9

Characterizing
Risk and Return
Finance 3rd Edition

Cornett, Adair, and Nofsinger

Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Introduction
Method for calculating returns

Assessment method for investment returns

Posits that historical returns are helpful in

predicting future returns

9-2

Computing Returns
Dollar Return

Percentage Return

9-3

Dollar Return
Includes capital gain or loss as well as

income

9-4

Percentage Returns
Returns across different investments are

more easily compared because they are

standardized
Can be used for most types of investments

9-5

Performance of Asset Classes

Historically, stocks have outperformed

bonds and cash on an average-return basis

Average returns not accurate picture of

annual returns

9-6

Average Annual Returns by Asset Class

9-7

Computing Volatility
Risk of Asset Classes

Risk versus Return

9-8

Computing Volatility
Standard deviation (StD) measures

volatility
StD is the square root of the variance
Represents the total risk of a security or

portfolio

9-9

Standard Deviation
The larger the standard deviation, the

higher the risk

9-10

Risk of Asset Classes

Stocks are more volatile than bonds or T-

bills

9-11

Risk versus Return

With any investment, there is a risk/return

tradeoff
The coefficient of variation (CoV) is a

relative measure of this relationship

9-12

Coefficient of Variation
Amount of risk (measured by volatility) per

unit of return

9-13

Forming Portfolios
Diversifying to reduce risk

Modern Portfolio Theory

Diversification
Portfolio Return

9-14

Diversifying to Reduce Risk

Two main components of total risk
Firm-specific risk
Market risk

9-15

Diversifying to Reduce Risk

Firm-specific risk is referred to as

diversifiable risk
Market risk is non-diversifiable risk
This risk applies across all securities in any

given market

9-16

Adding Stocks to a Portfolio Reduces Risk

9-17

Modern Portfolio Theory

Risk is reduced when securities are

combined
Optimal portfolio is the combination of

securities that produce the highest return

for the amount of risk taken

9-18

Efficient Portfolios with Four Stocks

9-19

Diversification
When stocks returns not are perfectly

correlated
price movements often counteract each other

With perfect positive correlation,

diversification does not affect risk

9-20

Portfolio Return
Return calculation
comprised of the individual returns of each

security in portfolio and the relative weight of

each in the portfolio

9-21