INVESTMENTS

Chapter 6
The Returns and Risks from
Investing

Learning Objectives

Define return and state its two components.

Explain the relationship between return and risk.
Identify the sources of risk.
Describe the different methods of measuring
returns.
Describe the different methods of measuring risk.
Discuss the returns and risks from investing in
major financial assets in the past.

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Asset Valuation
Function of both return and risk

At the centre of security analysis

How should realized return and risk be

measured?

The realized risk-return tradeoff is based on

the past
The expected future risk-return tradeoff is
uncertain and may not occur

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Return Components
Returns 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 security

Capital Gain or Loss: Price appreciation or

depreciation

The change in price of the asset

Total Return = Yield + Price Change

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Risk Sources
Interest Rate Risk

Affects market value

and resale price

Financial Risk

Liquidity Risk

Market Risk

Overall market
effects

Inflation Risk

Purchasing power
variability

Business Risk

Tied to debt financing

Time and price
concession required to
sell security

Exchange Rate Risk

Country Risk

Potential change in
degree of political
stability

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Types of Risk
Two general types:

Systematic (market) risk

Pervasive, affecting all securities, cannot be

avoided
Interest rate or market or inflation risks

Non-systematic (non-market) risk

Unique characteristics specific to a security

Total Risk = General Risk + Specific Risk =

Systematic Risk + Non-Systematic Risk

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Measuring Returns
Total Return (TR) compares 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

CF
(P
PPBB))
CF

(P

tt
EE
TR
TR
PPBB
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Measuring Returns
Total Return can be either positive or negative

When cumulating or compounding, negative

returns are a problem

A Return Relative solves the problem

because it is always positive

CF
P
CF

P
tt
EE
RR
1
RR
1 TR
TR
P
PBB
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Measuring Returns
To measure the level of wealth created by an
investment rather than the change in wealth,
returns need to be cumulated over time
Cumulative Wealth Index, CWIn, over n
periods, =

WI
WI0 ((11 TR
TR1)()(11 TR
TR2 )...(
)...(11 TR
TRn ))
0
1
2
n
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Measuring International Returns

International returns include any realized
exchange rate changes

If foreign currency depreciates, returns are

lower in domestic currency terms

Total Return in domestic currency =

End
Val.
of
For.Curr.

End
Val.
of
For.Curr.
11
RR
RR

Begin

Begin Val.
Val. of
of For.Curr.
For.Curr.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Summary Statistics for Returns

TR, RR, and CWI are useful for a given, single
time period
What about summarizing returns over several
time periods?

Arithmetic mean and geometric mean

Arithmetic mean, or simply mean

XX

XX
nn

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

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

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

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

((11TR
TR11)()(11 TR
TR22)...(
)...(11TR
TRnn)) 11
11//nn

Difference between Geometric mean and

Arithmetic mean depends on the variability of
returns, s

11GG 11 XX ss22
22

22

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Inflation-Adjusted Returns
Returns measures are not adjusted for
inflation

Purchasing power of investment may change

over time
Consumer Price Index (CPI) is a possible
measure of inflation

1
TR

1
TR

TR
1
TRIAIA
1
11 CPI
CPI
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Measuring Risk
Risk is the chance that the actual outcome will
be different than the expected outcome
Standard Deviation measures the deviation of
returns from the mean
1/2
22 1/2

ss

1
n

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

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
Bond default premium is the difference
between the return on long term corporate
bonds and long term government bonds

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Risk Premiums

Equity Risk Premium, ERP, =

11TR

TRCS
CS
11

11 RF

RF

or,
or,

TR
RF
TRCS
CS RF

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

The Risk-Return Record

Since 1938, cumulative wealth indexes show
stock returns dominate bond returns

Stock standard deviations also exceed bond

standard deviations

Annual geometric mean return for the time

period between 1938 and 2007 for Canadian
common stocks is 10.68% with standard
deviation of 16.22%

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Table 6-5 Summary Statistics of Annual Total

Returns for Major Financial Assets, 19382007

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

Cumulative Wealth Indexes

On an inflation-adjusted basis

CWI
CWI
CWI
CWIIAIA
CI
CIINF
INF
CWI
CWI
CPC

CPC YI
YI
CWI
CWI
YI

YI CPC
CPC

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 6

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