Return

The money which is made or lost on an

investment.

Risk
The chance or uncertainty of loss.

When investing, you need to find a balance

between risk & reward.
Risk-Return Tradeoff
The relationship between risk & return, in
which investments with more risk should
provide higher returns, & vice-versa.
Components of Return
- Current Income: Monies (or near-cash)
received as a result of owning an investment.
- Capital Gains/Losses: Difference between
the proceeds from the sale of an investment
& its original purchase price.

Total Return
The sum of current income & capital gains (or
losses) earned on an investment over a
specified period of time.
The rate of return indicates how rapidly an
investor can build wealth. Remember the Rule of
72.

Allows us to keep score on how our investments

are doing compared to our expectations.

Historical Performance:

- Provides a basis for future expectations.

- Does not guarantee future performance.
Expected Return

- Return an investor thinks an investment will

earn in the future.

- Determines what an investor is willing to

pay for an investment or if they are willing
to make an investment.
 Key Factors in Levels of Return

Internal Characteristics External Forces*

• Type or Risk of • Political Environment

Investment
(i.e., stocks vs. bonds)
• Company’s Quality of
Management
• Company’s Amount of
Debt or Equity
• Business Environment
• Economic Environment
• Inflation - Rising Price
Levels
• Deflation - Falling Price
Levels

* External Forces are beyond a company’s control.

Satisfactory Investment

- An investment in which the Present Value (PV)

of benefits equals or exceeds the Present Value
(PV) of its costs.

- Net Present Value (NPV) of the Future Returns

is greater than or equal to the Present Value
(PV) or costs of the investment.
Nominal Rate of Return
Return on an investment expressed in today’s dollars.
It includes inflation.

Real Rate of Return

Expresses an investment’s return in terms of real
purchasing power by deducting inflation.

Real Rate Nominal Rate Actual

of Return = of Return - Inflation Rate
 Required Return = Forecast/Prediction
The rate of return an investor must earn on an
investment to be fully compensated for its risk. It’s an
expectation or prediction that causes one to invest.

Required Expected Risk

Return on
Investment
= [ Real Rate
of Return + Inflation
Premium ]+ Premium for
Investment

OR

Required Return
on Investment = [ Risk-Free
Rate ] + Risk Premium
for Investment
Risk-Free Rate
- The rate of return that can be earned on a
risk-free investment.

- The most typical “risk-free” investment is

considered to be the 3-month US Treasury Bill.

Expected
Risk-Free Real Rate
Rate = of Return + Inflation
Premium
Risk Premium

- Additional return an investor requires on an

investment to compensate for risks based
upon investment & its characteristics.

- Investment’s characteristics are the type,

maturity & features.

- Issuer’s characteristics are industry & company

factors.
Holding Period
The period of time over which an investor wishes
to measure the return on an investment vehicle.

Realized Return
Current return actually received by an investor
during the given return period.

Paper Return
Return that has been achieved but not yet
realized - no sale has taken place.
Holding Period Return
The total return earned from holding an
investment for a specified holding period (usually
1 year or less).

Income During Capital Gain or Loss

Holding Period Period + During Period
Return =
Beginning Investment Value

Capital Gain or Ending Beginning

Loss During Period = Investment Value - Investment Value
Advantages
- Easy to calculate.
- Easy to understand.
- Considers income & growth.

Disadvantages
- Does not consider time value of money.
- Rate may be inaccurate if time period is longer
than one year.
Internal Rate of Return

- Determines the compound annual rate of

return earned on an investment held for
longer than one year.

- Applies the Time Value of Money (TVM).

What is the yield (IRR) on an investment
costing $1,000 today that you expect will be worth
$1,400 at the end of a 5-year holding period?
Advantages & Disadvantages of IRR

Advantages Disadvantages

• Uses TVM. • Calculation is more

• Allows investments of complex than Holding
different investment Period Rate of Return
periods to be compared (HPR).
with each other.
• If the yield is equal to or
greater than the required
return, the investment is
acceptable.
Use TVM to solve for Yield (IRR) to measure return
assumes that all income earned over the investment
time period is reinvested at the same rate as the
original investment.

Reinvestment Rate
The rate of return earned on interest or other income
received from an investment over its entire time period.

Fully Compounded Rate of Return

The rate of return that includes interest earned on
interest.
Earning Interest on Interest
Assume $1,000, 8%, 20-year Treasury Bond.
 Types of Risk
Stock-Specific Risk Passivity Risk Market Risk
• Any single stock • Putting your money • Investing subjects
carries a specific in a savings account, your money to the
amount of risk for instead of investing, risk that the financial
the investor. because you do not markets will decline.
• Minimize this risk trust the financial • Uncertainty due to
by making sure markets. changes in the overall
your portfolio is • Substantial earnings stock market due to
diversified. can be lost because global, political, social
you did nothing with or economic events &
your money. even the mood of
• Interest rates cannot investors.
keep up with the rate
of inflation resulting
in the decreased
purchasing power of
your money.
 Types of Risk
Credit Risk Currency Risk Interest Rate Risk
• Usually associated with • Occurs due to • When bond interest
bond investments, currency fluctuations rates rise, the price of
credit risk is the which affect the value the bonds falls (& vice
of foreign investments versa).
possibility that a
& profits or the • Fluctuating interest
company, agency or
holdings of US rates have a significant
municipality might not companies with
be able to make impact on stocks &
interests overseas. bonds.
interest on principal
• Likelihood increases
payments on its notes
during times of
or bonds. geopolitical instability.

Economic Risk
• When the economy slows,
corporate profits & those
stocks could be hurt.
Risk-Return Tradeoffs
Risk-Indifferent
Describes an investor who does not require a change in
return as compensation for greater risk.

Risk-Averse
Describes an investor who requires greater return in
exchange for greater risk.

Risk-Seeking
Describes an investor who will accept a lower return in
exchange for greater risk.
 What Is Your Risk Tolerance?

Be sure to complete the Investment Risk Tolerance

Quiz. There will be a question on Exam 1.
Random Walk
The theory that stock price movements are
unpredictable so, there is no way to know where
prices are headed.

- Some studies about stock price movements

indicate stocks do not move in neat patterns.

- This random pattern is a natural outcome of

markets that are highly efficient & respond quickly
to changes in material information.

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Efficient Market
A market in which securities reflect all possible
information quickly & accurately. To have an
efficient market your must have:
- Many knowledgeable investors actively analyzing
& trading stocks.
- Information is widely-available to all investors.
- Events (such as labor strikes or accidents) tend to
happen randomly.
- Investors react quickly & accurately to new
information.
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Efficient Market Hypothesis (EMH)

Information is reflected in prices - not only

the type & source of information, but also
the quality & speed with which it is reflected
in prices. The more information that is
incorporated into prices, the more efficient
the market becomes.

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 Three (3) Levels of the EMH
Weak Form Semi-Strong Form Strong Form
EMH EMH EMH

• Historic data on • Abnormally large • There is no

stock prices are profits cannot be information public
of no value in consistently or private/insider
predicting future earned using all that allows
stock price current public investors to
changes. information, consistently earn
even by abnormally high
• Prices follow a professionals. returns.
“random walk.”
• Neither Technical
• Technical Analysis nor Fundamental
is of no value. Analysis is of any
• Fundamental value.
Analysis can lead • Only insider
to under-valued information is of
stocks. value.
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Calendar Effects
- Stocks returns may be closely tied to the time of
year or time of week.
- Questionable if really provide opportunity.
- Example: January Effect.

Small-Firm Effect
- Size of a firm impacts stock returns.
- Small firms may offer higher returns than larger
firms, even after adjusting for risk.
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Post Earnings Announcement Drift &
Momentum

- Stock price adjustments may continue after

earnings adjustments have been
announced.

- Unusually good quarterly earnings reports

may signal buying opportunity.

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Value Effect

- Buy stocks with relatively low prices

relative to Price/Earnings (P/E) or market
value to book value.

- Low P/E stocks may outperform high P/E

stocks, even after adjusting for risk.

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Stocks that appear to earn abnormally returns are
actually riskier, so higher returns merely represent
compensation for risk.

Some anomalies may simply be patterns that

appeared by chance & are thus not likely to persist
over time – Super Bowl anomaly.

Behavioral biases may cause investors to make

systematic mistakes when they invest. These
mistakes are linked to cognitive biases that are
hard-wired into human nature.
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 Weekly Assignment
• Watch Video - Risk in Investing
(Module 5).

• Complete Your Investment Risk

Tolerance Quiz.

• Work on your Investment

Assignment.