008 Yearbook , Ibbotson Associates, Inc., Chicago (annually updates work by
Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.
5
Average rates of return on T-bills, government
b d d k bonds, and common stocks, 1900-2008
Average annual rate of return (%) Average annual rate of return (%)
Average risk
premium
(extra return
Nominal Real versus T-bills)
Treasury bills 4 0 1 1 0 Treasury bills 4.0 1.1 0
Government 5.5 2.6 1.5
bonds
Common 11.1 8.0 7.1 Common
stocks
11.1 8.0 7.1
6
Using historical evidence to evaluate
t d t f it l todays cost of capital
Suppose there is an investment project that has the Suppose there is an investment project that has the
same risk as Standard and Poors Composite Index.
What rate should you use to discount this projects
forecasted cash flows? forecasted cash flows?
The currently expected rate of return on the y p
market portfolio (r
m
)
7
A ti ti f An estimation of r
m
The future value will be like the past r =11 1% The future value will be like the past, r
m
=11.1%
r
m
is not likely to be stable over time.
r
m
= r
f
+ risk premium, and r
f
varies
r (2009) r
m
(2009)
= r
f
( i on T-bill in 2009)+ nominal risk premium
f
= .002 + .071 = .073, or 7.3%
Assumption: there is a nominal stable risk premium on Assumption: there is a nominal, stable risk premium on
the market portfolio
What really is the risk premium?
8
A ti ti f An estimation of r
m
CFOs expect a market risk premium that is several CFOs expect a market risk premium that is several
percentage points below the historical average
History is unlikely to be repeated.
History may overstate the risk premium y y p
9
Average market risk premiums (nominal g p
return on stocks minus nominal return on bills), 1900-2008
10
11
7
8
9
10
Risk premium, %
543 55 561 567
604 6.29
6.94 7.13
7.94
8.34 8.4
8.74
9.1
9.61
10.21
3
4
5
6
4.29
4.69
5.05
5.43 5.5 5.61 5.67
6.04
0
1
2
3
k
m
d d n y a
. s
e
.
n
a a y e n y
D
e
n
m
a
r
k
B
e
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g
i
u
m
w
i
t
z
e
r
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a
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d
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a
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.
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.
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A
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a
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U
.
S
.
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w
e
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n
A
u
s
t
r
a
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i
a
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t
h

A
f
r
i
c
a
G
e
r
m
a
n
y
F
r
a
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c
e
J
a
p
a
n
I
t
a
l
y
D
S
w
N
e
t
S
o
u
G
Reason 1: Risk premium varies by country
If the inflation rate is i, then the real risk premium is (r
m
-r
f
)/(1+i)
The real risk premium may be significantly lower than nominal
premium for Italy.
10
Dividend yields in the U.S.A. 1900
2008 2008
Reason 2: Mutual funds, pension
9.00
10.00
funds, and other financial
institutions make it easier for
7.00
8.00
investors to reduce risk
5.00
6.00
e
n
d

Y
i
e
l
d

(
%
)
3.00
4.00
D
i
v
i
d
e
1.00
2.00
0.00
1
9
0
0
1
9
0
5
1
9
1
0
1
9
1
5
1
9
2
0
1
9
2
5
1
9
3
0
1
9
3
5
1
9
4
0
1
9
4
5
1
9
5
0
1
9
5
5
1
9
6
0
1
9
6
5
1
9
7
0
1
9
7
5
1
9
8
0
1
9
8
5
1
9
9
0
1
9
9
5
2
0
0
0
2
0
0
5
11
How to measure risk?
The relationship between risks borne and The relationship between risks borne and
risk premium demanded.
Rates of return for U.S. common stocks:
1900 2008
Stock Market Index Returns
1900-2008
60.0
80.0
40.0
R
e
t
u
r
n
20.0
n
t
a
g
e

R
-20.0
0.0
P
e
r
c
e
-40.0
20.0
-60.0
Year
Source: Ibbotson Associates
13
Histogram of annual stock market
t (1900 2008) returns (1900-2008)
# f
21
24
24
#of Years
21
17
13
16
20
11
11
8
12
16
1
2
4
3
2 4
8
0
0

t
o

-
4
0
0

t
o

-
3
0
0

t
o

-
2
0
0

t
o

-
1
0
1
0

t
o

0
0

t
o

1
0
0

t
o

2
0
0

t
o

3
0
0

t
o

4
0
0

t
o

5
0
0

t
o

6
0
-
5
0
-
4
0
-
3
0
-
2
0 -
1 0
1
0
2
0
3
0
4
0
5
0
Return %
14
Price changes vs. normal distribution:
il h IBM - Daily % change 1988-2008
3.5
4.0
2.5
3.0
2.0
2.5
f

d
a
y
s
1.0
1.5
o
r
t
i
o
n

o
f
0.0
0.5
P
r
o
p
o
-7 -6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8
Daily%change Daily % change
15
Standard deviation vs. expected return:
I t t A Investment A
16
18
20
12
14
16
i
t
y
8
10
12
p
r
o
b
a
b
i
l
4
6
8
%

p
0
2
-50 0 50
% return
16
Standard deviation vs. expected return:
I t t B Investment B
20
16
18
20
12
14
16
l
i
t
y
8
10
12
p
r
o
b
a
b
i
4
6
%

p
0
2
-50 0 50
% return
17
Standard deviation vs. expected return:
I t t C Investment C
20
16
18
20
12
14
16
l
i
t
y
8
10
12
p
r
o
b
a
b
i
4
6
%

p
0
2
-50 0 50
% return
18
M i i k Measuring risk
Variance - Average value of squared deviations from mean A Variance Average value of squared deviations from mean. A
measure of volatility.
St d d D i ti A l f d d i ti f Standard Deviation - Average value of squared deviations from
mean. A measure of volatility.
Coin toss game - calculating variance and standard deviation
19
I di id l iti Individual securities
The characteristics of individual securities that are of The characteristics of individual securities that are of
interest are the:
Expected return
Variance and standard deviation Variance and standard deviation
Covariance and correlation (to another security or index)
20
Expected return, variance, and
i covariance
Consider the following two risky asset world Consider the following two risky asset world.
There is a 1/3 chance of each state of the economy, y
and the only assets are a stock fund and a bond fund.
Rate of Return
Scenari o Probabi l i ty Stock Fund Bond Fund Sce a o obab ty Stoc u d o d u d
Recession 33.3% -7% 17%
Normal 33.3% 12% 7% Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
21
E t d t Expected return
St k F d B d F d Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Devi ati on Return Devi ati on Scenario Return Devi ati on Return Devi ati on
Recessi on -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
V i 0 0205 0 0067 Vari ance 0.0205 0.0067
Standard Devi ati on 14.3% 8.2%
%) 28 (
3
1
%) 12 (
3
1
%) 7 (
3
1
) ( + + =
S
r E
% 11 ) (
3 3 3
=
S
r E
22
V i Variance
SStock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Devi ati on Return Devi ati on
Recessi on -7% 0.0324 17% 0.0100
N l 12% 0 0001 7% 0 0000 Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11 00% 7 00% Expected return 11.00% 7.00%
Vari ance 0.0205 0.0067
Standard Devi ati on 14 3% 8 2% Standard Devi ati on 14.3% 8.2%
0324 %) 11 % 7 (
2
0324 . %) 11 % 7 (
2
=
23
V i Variance
SStock Fund Bond Fund
Rate of Squared Rate of Squared
S i Scenario Return Devi ati on Return Devi ati on
Recessi on -7% 0.0324 17% 0.0100
Normal 12% 0 0001 7% 0 0000 Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11 00% 7 00% Expected return 11.00% 7.00%
Vari ance 0.0205 0.0067
Standard Devi ati on 14.3% 8.2% Standard Devi ati on 14.3% 8.2%
1
) 0289 . 0001 . 0324 (.
3
1
0205 . + + =
3
24
St d d d i ti Standard deviation
Stock Fund Bond Fund Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario R t D i ti R t D i ti Scenario Return Devi ati on Return Devi ati on
Recessi on -7% 0.0324 17% 0.0100
Normal 12% 0 0001 7% 0 0000 Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11 00% 7 00% Expected return 11.00% 7.00%
Vari ance 0.0205 0.0067
Standard Devi ati on 14.3% 8.2% Standard Devi ati on 14.3% 8.2%
0205 . 0 % 3 . 14 =
25
The annual standard deviations and
i f h f li variances for three portfolios, 1900-2008
Standard
Portfolio
Standard
deviation Variance
Treasury bills 2.8 7.7
Government bonds 8.3 69.3
Common stocks 20.2 406.4
26
E it k t i k b t Equity market risk: by country
%
Average Risk (1900-2008)
35
40
u
r
n
s
,

%
g ( )
25
30
35
u
a
l

R
e
t
u
2183 2205
22.99 23.23 23.42 23.51 23.98 24.09
25.28
28.32
29.57
33.93 34.3
15
20
o
f

A
n
n
u
17.02
18.45 19.22
20.16
21.83 22.05
22.99 23.23
0
5
10
v
i
a
t
i
o
n

o
0
C
a
n
a
d
a
u
s
t
r
a
l
i
a
z
e
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l
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d
U
.
S
.
U
.
K
.
n
m
a
r
k
S
p
a
i
n
e
r
l
a
n
d
s
A
f
r
i
c
a
I
r
e
l
a
n
d
w
e
d
e
n
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l
g
i
u
m
F
r
a
n
c
e
N
o
r
w
a
y
J
a
p
a
n
I
t
a
l
y
r
m
a
n
y
a
r
d

D
e
v
C
A
u
S
w
i
t
z
D
e
n
N
e
t
h
e
S
o
u
t
h

I
S
w
B
e
F
N
G
e
r
S
t
a
n
d
a
27
D J i k Dow Jones risk
Annualized Standard Deviation of the DJ IA over the preceding 52
70
p g
weeks (1900 2008)
50
60
%
)
40
v
i
a
t
i
o
n

(
%
20
30
d
a
r
d

D
e
v
10
20
S
t
a
n
d
0
Years
28
C i t Comparing returns
29
C i Covariance
Stock Bond
Scenario Devi ati on Devi ati on Product Wei ghted g
Recessi on -18% 10% -0.0180 -0.0060
Normal 1% 0% 0.0000 0.0000
Boom 17% -10% -0.0170 -0.0057
Sum -0.0117
C i 0 0117 Covari ance -0.0117
h h d Deviation compares return in each state to the expected
return.
Weighted takes the product of the deviations multiplied by
h b bili f h the probability of that state.
30
Th t d i k f tf li
Stock Fund Bond Fund
The return and risk for portfolios
Stock Fund Bond Fund
Rate of Squared Rate of Squared
Scenario Return Devi ati on Return Devi ati on Scenario Return Devi ati on Return Devi ati on
Recessi on -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Vari ance 0.0205 0.0067
Standard Devi ati on 14.3% 8.2%
Note that stocks have a higher expected return than bonds and
higher risk Let us turn now to the risk-return tradeoff of a higher risk. Let us turn now to the risk return tradeoff of a
portfolio that is 50% invested in bonds and 50% invested in
stocks stocks.
31
P tf li Portfolios
Rate of Return Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0%
Variance 00205 00067 00010
h f h f l h d f h
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The rate of return on the portfolio is a weighted average of the
returns on the stocks and bonds in the portfolio:
S S B B P
r w r w r + =
%) 17 ( % 50 %) 7 ( % 50 % 5 + = %) 17 ( % 50 %) 7 ( % 50 % 5 + =
32
P tf li Portfolios
Rate of Return Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 50% 00016 Recession 7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0% p
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The expected rate of return on the portfolio is a weighted
average of the expected returns on the securities in the average of the expected returns on the securities in the
portfolio.
%) 7 ( % 50 %) 11 ( % 50 % 9 +
) ( ) ( ) (
S S B B P
r E w r E w r E + =
%) 7 ( % 50 %) 11 ( % 50 % 9 + =
33
P tf li Portfolios
Rate of Return Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016 ecession 7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0%
V i 00205 00067 00010
h f h f h k
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
The variance of the rate of return on the two risky assets
portfolio is
BS S S B B
2
S S
2
B B
2
P
) )(w 2(w ) (w ) (w + + =
where
BS
is the correlation coefficient between the returns
h k d b d f d
BS S S B B S S B B P
) )( ( ) ( ) (
on the stock and bond funds.
34
P tf li
Rate of Return
Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.0016
Normal 12% 7% 9.5% 0.0000
Boom 28% -3% 12.5% 0.0012
Expected return 11.00% 7.00% 9.0%
Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%
Observe the decrease in risk that diversification offers.
An equally weighted portfolio (50% in stocks and 50% in
bonds) has less risk than either stocks or bonds held in
isolation.
35
C l ti Correlation
) , ( b a Cov ) , (
=
o o

b a
b a Cov
998 . 0
) 082 )( 143 (
0117 .
=

=
) 082 )(. 143 (.

36
P tf li i k Portfolio risk
The shaded boxes contain variance terms; the remainder contain The shaded boxes contain variance terms; the remainder contain
covariance terms.
T l l t tf li i To calculate portfolio variance
add up the boxes.
1
2
The variance of the return on
a portfolio with
3
4
STOCK
many securities is
more dependent
5
6
STOCK
on the covariances between
the individual securities than
on the variances of
the individual securities
N
1 2 3 4 5 6 N
STOCK
37
Th ffi i t t f t t
% in stocks Risk Return
The efficient set for two assets
Portfolo Risk and Ret rn Combinations 0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 48% 76%
12.0%
n
Portfolo Risk and Return Combinations
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
100%
stocks
9.0%
10.0%
11.0%
R
e
t
u
r
n
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50 00% 3 08% 9 00%
100%
b d
stocks
6 0%
7.0%
8.0%
9 0%
t
f
o
l
i
o

R
50.00% 3.08% 9.00%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
bonds
5.0%
6.0%
0.0% 5.0% 10.0% 15.0% 20.0%
P
o
r
t
P tf li Ri k ( t d d d i ti )
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 109% 104%
We can consider other portfolio
Portfolio Risk (standard deviation)
85% 10.9% 10.4%
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
weights besides 50% in stocks and
50% in bonds.
38
Th ffi i t t f t t
% in stocks Risk Return
The efficient set for two assets
Portfolio Risk and Return Combinations
% in stocks Risk Return
0% 8.2% 7.0%
5% 7.0% 7.2%
10% 5.9% 7.4%
15% 48% 76%
12.0%
e
t
u
r
n
Portfolio Risk and Return Combinations
15% 4.8% 7.6%
20% 3.7% 7.8%
25% 2.6% 8.0%
30% 1.4% 8.2%
9 0%
10.0%
11.0%
l
i
o

R
e
100%
stocks
35% 0.4% 8.4%
40% 0.9% 8.6%
45% 2.0% 8.8%
50% 31% 90%
7.0%
8.0%
9.0%
P
o
r
t
f
o
l
100%
bonds
50% 3.1% 9.0%
55% 4.2% 9.2%
60% 5.3% 9.4%
65% 6.4% 9.6%
5.0%
6.0%
0.0% 5.0% 10.0% 15.0% 20.0%
P
bonds
70% 7.6% 9.8%
75% 8.7% 10.0%
80% 9.8% 10.2%
85% 10.9% 10.4%
Notethat someportfoliosarebetter
Portfolio Risk (standard deviation)
90% 12.1% 10.6%
95% 13.2% 10.8%
100% 14.3% 11.0%
Note that some portfolios are better
than others. They have higher returns
for thesamelevel of riskor less. for the same level of risk or less.
39
P tf li ith i l ti Portfolios with various correlations
n
r
e
t
u
r
n
100%
stocks
=-1.0
Relationship depends on
=1.0
correlation coefficient
-1.0 < < +1.0
100%
bonds
=0.2

If = +1.0, no risk reduction is possible

If = 1 0 complete risk reduction is possible
o
If = 1.0, complete risk reduction is possible
As long as <1, the standard deviation of a portfolio of two
securities is less than the weighted average of the standard
deviations of the individual securities.
40
P tf li Portfolio
C l ti C ffi i t = 18 Correlation Coefficient = .18
Stocks o % of Portfolio Avg Return
Campbell 15.8 60% 3.1%
Boeing 23.7 40% 9.5% g
Standard Deviation = weighted avg = 19 0 Standard Deviation weighted avg 19.0
Standard Deviation = Portfolio = 14.6
R i h d P f li 5 7% Return = weighted avg = Portfolio = 5.7%
41
M k it P tf li Th
10
Markowitz Portfolio Theory
8
9
Boeing
7
8 Boeing
)
5
6
40% in Boeing
e
t
u
r
n

(
%
3
4
e
c
t
e
d

r
e
1
2
Campbell Soup
E
x
p
e
0
1
0 00 5 00 10 00 15 00 20 00 25 00 0.00 5.00 10.00 15.00 20.00 25.00
Standard deviation
42
M k it P tf li Th Markowitz Portfolio Theory
Combining stocks into portfolios can reduce Combining stocks into portfolios can reduce
standard deviation, below the level obtained from a
simple weighted average calculation.
Correlation coefficients make this possible Correlation coefficients make this possible.
The efficient portfolios offer the highest p g
expected return for any level of risk.
43
Expected Standard
Efficient Portfolios
Percentages Allocated to Each Stock
Stock Return Deviation A B C D
Amazon.com 22.8 50.9 100 19.1 10.9
Ford 19.0 47.2 19.9 11.0
Dell 13.4 30.9 15.6 10.3
Starbucks 9.0 30.3 13.7 10.7 3.6
Boeing 9 5 23 7 9 2 10 5 Boeing 9.5 23.7 9.2 10.5
Disney 7.7 19.6 8.8 11.2
Newmont 7.0 36.1 9.9 10.2
ExxonMobil 4.7 19.1 9.7 18.4
Johnson & Johnson 3.8 12.6 7.4 33.9
Campbell Soup 3.1 15.8 8.4 33.9
Expected portfolio return 22.8 14.1 10.5 4.2
Portfolio standard deviation 50.9 22.0 16.0 8.8 Portfolio standard deviation 50.9 22.0 16.0 8.8
44 Note: Standard deviations and the correlations between stock returns were estimated from monthly returns
January 2004-December 2008. Efficient portfolios are calculated assuming that short sales are prohibited.
Effi i t f ti Efficient frontier
4 Efficient Portfolios all from the same 10 stocks 4 Efficient Portfolios all from the same 10 stocks
45
Th ffi i t t f iti The efficient set for many securities
Consider a world with many risky assets; we can still Consider a world with many risky assets; we can still
identify the opportunity set of risk-return
combinations of various portfolios.
r
e
t
u
r
n
r
Individual
Assets Assets
o
P
46
Effi i t f ti Efficient frontier
Each half egg shell represents the possible weighted combinations Each half egg shell represents the possible weighted combinations
for two stocks.
Th it f ll t k t tit t th ffi i t The composite of all stock sets constitutes the efficient
frontier
Expected Return (%)
Standard Deviation
47
Th ffi i t t f iti The efficient set for many securities
r
e
t
u
r
n
r
minimum
variance
portfolio
Individual Assets
Th ti f th t it t b th i i
o
P
The section of the opportunity set above the minimum
variance portfolio is the efficient frontier.
48
Effi i t f ti Efficient frontier
Goal is to move
Return
up and left.
WHY?
B
N
AB
ABN
A
AB
Risk
The ratio of the risk premium to
f p
r r
o

= Ratio Sharpe
p
the standard deviation is called
the Sharpe ratio:
49
p
o
the Sharpe ratio:
M i i k Measuring risk
Diversification Strategy designed to reduce risk by Diversification - Strategy designed to reduce risk by
spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm.
Also called diversifiable risk specific risk Also called diversifiable risk, specific risk,
unsystematic risk, or residual risk.
Market Risk - Economy-wide sources of risk that
affect the overall stock market Also called affect the overall stock market. Also called
undiversifiable risk or systematic risk.
50
Ri k S t ti d t ti Risk: Systematic and unsystematic
W b k d th t t l i k f h ldi t k We can break down the total risk of holding a stock
into two components: systematic risk and
o
2
Total risk
y
unsystematic risk:
U R R + =
Total risk
becomes
m R R + + =
c
where
m R R + + =
Nonsystematic Risk: c
risk ic unsystemat the is
risk systematic the is

m
Systematic Risk: m
risk ic unsystemat the is
n
51
Excess standard deviation against time
d b f t k and number of stocks
Bloomfield et al (1977 JFE): A portfolio of 20 stocks Bloomfield et al. (1977, JFE): A portfolio of 20 stocks
attains a large fraction of the total benefits of
di ifi i diversification.
In the first two subsamples a portfolio of 20 stocks p p
reduced annualized excess standard deviation to about five
percent but in the 1986 to 1997 subsample this level of percent, but in the 1986 to 1997 subsample, this level of
excess standard deviation required almost 50 stocks.
The increase in idiosyncratic volatility over time has
increased the number of randomly selected stocks needed y
to achieve relatively complete portfolio
diversification diversification.
52
Campbell et al. (2001) JF
Excess standard deviation against time
d b f t k and number of stocks
The annualized excess standard deviation against
the number of stocks in the portfolio, for
sample periods 1963 to 1973 (solid line), 1974 p p ( ),
to 1985 (bottom dashed line), and 1986 to 1997
(top dashed line) (top dashed line)
53
Campbell et al. (2001) JF
E t d d d i ti i t ti Excess standard deviation against time
54
Campbell et al. (2001) JF
E t d d d i ti i t ti Excess standard deviation against time
It shows the annualized excess standard deviation each It shows the annualized excess standard deviation each
year, calculated from daily data during the year, of
ll h d f l 2 20 d 0 equally weighted portfolios containing 2, 5, 20, and 50
stocks over the standard deviation of an equally q y
weighted index.
Th fi h d t i i th The figure shows a modest increase in the excess
standard deviation of a typical 50-stock portfolio, but a
much more dramatic increase in the excess standard
deviation of a typical 2-stock portfolio, from about 25 yp p ,
percent in the early 1960s to a peak of 50 percent in the
l 1990 early 1990s.
55
Campbell et al. (2001) JF
Average correlations among individual
t k stocks
56
Average R
2
statistics of market model
f i di id l t k for individual stocks
57
Campbell, Lettau, Malkiel, and Xu (2001)
Correlations among individual stocks and the Correlations among individual stocks and the
explanatory power of the market model for a typical
stock have declined, whereas the number of stocks
needed to achieve a given level of diversification has needed to achieve a given level of diversification has
increased.
58
Campbell et al. (2001) JF
Ri k h h ldi th k t tf li Risk when holding the market portfolio
Market Portfolio Portfolio of all assets in the Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market index,
such as the S&P Composite Index.
Beta Sensitivity of a stocks return to the return on Beta - Sensitivity of a stock s return to the return on
the market portfolio. A stocks contribution to
portfolio risk. Beta measures the responsiveness of a
security to movements in the market portfolio (i e security to movements in the market portfolio (i.e.,
systematic risk).
) ( R R Cov
) (
) (
2
,
M
M i
i
R
R R Cov
o
| =
) (
M
59
Beta of Anchovy Queen restaurant
h i chain
456/6 =76
60
P tf li i k Portfolio risk
The return on Dell stock
changes on average g g
by 1.41% for each
additional 1% change in additional 1% change in
the market return. Beta
i th f 1 41 is therefore 1.41.
61
E ti ti | ith i Estimating | with regression
i Security Returns
Slope =
i
Return on
market % market %
R
i
=
i
+
i
R
m
+
i i i

i m i
62
P tf li i k Portfolio risk
63
S t ti i k d b t Systematic risk and betas
Factor model: Factor model:
F F F R R
k k
+ + + + + = ...
2 2 1 1
Where is specific to a particular stock and
l d i h h f h k uncorrelated with the term for other stocks.
Use an index of stock market returnslike the
S&P500, as the single factor:
Market model:
R R R R P S
P S
+ + = ) ( 500 &
500 &
R R R R + + ) (
Market model:
R R R R M
M
+ + = ) (
M
R R o = + +
64
M