RISK & RETURN

The concept and measurement of Return:

Realized and Expected return.
Ex-ante and ex-post returns

The concept of Risk:
Sources and types of risk.
Measurement of risk :
Range,
Std Deviation and
Co-Efficient of Variation.
Risk-return trade-off



1
2
/
5
/
2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y


Risk, Return &Portfolio
Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

LEARNING OBJECTIVES
The difference among the most important types of returns
How to estimate expected returns and risk for individual
securities
What happens to risk and return when securities are
combined in a portfolio
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

INTRODUCTION TO RISK AND RETURN
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

INTRODUCTION TO RISK AND RETURN
Risk and return are the two most
important attributes of an
investment.

Research has shown that the two are
linked in the capital markets and
that generally, higher returns can
only be achieved by taking on
greater risk.

Risk isnt just the potential loss of
return, it is the potential loss of the
entire investment itself (loss of
both principal and interest).

Consequently, taking on additional
risk in search of higher returns is a
decision that should not be taking
lightly.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Return
%
RF
Risk
Risk Premium
Real Return
Expected Inflation Rate
RISK RETURN TRADE OFF

The concept of investment return is widely
understood. For example, a 10% per annum return on a
capital sum of $100,000 would result in $10,000 increase in
value for the year. However, what exactly is risk?.
Risk is for the most part unavoidable in life generally as
much as in investing!
In investments, the term risk is often expressed as
volatility or variations in returns.
In investment terms, the concept of volatility is the
measurement of fluctuation in the market values of various
asset classes as they rise and fall over time.

The greater the volatility the more rises and falls are
recorded by an individual asset class.

The reward for accepting greater volatility is the likely
hood of higher investment returns over mid to longer
term.
The disadvantage can mean lower returns in the shorter
term. It must also be remembered that it can mean an
increase or decrease in capital.
All investments involve some risk. In general terms the
higher the risk, the higher the potential return, or
loss. Conversely the lower the risk the lower the potential
return, or loss.
The long-term risk/return trade off between different
asset classes is illustrated in the following graph:

Risk, Return and Portfolio Theory
12/5/2013
Risk, Return and Portfolio Theory
12/5/2013
MEASURING RETURNS
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MANY DIFFERENT MATHEMATICAL DEFINITIONS OF
"RETURNS"...
MEASURE PAST
PERFORMANCE
=> "EX POST" OR HISTORICAL
RETURNS.
MEASURE EXPECTED
FUTURE PERFORMANCE
=> "EX ANTE" OR EXPECTED
RETURNS.

1) PERIOD-BY-PERIOD
RETURNS
2) MULTIPERIOD RETURN
MEASURES
TWO MAJOR TYPES
OF MATHEMATICAL
RETURN
Returns
Single
Period
Ex-Post
Returns
Ex-Ante
Returns
Multi-
Period
Ex-Post
Returns
Ex-Ante
Returns

1
2
/
5
/
2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

CHAPTER 9 LECTURE.
QUANTIFYING & MEASURING INVESTMENT
PERFORMANCE: "RETURNS"
RETURNS
RETURNS = PROFITS (IN THE
INVESTMENT GAME)
RETURNS = OBJECTIVE TO MAXIMIZE
(CET.PAR.)
RETURNS = WHAT YOU'VE GOT
WHAT YOU HAD TO BEGIN WITH, AS A
PROPORTION OF WHAT YOU HAD TO BEGIN WITH.
QUANTITATIVE RETURN MEASURES
NECESSARY TO:
MEASURE PAST PERFORMANCE
=> "EX POST" OR HISTORICAL RETURNS;
MEASURE EXPECTED FUTURE PERFORMANCE
=> "EX ANTE" OR EXPECTED RETURNS.
MANY DIFFERENT MATHEMATICAL DEFINITIONS OF
"RETURNS"...
1) PERIOD-BY-PERIOD
RETURNS
2) MULTIPERIOD
RETURN MEASURES
TWO MAJOR TYPES
OF MATHEMATICAL
RETURN
Returns
Single
Period
Ex-Post
Returns
Ex-Ante
Returns
Multi-
Period
Ex-Post
Returns
Ex-Ante
Returns
TYPE 1: PERIOD-BY-PERIOD RETURNS . . .
"PERIODIC" RETURNS
SIMPLE "HOLDING PERIOD RETURN"
(HPR)
MEASURES WHAT THE INVESTMENT
GROWS TO WITHIN EACH SINGLE
PERIOD OF TIME,
ASSUMING ALL CASH FLOW (OR
VALUATION) IS ONLY AT BEGINNING AND
END OF THE PERIOD OF TIME (NO
INTERMEDIATE CASH FLOWS).
TYPE 1: PERIOD-BY-PERIOD RETURNS (CONTD)
RETURNS MEASURED SEPARATELY OVER EACH
OF A SEQUENCE OF REGULAR AND
CONSECUTIVE (RELATIVELY SHORT) PERIODS
OF TIME.
SUCH AS: DAILY, MONTHLY, QUARTERLY, OR
ANNUAL RETURNS SERIES.
E.G.: RETURN TO IBM STOCK IN: 1990, 1991,
1992, ...
PERIODIC RETURNS CAN BE AVERAGED
ACROSS TIME TO DETERMINE THE "TIME-
WEIGHTED" MULTI-PERIOD RETURN.
TYPE 1: PERIOD-BY-PERIOD RETURNS
(CONTD)
THE PERIODS USED TO DEFINE PERIODIC
RETURNS SHOULD BE SHORT ENOUGH THAT
THE ASSUMPTION OF NO INTERMEDIATE CASH
FLOWS DOES NOT MATTER.
TYPE 2: MULTIPERIOD RETURN
MEASURES
PROBLEM: WHEN CASH FLOWS OCCUR AT
MORE THAN TWO POINTS IN TIME, THERE IS
NO SINGLE NUMBER WHICH UNAMBIGUOUSLY
MEASURES THE RETURN ON THE
INVESTMENT.
TYPE 2: MULTIPERIOD RETURN
MEASURES (CONTD)
NEVERTHELESS, MULTI-PERIOD
RETURN MEASURES GIVE A SINGLE
RETURN NUMBER (TYPICALLY QUOTED
PER ANNUM) MEASURING THE
INVESTMENT PERFORMANCE OF A
LONG-TERM (MULTI-YEAR) INVESTMENT
WHICH MAY HAVE CASH FLOWS AT
INTERMEDIATE POINTS IN TIME
THROUGHOUT THE "LIFE" OF THE
INVESTMENT.
TYPE 2: MULTIPERIOD RETURN
MEASURES (CONTD)
THERE ARE MANY DIFFERENT MULTI-PERIOD
RETURN MEASURES, BUT THE MOST FAMOUS
AND WIDELY USED (BY FAR) IS:
THE "INTERNAL RATE OF RETURN"
(IRR).
THE IRR IS A "DOLLAR-WEIGHTED" RETURN
BECAUSE IT REFLECTS THE EFFECT OF
HAVING DIFFERENT AMOUNTS OF DOLLARS
INVESTED AT DIFFERENT PERIODS IN TIME
DURING THE OVERALL LIFETIME OF THE
INVESTMENT.
ADVANTAGES OF PERIOD-BY-PERIOD
(TIME-WEIGHTED) RETURNS:
1) ALLOW YOU TO TRACK PERFORMANCE OVER
TIME, SEEING WHEN INVESTMENT IS DOING
WELL AND WHEN POORLY.
ADVANTAGES OF PERIOD-BY-PERIOD (TIME-
WEIGHTED) RETURNS (CONTD)
2) ALLOW YOU TO QUANTIFY RISK (VOLATILITY)
AND CORRELATION (CO-MOVEMENT) WITH
OTHER INVESTMENTS AND OTHER PHENOMENA.
ADVANTAGES OF PERIOD-BY-PERIOD (TIME-
WEIGHTED) RETURNS (CONTD)
3) ARE FAIRER FOR JUDGING
INVESTMENT PERFORMANCE WHEN THE
INVESTMENT MANAGER DOES NOT HAVE
CONTROL OVER THE TIMING OF CASH
FLOW INTO OR OUT OF THE INVESTMENT
FUND (E.G., A PENSION FUND).
ADVANTAGES OF MULTI-PERIOD
RETURNS:
1) DO NOT REQUIRE KNOWLEDGE OF MARKET
VALUES OF THE INVESTMENT ASSET AT
INTERMEDIATE POINTS IN TIME (MAY BE
DIFFICULT TO KNOW FOR REAL ESTATE).
ADVANTAGES OF MULTI-PERIOD
RETURNS (CONTD)
2) GIVES A FAIRER (MORE COMPLETE)
MEASURE OF INVESTMENT
PERFORMANCE WHEN THE
INVESTMENT MANAGER HAS CONTROL
OVER THE TIMING AND AMOUNTS OF
CASH FLOW INTO AND OUT OF THE
INVESTMENT VEHICLE (E.G., PERHAPS
SOME "SEPARATE ACCOUNTS" WHERE
MGR HAS CONTROL OVER CAPITAL
FLOW TIMING, OR A STAGED
DEVELOPMENT PROJECT).
ADVANTAGES OF MULTI-PERIOD
RETURNS (CONTD)
NOTE: BOTH HPRs AND IRRs ARE WIDELY
USED IN REAL ESTATE INVESTMENT
ANALYSIS
PERIOD-BY-PERIOD RETURNS...
"TOTAL RETURN" ("r"):
r
t
=(CF
t
+V
t
-V
t-1
)/ V
t-1
=((CF
t
+V
t
)/V
t-1
) -1
where: CF
t
= Cash Flow (net) in period "t"; V
t
=Asset
Value ("ex dividend") at end of period "t".
"INCOME RETURN" ("y", AKA "CURRENT
YIELD", OR JUST "YIELD"):
y
t
= CF
t
/ V
t-1

"APPRECIATION RETURN" ("g", AKA
"CAPITAL GAIN", OR "CAPITAL RETURN",
OR "GROWTH"):
g
t
= ( V
t
-V
t-1
) / V
t-1
= V
t
/ V
t-1
- 1
NOTE: r
t
= y
t
+ g
t

TOTAL RETURN IS MOST IMPORTANT:
To convert y into g, reinvest the cash flow back into
the asset.
To convert g into y, sell part of the holding in the
asset.
NOTE: This type of conversion is not so easy to do
with most real estate investments as it is with
investments in stocks and bonds.
EXAMPLE:
PROPERTY VALUE AT END OF 1994: =
$100,000
PROPERTY NET RENT DURING 1995: =
$10,000
PROPERTY VALUE AT END OF 1995: =
$101,000
WHAT IS 1995 R, G, Y ?...
y
1995
= $10,000/$100,000 = 10%
g
1995
= ($101,000 - $100,000)/$100,000 = 1%
r
1995
= 10% + 1% = 11%
A NOTE ON RETURN TERMINOLOGY
"INCOME RETURN" - YIELD, CURRENT
YIELD, DIVIDEND YIELD.
IS IT CASH FLOW BASED OR ACCRUAL
INCOME BASED?
SIMILAR TO "CAP RATE".
IS A RESERVE FOR CAPITAL EXPENDITURES
TAKEN OUT?
CI TYPICALLY 1% - 2% /YR OF V.
EXAMPLE: V=1000, NOI=100, CI=10:
y
t
= (100-10)/1000 = 9%, cap rate = 100/1000 = 10%
"YIELD"
CAN ALSO MEAN: "TOTAL YIELD", "YIELD TO
MATURITY"
THESE ARE IRRs, WHICH ARE TOTAL RETURNS,
NOT JUST INCOME.
"BASIS POINT" = 1 / 100th PERCENT = .0001
CONTINUOUSLY COMPOUNDED
RETURNS:
THE PER ANNUM CONTINUOUSLY
COMPOUNDED TOTAL RETURN IS:

WHERE "Y" IS THE NUMBER (OR FRACTION) OF
YEARS BETWEEN TIME "t-1" AND "t".
( ) )
Yr
( *
V
=
CF
+
V
Y )
V
( - )
CF
+
V
( =
r
t 1 - t t t 1 - t t t t
EXP LN LN
EXAMPLE:
01/01/98 V = 1000
03/31/99 V = 1100 & CF = 50

PER ANNUM
r = (LN(1150) LN(1000)) / 1.25
= 7.04752 6.90776
= 11.18%
"REAL" VS. "NOMINAL" RETURNS
NOMINAL RETURNS ARE THE "ORDINARY"
RETURNS YOU NORMALLY SEE QUOTED OR
EMPIRICALLY MEASURED. UNLESS IT IS
EXPLICITLY STATED OTHERWISE, RETURNS
ARE ALWAYS QUOTED AND MEASURED IN
NOMINAL TERMS. The NOMINAL Return is
the Return in Current Dollars (dollars of the
time when the return is generated).
REAL RETURNS ARE NET OF INFLATION. The
REAL Return is the Return measured in
constant purchasing power dollars ("constant
dollars").
EXAMPLE:
Suppose INFLATION=5% in 1992 (i.e., need $1.05
in 1992 to buy what $1.00 purchased in 1991).
So: $1.00 in "1992$" = 1.00/1.05 = $0.95 in
"1991$
If r
t
= Nominal Total Return, year t
i
t
= Inflation, year t
R
t
= Real Total Return, year t
Then: R
t
= (1+r
t
)/(1+i
t
) - 1 = r
t
- (i
t
+ i
t
R
t
)
. r
t
- i
t
,
Thus: NOMINAL Return = REAL Return +
Inflation Premium
Inflation Premium = i
t
+ i
t
R
t
. I
t

IN THE CASE OF THE CURRENT YIELD
(Real y
t
)=(Nominal y
t
)/(1+i
t
) . (Nominal y
t
)
EXAMPLE:
1991 PROPERTY VALUE = $100,000
1992 NET RENT = $10,000
1992 PROPERTY VALUE = $101,000
1992 INFLATION = 5%

WHAT IS THE REAL r, y, and g for 1992?
ANSWER:
Real g = (101,000/1.05)/100,000-1= -3.81%
. -4%
(versus Nominal g=+1%)
Real y = (10,000/1.05)/100,000 = +9.52%
. 10%
(versus Nominal y=10% exactly)
Real r = (111,000/1.05)/100,000-1=+5.71%
. 6%
(versus Nominal r = 11%)
= g + y =+9.52%+(-3.81%) .
10% - 4%
RISK
INTUITIVE MEANING...
THE POSSIBILITY OF NOT MAKING THE
EXPECTED RETURN:

r
t
= E
t-j
[r
t
]
MEASURED BY THE RANGE OR
STD.DEV. IN THE EX ANTE
PROBABILITY DISTRIBUTION OF THE
EX POST RETURN . . .
0%
25%
50%
75%
100%
-10% -5% 0% 5% 10% 15% 20% 25% 30%
Returns
P
r
o
b
a
b
i
l
i
t
y
A
B
C
Figure 1







C RISKER THAN B.
B RISKIER THAN A.
A RISKLESS.
WHAT IS THE EXPECTED RETURN? . . .
EXAMPLE OF RETURN RISK
QUANTIFICATION:
SUPPOSE 2 POSSIBLE FUTURE RETURN
SCENARIOS. THE RETURN WILL EITHER BE:
+20%, WITH 50% PROBABILITY
OR:
-10%, WITH 50% PROBABILITY
"EXPECTED" (EX ANTE) RETURN
= (50% CHANCE)(+20%) + (50% CHANCE)(-10%)
= +5%
RISK (STD.DEV.) IN THE RETURN
= SQRT{(0.5)(20-5)
2
+ (0.5)(-10-5)
2
}
= "15%
THE RISK/RETURN TRADEOFF..
INVESTORS DON'T LIKE RISK!
SO THE CAPITAL MARKETS
COMPENSATE THEM BY PROVIDING
HIGHER RETURNS (EX ANTE) ON MORE
RISKY ASSETS . . .
Risk
Expected
Return
r
f
RISK & RETURN:
TOTAL RETURN = RISKFREE RATE + RISK
PREMIUM

r
t
= r
f,t
+ RP
t

RISK FREE RATE
RISKFREE RATE (r
f,t
)
= Compensation for TIME
= "Time Value of Money"
. US Treasury Bill Return (For Real Estate,
usually use Long Bond)
RISK PREMIUM
RISK PREMIUM (RP
t
):
EX ANTE: E[RP
t
]
= E[r
t
] - r
f,t

= Compensation for RISK
EX POST: RP
t

= r
t
- r
f,t

= Realization of Risk ("Throw of Dice")
RELATION BETWEEN RISK & RETURN:
GREATER RISK <===> GREATER RISK PREMIUM

(THIS IS EX ANTE, OR ON AVG. EX POST, BUT
NOT NECESSARILY IN ANY GIVEN YEAR OR
ANY GIVEN INVESTMENT EX POST)
EXAMPLE OF RISK IN REAL ESTATE:
PROPERTY "A" (OFFICE):
VALUE END 1998 = $100,000
POSSIBLE VALUES END 1999
$110,000 (50% PROB.)
$90,000 (50% PROB.)
STD.DEV. OF g
99
= 10%
EXAMPLE (CONTD)
PROPERTY "B" (BOWLING ALLEY):
VALUE END 1998 = $100,000
POSSIBLE VALUES END 1999
$120,000 (50% PROB.)
$80,000 (50% PROB.)
STD.DEV. OF g
99
= 20%
EXAMPLE (CONTD)
B IS MORE RISKY THAN A.

T-BILL RETURN = 7%
EXAMPLE (CONTD)
A: Office Building
Known as of end 1998
Value = $100,000
Expected value end 99
= $100,000
Expected net rent 99 =
$11,000
Ex ante risk premium =
11% - 7% = 4%
B: Bowling Alley
Known as of end 1998
Value = $100,000
Expected value end 99
= $100,000
Expected net rent 99 =
$15,000
Ex ante risk premium =
15% - 7% = 8%
EXAMPLE (CONTD) SUPPOSE THE
FOLLOWING OCCURRED IN 1999
A: Office Building
Not known until end
1999
End 99 Value =
$110,000
99 net rent = $11,000
99 Ex post risk
premium = 21% - 7% =
14%
(The Dice Rolled
Favorably)
B: Bowling Alley
Not known until end
1999
End 99 Value =
$80,000
99 net rent = $15,000
99 Ex post risk
premium = -5% - 7% =
-12%
(The Dice Rolled
Unfavorably)
SUMMARY:
THREE USEFUL WAYS TO BREAK TOTAL
RETURN INTO TWO COMPONENTS...
1) TOTAL RETURN = CURRENT YIELD +
GROWTH
r = y + g
2) TOTAL RETURN = RISKFREE RATE + RISK
PREMIUM
r = r
f
+ RP
3) TOTAL RETURN = REAL RETURN +
INFLATION PREMIUM
r = R + (i+iR) . R + I
"TIME-WEIGHTED INVESTMENT". . .
SUPPOSE THERE ARE CFs AT INTERMEDIATE
POINTS IN TIME WITHIN EACH PERIOD (E.G.,
MONTHLY CFs WITHIN QUARTERLY RETURN
PERIODS).
THEN THE SIMPLE HPR FORMULAS ARE NO
LONGER EXACTLY ACCURATE.
"TIME-WEIGHTED INVESTMENT". . .
A WIDELY USED SIMPLE ADJUSTMENT IS TO
APPROXIMATE THE IRR OF THE PERIOD
ASSUMING THE ASSET WAS BOUGHT AT THE
BEGINNING OF THE PERIOD AND SOLD AT
THE END, WITH OTHER CFs OCCURRING AT
INTERMEDIATE POINTS WITHIN THE PERIOD.
THIS APPROXIMATION IS DONE BY
SUBSTITUTING A TIME-WEIGHTED
INVESTMENT IN THE DENOMINATOR
INSTEAD OF THE SIMPLE BEGINNING-OF-
PERIOD ASSET VALUE IN THE
DENOMINATOR.
"TIME-WEIGHTED INVESTMENT". . .

+
=
i i
i
CF w BegVal
CF BegVal EndVal
r

where:
= sum of all net cash flows occurring in
period t,
w
i
= proportion of period t remaining at
the time when net cash flow "i" was received
by the investor.
(Note: cash flow from the investor to the
investment is negative; cash flow from the
investment to the investor is positive.)
i
CF
EXAMPLE . . .
CF: Date:
- 100 12/31/98
+ 10 01/31/99
+100 12/31/99
Simple HPR: (10 + 100-100) / 100
= 10 / 100
= 10.00%
TWD HPR: (10 + 100-100) / (100
(11/12)10)
= 10 / 90.83
= 11.01%

IRR: = 11.00% . . .
EXAMPLE (CONTD)
( ) ( )
% 00 . 11 1 ) 0087387 . 1 ( /
% 87387 . 0 /
/ 1
100
/ 1
0
/ 1
10
100 0
12
12
11
2
= =
=
+
+
+
+
+
+ =

=
yr IRR
mo IRR
mo IRR mo IRR
mo IRR
j
j
THE DEFINITION OF THE "NCREIF"
PERIODIC RETURN FORMULA . . .
THE MOST WIDELY USED INDEX OF
PERIODIC RETURNS IN COMMERCIAL
REAL ESTATE IN THE US IS THE "NCREIF
PROPERTY INDEX" (NPI).
NCREIF = "NATIONAL COUNCIL OF
REAL ESTATE INVESTMENT
FIDUCIARIES
INSTITUTIONAL QUALITY R.E.
QUARTERLY INDEX OF TOTAL RETURNS
PROPERTY-LEVEL
APPRAISAL-BASED
NCREIF FORMULA
FORMULA INCLUDES A TIME-WEIGHTED
INVESTMENT DENOMINATOR, ASSUMING:
ONE-THIRD OF THE QUARTERLY PROPERTY
NOI IS RECEIVED AT THE END OF EACH
CALENDAR MONTH;
PARTIAL SALES RECEIPTS MINUS CAPITAL
IMPROVEMENT EXPENDITURES ARE
RECEIVED MIDWAY THROUGH THE
QUARTER...


[Note: (1/3)NOI =
(2/3)(1/3)NOI+(1/3)(1/3)NOI+(0)(1/3)NOI ]
( )
( )( ) ( )NOI CI PS BegVal
NOI CI PS BegVal EndVal
r
NPI
3 1 2 1
+ +
=
MULTI-PERIOD RETURNS
SUPPOSE YOU WANT TO KNOW WHAT IS
THE RETURN EARNED OVER A MULTI-
PERIOD SPAN OF TIME, EXPRESSED AS
A SINGLE AVERAGE ANNUAL RATE?...

YOU COULD COMPUTE THE AVERAGE
OF THE HPRs ACROSS THAT SPAN OF
TIME.

THIS WOULD BE A "TIME-WEIGHTED"
AVERAGE RETURN.
MULTI-PERIOD RETURNS (CONTD)
IT WILL:
=> Weight a given rate of return more if it
occurs over a longer interval or more frequently in
the time sample.

=> Be independent of the magnitude of
capital invested at each point in time; Not affected
by the timing of capital flows into or out of the
investment.
MULTI-PERIOD RETURNS (CONTD)
YOU CAN COMPUTE THIS AVERAGE USING
EITHER THE ARITHMETIC OR GEOMETRIC
MEAN...

Arithmetic average return over 1992-94:
= (r
92
+ r
93
+ r
94
)/3

Geometric average return over 1992-94:
= [(1+r
92
)(1+r
93
)(1+r
94
)]
(1/3)
1
ARITHMETIC VS. GEOMETRIC MEAN
Arithmetic Mean:
=> Always greater than geometric mean.
=> Superior statistical properties:
* Best "estimator" or "forecast" of "true" return.
=> Mean return components sum to the mean
total return
=> Most widely used in forecasts & portfolio
analysis.
ARITHMETIC VS. GEOMETRIC MEAN
(CONTD)
Geometric Mean:
=> Reflects compounding ("chain-linking") of
returns:
* Earning of "return on return".
=> Mean return components do not sum to mean
total return
* Cross-product is left out.
=> Most widely used in performance evaluation.
ARITHMETIC VS. GEOMETRIC MEAN
(CONTD)
The two are more similar:
- The less volatility in returns across
time
- The more frequent the return
interval
(Note: "continuously compounded" returns
(log differences) side-steps around this
issue. (There is only one continuously-
compounded mean annual rate: arithmetic
& geometric distinctions do not exist).
TIME-WEIGHTED RETURNS:
NUMERICAL EXAMPLES
An asset that pays no dividends . . .
Year:

End of year asset
value:


HPR:

1992

$100,000



1993

$110,000

(110,000 - 100,000) / 100,000 = 10.00%

1994

$121,000

(121,000 - 110,000) / 110,000 = 10.00%

1995

$136,730

(136,730 - 121,000) / 121,000 = 13.00%

THREE-YEAR AVERAGE ANNUAL RETURN
(1993-95):
Arithmetic mean:
= (10.00 + 10.00 + 13.00) / 3
= 11.00%

Geometric mean:
= (136,730 / 100,000)
(1/3)
- 1
= ((1.1000)(1.1000)(1.1300))
(1/3)
- 1
= 10.99%

Continuously compounded:
= LN(136,730 / 100,000) / 3
= (LN(1.1)+LN(1.1)+LN(1.13)) / 3
= 10.47%

ANOTHER EXAMPLE



Year:

End of year
asset value:


HPR:

1992

$100,000



1993

$110,000

(110,000 - 100,000) / 100,000 = 10.00%

1994

$124,300

(124,300 - 110,000) / 110,000 = 13.00%

1995

$140,459

(140,459 - 124,300) / 124,300 = 13.00%

THREE-YEAR AVERAGE ANNUAL RETURN
(1993-95):
Arithmetic mean:
= (10.00 + 13.00 + 13.00) / 3
= 12.00%

Geometric mean:
= (140,459 / 100,000)
(1/3)
- 1
= ((1.1000)(1.1300)(1.1300))
(1/3)
- 1
= 11.99%

Continuously compounded:
= LN(140,459 / 100,000) / 3
= (LN(1.1)+LN(1.13)+LN(1.13)) / 3
= 11.32%
ANOTHER EXAMPLE
Year:

End of year
asset value:


HPR:

1992

$100,000



1993

$110,000

(110,000 - 100,000) / 100,000 = 10.00%

1994

$121,000

(121,000 - 110,000) / 110,000 = 10.00%

1995

$133,100

(133,100 - 121,000) / 121,000 = 10.00%

THREE-YEAR AVERAGE ANNUAL RETURN
(1993-95):
Arithmetic mean:
= (10.00 + 10.00 + 10.00) / 3
= 10.00%

Geometric mean:
= (133,100 / 100,000)
(1/3)
- 1
= ((1.1000)(1.1000)(1.1000))
(1/3)
- 1
= 10.00%

Continuously comp'd:
= LN(133,100 / 100,000) / 3
= (LN(1.1)+LN(1.1)+LN(1.1)) / 3 = 9.53%
ANOTHER MULTI-PERIOD RETURN
MEASURE: THE IRR...
CANT COMPUTE HPRs IF YOU DONT
KNOW ASSET VALUE AT INTERMEDIATE
POINTS IN TIME (AS IN REAL ESTATE
WITHOUT REGULAR APPRAISALS)

SO YOU CANT COMPUTE TIME-
WEIGHTED AVERAGE RETURNS.

You need the IRR.
IRR
SUPPOSE YOU WANT A RETURN
MEASURE THAT REFLECTS THE EFFECT
OF THE TIMING OF WHEN (INSIDE OF
THE OVERALL TIME SPAN COVERED)
THE INVESTOR HAS DECIDED TO PUT
MORE CAPITAL INTO THE INVESTMENT
AND/OR TAKE CAPITAL OUT OF THE
INVESTMENT.

You need the IRR.
IRR
FORMAL DEFINITION OF IRR

"IRR" (INTERNAL RATE OF RETURN) IS THAT
SINGLE RATE THAT DISCOUNTS ALL THE NET
CASH FLOWS OBTAINED FROM THE
INVESTMENT TO A PRESENT VALUE EQUAL TO
WHAT YOU PAID FOR THE INVESTMENT AT THE
BEGINNING:
IRR
CF
t
= Net Cash Flow to Investor in Period "t
CF
0
is usually negative (capital outlay).
Note: CF
t
is signed according to the convention:
cash flow from investor to investment is
negative,
cash flow from investment to investor is positive.
Note also: Last cash flow (CF
N
) includes two
components:
The last operating cash flow plus
The (ex dividend) terminal value of the asset
("reversion").
) IRR + (1
CF
+ . . . +
) IRR + (1
CF
+
IRR) + (1
CF
+
CF
= 0
N
N
2
2 1
0
WHAT IS THE IRR?...
(TRYING TO GET SOME INTUITION HERE .
. .)

A SINGLE ("BLENDED") INTEREST RATE,
WHICH IF ALL THE CASH IN THE
INVESTMENT EARNED THAT RATE ALL
THE TIME IT IS IN THE INVESTMENT,
THEN THE INVESTOR WOULD END UP
WITH THE TERMINAL VALUE OF THE
INVESTMENT (AFTER REMOVAL OF
CASH TAKEN OUT DURING THE
INVESTMENT):
WHAT IS THE IRR? (CONTD)
where PV = -CF
0
, the initial cash "deposit" in
the "account" (outlay to purchase the
investment).
IRR is "internal" because it includes only the
returns earned on capital while it is invested
in the project.
Once capital (i.e., cash) is withdrawn from the
investment, it no longer influences the IRR.
This makes the IRR a "dollar-weighted"
average return across time for the
investment, because returns earned when
more capital is in the investment will be
weighted more heavily in determining the
IRR.
( ) ( )
( )
( )
N N
N N
CF IRR CF IRR CF IRR PV = + + +

1 1 1
1
1
1

THE IRR INCLUDES THE EFFECT OF:
1. THE INITIAL CASH YIELD RATE (INITIAL
LEVEL OF CASH PAYOUT AS A
FRACTION OF THE INITIAL INVESTMENT;
2. THE EFFECT OF CHANGE OVER TIME
IN THE NET CASH FLOW LEVELS (E.G.,
GROWTH IN THE OPERATING CASH
FLOW);
3. THE TERMINAL VALUE OF THE ASSET
AT THE END OF THE INVESTMENT
HORIZON (INCLUDING ANY NET
CHANGE IN CAPITAL VALUE SINCE THE
INITIAL INVESTMENT WAS MADE).
IRR
THE IRR IS THUS A TOTAL RETURN MEASURE
(CURRENT YIELD PLUS GROWTH & GAIN).
NOTE ALSO:
THE IRR IS A CASH FLOW BASED RETURN
MEASURE...
- DOES NOT DIFFERENTIATE BETWEEN
"INVESTMENT" AND "RETURN ON OR
RETURN OF INVESTMENT".
- INCLUDES THE EFFECT OF CAPITAL
INVESTMENTS AFTER THE INITIAL
OUTLAY.
- DISTINGUISHES CASH FLOWS ONLY
BY THEIR DIRECTION: POSITIVE IF FROM
INVESTMENT TO INVESTOR, NEGATIVE IF
FROM INVESTOR TO INVESTMENT (ON
SAME SIDE OF "=" SIGN).
IRR
In general, it is not possible to algebraically determine
the IRR for any given set of cash flows. It is
necessary to solve numerically for the IRR, in
effect, solving the IRR equation by "trial & error".
Calculators and computers do this automatically.
ADDITIONAL NOTES ON THE IRR . . .
TECHNICAL PROBLEMS:
IRR MAY NOT EXIST OR NOT BE
UNIQUE (OR GIVE MISLEADING RESULTS)
WHEN CASH FLOW PATTERNS INCLUDE
NEGATIVE CFs AFTER POSITIVE CFs.
BEST TO USE NPV IN THESE CASES.
(SOMETIMES FMRR IS USED.)
ADDITIONAL NOTES ON THE IRR
(CONTD)
THE IRR AND TIME-WEIGHTED RETURNS:
IRR = TIME-WTD GEOMEAN HPR IF
(AND ONLY IF) THERE ARE NO INTERMEDIATE
CASH FLOWS (NO CASH PUT IN OR TAKEN OUT
BETWEEN THE BEGINNING AND END OF THE
INVESTMENT).
ADDITIONAL NOTES ON THE IRR
(CONTD)
THE IRR AND RETURN COMPONENTS:
IRR IS A "TOTAL RETURN"
IRR DOES NOT GENERALLY
BREAK OUT EXACTLY INTO A SUM OF: y
+ g: INITIAL CASH YIELD + CAPITAL
VALUE GROWTH COMPONENTS.
DIFFERENCE BETWEEN THE
IRR AND THE INITIAL CASH YIELD IS
DUE TO A COMBINATION OF GROWTH IN
THE OPERATING CASH FLOWS AND/OR
GROWTH IN THE CAPITAL VALUE.
THE IRR AND RETURN COMPONENTS
(CONTD)
IF THE OPERATING CASH FLOWS
GROW AT A CONSTANT RATE, AND IF THE
ASSET VALUE REMAINS A CONSTANT
MULTIPLE OF THE CURRENT OPERATING
CASH FLOWS, THEN THE IRR WILL
INDEED EXACTLY EQUAL THE SUM OF
THE INITIAL CASH YIELD RATE PLUS THE
GROWTH RATE (IN BOTH THE CASH
FLOWS AND THE ASSET CAPITAL VALUE),
AND IN THIS CASE THE IRR WILL ALSO
EXACTLY EQUAL BOTH THE ARITHMETIC
AND GEOMETRIC TIME-WEIGHTED MEAN
(CONSTANT PERIODIC RETURNS):
IRR
t,t+N
=r
t,t+N
=y
t,t+N
+g
t,t+N
.
ADDITIONAL NOTES ON THE IRR
(CONTD)
THE IRR AND TERMINOLOGY:
IRR OFTEN CALLED "TOTAL YIELD"
(APPRAISAL)
"YIELD TO MATURITY" (BONDS)
EX-ANTE IRR = "GOING-IN IRR".
DOLLAR-WEIGHTED & TIME-WEIGHTED
RETURNS:A NUMERICAL EXAMPLE . . .
"OPEN-END" (PUT) OR (CREF).

INVESTORS BUY AND SELL "UNITS" ON
THE BASIS OF THE APPRAISED VALUE OF
THE PROPERTIES IN THE FUND AT THE
END OF EACH PERIOD.

SUPPOSE THE FUND DOESN'T PAY OUT
ANY CASH, BUT REINVESTS ALL
PROPERTY INCOME. CONSIDER 3
CONSECUTIVE PERIODS. . .
INVESTMENT PERIODIC RETURNS:
HIGH, LOW, HIGH . . .





GEOM MEAN TIME-WTD RETURN = (1.089)
(1/3)
-1 =
2.88%


1996

1997

1998

1999

YR END UNIT VALUE

$1000

$1100

$990

$1089

PERIODIC RETURN



+10.00%

-10.00%

+10.00%

INVESTOR #1, "MR. SMART" (OR
LUCKY): GOOD TIMING . . .






IRR = IRR(-2000,1100,0,1089) = 4.68%
END OF YEAR:

1996

1997

1998

1999

UNITS BOUGHT

2







UNITS SOLD



1



1

CASH FLOW

-$2000

+$1100

0

$1089

INVESTOR #2, "MR. DUMB" (OR
UNLUCKY): BAD TIMING . . .






IRR = IRR(-1000,-1100,990,1089) = -0.50%
END OF YEAR:

1996

1997

1998

1999

UNITS BOUGHT

1

1





UNITS SOLD





1

1

CASH FLOW

-$1000

-$1100

+$990

$1089

EXAMPLE (CONTD)
DOLLAR-WTD RETURN BEST FOR
MEASURING INVESTOR PERFORMANCE IF
INVESTOR CONTROLLED TIMING OF CAP.
FLOW.

TIME-WTD RETURN BEST FOR MEASURING
PERFORMANCE OF THE UNDERLYING
INVESTMENT (IN THIS CASE THE PUT OR
CREF), AND THEREFORE FOR MEASURING
INVESTOR PERFORMANCE IF INVESTOR
ONLY CONTROLS WHAT TO INVEST IN BUT
NOT WHEN.


MEASURING RETURNS
INTRODUCTION
Ex Ante Returns
Return calculations may be done before-the-fact,
in which case, assumptions must be made about
the future

Ex Post Returns
Return calculations done after-the-fact, in order to
analyze what rate of return was earned.

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING RETURNS
INTRODUCTION
According to the constant growth DDM can be decomposed into the two
forms of income that equity investors may receive, dividends and capital
gains.





WHEREAS

Fixed-income investors (bond investors for example) can expect to earn
interest income as well as (depending on the movement of interest
rates) either capital gains or capital losses.



| | | | | | Yield loss) (or Gain Capital Yield Dividend / Income

0
1
+ = +
(

= g
P
D
k
c
Risk, Return and Portfolio Theory
MEASURING RETURNS
INCOME YIELD
Income yield is the return earned in the form of a
periodic cash flow received by investors.
The income yield return is calculated by the
periodic cash flow divided by the purchase price.





Where CF
1
= the expected cash flow to be received
P
0
= the purchase price
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

yield Income
0
1
P
CF
=
[8-1]
INCOME YIELD
STOCKS VERSUS BONDS
Figure 8-1 illustrates the income yields for both bonds and stock in Canada from
the 1950s to 2005

The dividend yield is calculated using trailing rather than
forecast earns (because next years dividends cannot be
predicted in aggregate), nevertheless dividend yields have
exceeded income yields on bonds.
Reason risk
The risk of earning bond income is much less than the risk
incurred in earning dividend income.


(Remember, bond investors, as secured creditors of the first have a
legally-enforceable contractual claim to interest.)

(See Figure 8 -1 on the following slide)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EX POST VERSUS EX ANTE RETURNS
MARKET INCOME YIELDS
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

8-1 FIGURE
Insert Figure 8 - 1
MEASURING RETURNS
COMMON SHARE AND LONG CANADA BOND YIELD GAP
Average Yield Gap
(%)
1950s 0.82
1960s 2.35
1970s 4.54
1980s 8.14
1990s 5.51
2000s 3.55
Overall 4.58
Table 8-1 Average Yield Gap
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Table 8 1 illustrates the income yield gap between stocks and bonds over recent
decades
The main reason that this yield gap has varied so much over time is that the return
to investors is not just the income yield but also the capital gain (or loss) yield as
well.
MEASURING RETURNS
DOLLAR RETURNS
Investors in market-traded securities (bonds or stock) receive
investment returns in two different form:
Income yield
Capital gain (or loss) yield

The investor will receive dollar returns, for example:
$1.00 of dividends
Share price rise of $2.00

To be useful, dollar returns must be converted to percentage returns as a
function of the original investment. (Because a $3.00 return on a $30
investment might be good, but a $3.00 return on a $300 investment would
be unsatisfactory!)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING RETURNS
CONVERTING DOLLAR RETURNS TO PERCENTAGE RETURNS
An investor receives the following dollar returns a stock
investment of $25:
$1.00 of dividends
Share price rise of $2.00

The capital gain (or loss) return component of total return is calculated:
ending price minus beginning price, divided by beginning price
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

% 8 08 .
$25
$25 - $27
return (loss) gain Capital
0
0 1
= = =

=
P
P P
[8-2]
MEASURING RETURNS
TOTAL PERCENTAGE RETURN
The investors total return (holding period return) is:
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

% 12 12 . 0 08 . 0 04 . 0
25 $
25 $ 27 $
25 $
00 . 1 $



yield loss) (or gain Capital yield Income return Total
0
0 1
0
1
0
0 1 1
= = + =
(

+
(

=
(

+
(

=
+
=
+ =
P
P P
P
CF
P
P P CF
[8-3]
MEASURING RETURNS
TOTAL PERCENTAGE RETURN GENERAL FORMULA
The general formula for holding period return is:
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y



yield loss) (or gain Capital yield Income return Total
0
0 1
0
1
0
0 1 1
(

+
(

=
+
=
+ =
P
P P
P
CF
P
P P CF
[8-3]
MEASURING AVERAGE RETURNS
EX POST RETURNS
Measurement of historical rates of return that have been
earned on a security or a class of securities allows us to
identify trends or tendencies that may be useful in
predicting the future.
There are two different types of ex post mean or average
returns used:
Arithmetic average
Geometric mean
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING AVERAGE RETURNS
ARITHMETIC AVERAGE





Where:
r
i
= the individual returns
n = the total number of observations

Most commonly used value in statistics
Sum of all returns divided by the total number of
observations
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

(AM) Average Arithmetic
1
n
r
n
i
i
=
=
[8-4]
MEASURING AVERAGE RETURNS
GEOMETRIC MEAN





Measures the average or compound growth rate
over multiple periods.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

1 1 1 1 1 (GM) Mean Geometric
1
3 2 1
- )] r )...( r )( r )( r [(
n
n
+ + + + =
[8-5]
MEASURING AVERAGE RETURNS
GEOMETRIC MEAN VERSUS ARITHMETIC AVERAGE
If all returns (values) are identical the geometric mean =
arithmetic average.

If the return values are volatile the geometric mean < arithmetic
average

The greater the volatility of returns, the greater the difference
between geometric mean and arithmetic average.

(Table 8 2 illustrates this principle on major asset classes 1938 2005)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING AVERAGE RETURNS
AVERAGE INVESTMENT RETURNS AND STANDARD DEVIATIONS
Annual
Arithmetic
Average (%)
Annual
Geometric
Mean (%)
Standard Deviation
of Annual Returns
(%)
Government of Canada treasury bills 5.20 5.11 4.32
Government of Canada bonds 6.62 6.24 9.32
Canadian stocks 11.79 10.60 16.22
U.S. stocks 13.15 11.76 17.54
Source: Data are from the Canadian Institute of Actuaries
Table 8 - 2 Average Investment Returns and Standard Deviations, 1938-2005
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

The greater the difference,
the greater the volatility of
annual returns.
MEASURING EXPECTED (EX ANTE) RETURNS
While past returns might be interesting, investors are
most concerned with future returns.
Sometimes, historical average returns will not be realized
in the future.
Developing an independent estimate of ex ante returns
usually involves use of forecasting discrete scenarios
with outcomes and probabilities of occurrence.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

ESTIMATING EXPECTED RETURNS
ESTIMATING EX ANTE (FORECAST) RETURNS
The general formula





Where:
ER = the expected return on an investment
R
i
= the estimated return in scenario i
Prob
i
= the probability of state i occurring


R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

) Prob ( (ER) Return Expected
1
i
=
=
n
i
i
r
[8-6]
ESTIMATING EXPECTED RETURNS
ESTIMATING EX ANTE (FORECAST) RETURNS
Example:
This is type of forecast data that are required to make an
ex ante estimate of expected return.







State of the Economy
Probability of
Occurrence
Possible
Returns on
Stock A in that
State
Economic Expansion 25.0% 30%
Normal Economy 50.0% 12%
Recession 25.0% -25%
Risk, Return and Portfolio Theory
ESTIMATING EXPECTED RETURNS
ESTIMATING EX ANTE (FORECAST) RETURNS USING A SPREADSHEET APPROACH
Example Solution:
Sum the products of the probabilities and possible returns
in each state of the economy.







(1) (2) (3) (4)=(2)(1)
State of the Economy
Probability of
Occurrence
Possible
Returns on
Stock A in that
State
Weighted
Possible
Returns on
the Stock
Economic Expansion 25.0% 30% 7.50%
Normal Economy 50.0% 12% 6.00%
Recession 25.0% -25% -6.25%
Expected Return on the Stock = 7.25%
Risk, Return and Portfolio Theory
ESTIMATING EXPECTED RETURNS
ESTIMATING EX ANTE (FORECAST) RETURNS USING A FORMULA APPROACH
Example Solution:
Sum the products of the probabilities and possible returns
in each state of the economy.







7.25%
) 25 . 0 (-25% 0.5) (12% .25) 0 (30%
) Prob (r ) Prob (r ) Prob (r
) Prob ( (ER) Return Expected
3 3 2 2 1 1
1
i
=
+ + =
+ + =
=

=
n
i
i
r
Risk, Return and Portfolio Theory
MEASURING RISK
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

RISK
Probability of incurring harm
For investors, risk is the probability of earning an
inadequate return.
If investors require a 10% rate of return on a given investment,
then any return less than 10% is considered harmful.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

RISK
ILLUSTRATED
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Possible Returns on the Stock
Probability
-30% -20% -10% 0% 10% 20% 30% 40%
Outcomes that produce harm
The range of total possible returns
on the stock A runs from -30% to
more than +40%. If the required
return on the stock is 10%, then
those outcomes less than 10%
represent risk to the investor.
A
RANGE
The difference between the maximum and minimum
values is called the range
Canadian common stocks have had a range of annual returns
of 74.36 % over the 1938-2005 period
Treasury bills had a range of 21.07% over the same period.
As a rough measure of risk, range tells us that common
stock is more risky than treasury bills.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

DIFFERENCES IN LEVELS OF RISK
ILLUSTRATED
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Possible Returns on the Stock
Probability
-30% -20% -10% 0% 10% 20% 30% 40%
Outcomes that produce harm
The wider the range of probable
outcomes the greater the risk of the
investment.
A is a much riskier investment than B B
A
HISTORICAL RETURNS ON DIFFERENT ASSET
CLASSES
Figure 8-2 illustrates the volatility in annual returns on three
different assets classes from 1938 2005.
Note:
Treasury bills always yielded returns greater than 0%
Long Canadian bond returns have been less than 0% in some
years (when prices fall because of rising interest rates), and the
range of returns has been greater than T-bills but less than stocks
Common stock returns have experienced the greatest range of
returns
(See Figure 8-2 on the following slide)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING RISK
ANNUAL RETURNS BY ASSET CLASS, 1938 - 2005
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

FIGURE 8-2
REFINING THE MEASUREMENT OF RISK
STANDARD DEVIATION ()
Range measures risk based on only two observations
(minimum and maximum value)
Standard deviation uses all observations.
Standard deviation can be calculated on forecast or possible
returns as well as historical or ex post returns.

(The following two slides show the two different formula used for Standard Deviation)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MEASURING RISK
EX POST STANDARD DEVIATION








ns observatio of number the
year in return the
return average the
deviation standard the
:
_
=
=
=
=
n
i r
r
Where
i
o
Risk, Return and Portfolio Theory

1
) (
post Ex
1
2
_

=

=
n
r r
n
i
i
o
[8-7]
MEASURING RISK
EXAMPLE USING THE EX POST STANDARD DEVIATION
Problem
Estimate the standard deviation of the historical returns on investment A
that were: 10%, 24%, -12%, 8% and 10%.
Step 1 Calculate the Historical Average Return




Step 2 Calculate the Standard Deviation

% 0 . 8
5
40

5
10 8 12 - 24 10
(AM) Average Arithmetic
1
= =
+ + +
= =

=
n
r
n
i
i
Risk, Return and Portfolio Theory
% 88 . 12 166
4
664
4
4 0 400 256 4
4
2 0 20 16 2
1 5
) 8 14 ( ) 8 8 ( ) 8 12 ( ) 8 24 ( 8) - (10
1
) (
post Ex
2 2 2 2 2
2 2 2 2 2
1
2
_
= = =
+ + + +
=
+ + +
=

+ + + +
=

=

=
n
r r
n
i
i
o
EX POST RISK
STABILITY OF RISK OVER TIME
Figure 8-3 (on the next slide) demonstrates that the relative riskiness of
equities and bonds has changed over time.

Until the 1960s, the annual returns on common shares were about four
times more variable than those on bonds.

Over the past 20 years, they have only been twice as variable.

Consequently, scenario-based estimates of risk (standard deviation) is
required when seeking to measure risk in the future. (We cannot safely
assume the future is going to be like the past!)

Scenario-based estimates of risk is done through ex ante estimates and
calculations.
Risk, Return and Portfolio Theory
RELATIVE UNCERTAINTY
EQUITIES VERSUS BONDS
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

FIGURE 8-3
MEASURING RISK
EX ANTE STANDARD DEVIATION
A Scenario-Based Estimate of Risk
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

) ( ) (Prob ante Ex
2
1
i i i
n
i
ER r =

=
o
[8-8]
SCENARIO-BASED ESTIMATE OF RISK
EXAMPLE USING THE EX ANTE STANDARD DEVIATION RAW DATA
State of the
Economy Probability
Possible
Returns on
Security A
Recession 25.0% -22.0%
Normal 50.0% 14.0%
Economic Boom 25.0% 35.0%
Risk, Return and Portfolio Theory
GIVEN INFORMATION INCLUDES:
- Possible returns on the investment for different
discrete states
- Associated probabilities for those possible returns
SCENARIO-BASED ESTIMATE OF RISK
EX ANTE STANDARD DEVIATION SPREADSHEET APPROACH
The following two slides illustrate an approach to solving
for standard deviation using a spreadsheet model.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

SCENARIO-BASED ESTIMATE OF RISK
FIRST STEP CALCULATE THE EXPECTED RETURN
State of the
Economy
Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Recession 25.0% -22.0% -5.5%
Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
Risk, Return and Portfolio Theory
Determined by multiplying
the probability times the
possible return.
Expected return equals the sum of
the weighted possible returns.
SCENARIO-BASED ESTIMATE OF RISK
SECOND STEP MEASURE THE WEIGHTED AND SQUARED DEVIATIONS
State of the
Economy Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Deviation of
Possible
Return from
Expected
Squared
Deviations
Weighted
and
Squared
Deviations
Recession 25.0% -22.0% -5.5% -32.3% 0.10401 0.02600
Normal 50.0% 14.0% 7.0% 3.8% 0.00141 0.00070
Economic Boom 25.0% 35.0% 8.8% 24.8% 0.06126 0.01531
Expected Return = 10.3% Variance = 0.0420
Standard Deviation = 20.50%
Risk, Return and Portfolio Theory
Second, square those deviations
from the mean.
The sum of the weighted and square deviations
is the variance in percent squared terms.
The standard deviation is the square root
of the variance (in percent terms).
First calculate the deviation of
possible returns from the expected.
Now multiply the square deviations by
their probability of occurrence.
SCENARIO-BASED ESTIMATE OF RISK
EXAMPLE USING THE EX ANTE STANDARD DEVIATION FORMULA
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

% 5 . 20 205 .
0420 .
) 06126 (. 25 . ) 00141 (. 5 . ) 10401 (. 25 .
) 8 . 24 ( 25 . ) 8 . 3 ( 5 . ) 3 . 32 ( 25 .
) 3 . 10 35 ( 25 . ) 3 . 10 14 ( 5 . ) 3 . 10 22 ( 25 .
) ( ) ( ) (
) ( ) (Prob ante Ex
2 2 2
2 2 2
2
3 3 1
2
2 2 2
2
1 1 1
2
1
i
= =
=
+ + =
+ + =
+ + =
+ + =
=

=
ER r P ER r P ER r P
ER r
i i
n
i
o
State of the
Economy Probability
Possible
Returns on
Security A
Weighted
Possible
Returns
Recession 25.0% -22.0% -5.5%
Normal 50.0% 14.0% 7.0%
Economic Boom 25.0% 35.0% 8.8%
Expected Return = 10.3%
MODERN PORTFOLIO THEORY
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

PORTFOLIOS
A portfolio is a collection of different securities such as stocks and
bonds, that are combined and considered a single asset

The risk-return characteristics of the portfolio is demonstrably
different than the characteristics of the assets that make up that
portfolio, especially with regard to risk.

Combining different securities into portfolios is done to achieve
diversification.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

DIVERSIFICATION
Diversification has two faces:

1. Diversification results in an overall reduction in portfolio
risk (return volatility over time) with little sacrifice in
returns, and
2. Diversification helps to immunize the portfolio from
potentially catastrophic events such as the outright
failure of one of the constituent investments.

(If only one investment is held, and the issuing firm goes
bankrupt, the entire portfolio value and returns are lost.
If a portfolio is made up of many different investments,
the outright failure of one is more than likely to be offset
by gains on others, helping to make the portfolio
immune to such events.)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EXPECTED RETURN OF A PORTFOLIO
MODERN PORTFOLIO THEORY
The Expected Return on a Portfolio is simply the weighted
average of the returns of the individual assets that make
up the portfolio:







The portfolio weight of a particular security is the
percentage of the portfolios total value that is invested in
that security.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

) (
n
1 i

=
=
i i p
ER w ER [8-9]
EXPECTED RETURN OF A PORTFOLIO
EXAMPLE
% 288 . 8 % 284 . 4 % 004 . 4
) % 6 (.714 ) % 14 (.286 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Portfolio value = $2,000 + $5,000 = $7,000
r
A
= 14%, r
B
= 6%,
w
A
= weight of security A = $2,000 / $7,000 = 28.6%
w
B
= weight of security B = $5,000 / $7,000 = (1-28.6%)= 71.4%









RANGE OF RETURNS IN A TWO ASSET
PORTFOLIO
In a two asset portfolio, simply by changing the weight of the
constituent assets, different portfolio returns can be achieved.

Because the expected return on the portfolio is a simple weighted
average of the individual returns of the assets, you can achieve
portfolio returns bounded by the highest and the lowest individual
asset returns.





R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

RANGE OF RETURNS IN A TWO ASSET
PORTFOLIO
Example 1:

Assume ER
A
= 8% and ER
B
= 10%



(See the following 6 slides based on Figure 8-4)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
A portfolio manager can select the relative weights of the two
assets in the portfolio to get a desired return between 8% (100%
invested in A) and 10% (100% invested in B)
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
The potential returns of
the portfolio are
bounded by the highest
and lowest returns of
the individual assets
that make up the
portfolio.
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
8 - 4 FIGURE
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 100% is
invested in Asset A is
8%.
% 8 %) 10 )( 0 ( %) 8 )( 0 . 1 ( = + = + =
B B A A p
ER w ER w ER
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 100% is
invested in Asset B is
10%.
% 10 %) 10 )( 0 . 1 ( %) 8 )( 0 ( = + = + =
B B A A p
ER w ER w ER
EXPECTED PORTFOLIO RETURN
AFFECT ON PORTFOLIO RETURN OF CHANGING RELATIVE WEIGHTS IN A AND B
Risk, Return and Portfolio Theory
8 - 4 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Portfolio Weight
10.50

10.00







9.50






9.00






8.50







8.00






7.50

7.00
0 0.2 0.4 0.6 0.8 1.0 1.2
ER
A
=8%
ER
B
=10%
The expected return on
the portfolio if 50% is
invested in Asset A and
50% in B is 9%.
% 9 % 5 % 4
%) 10 )( 5 . 0 ( %) 8 )( 5 . 0 (
= + =
+ =
+ =
B B A A p
ER w ER w ER
RANGE OF RETURNS IN A TWO ASSET
PORTFOLIO
Example 1:

Assume ER
A
= 14% and ER
B
= 6%



(See the following 2 slides )
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

RANGE OF RETURNS IN A TWO ASSET PORTFOLIO
E(R)
A
= 14%, E(R)
B
= 6%
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

A graph of this
relationship is
found on the
following slide.
Expected return on Asset A = 14.0%
Expected return on Asset B = 6.0%
Weight of
Asset A
Weight of
Asset B
Expected
Return on the
Portfolio
0.0% 100.0% 6.0%
10.0% 90.0% 6.8%
20.0% 80.0% 7.6%
30.0% 70.0% 8.4%
40.0% 60.0% 9.2%
50.0% 50.0% 10.0%
60.0% 40.0% 10.8%
70.0% 30.0% 11.6%
80.0% 20.0% 12.4%
90.0% 10.0% 13.2%
100.0% 0.0% 14.0%
RANGE OF RETURNS IN A TWO ASSET PORTFOLIO
E(R)
A
= 14%, E(R)
B
= 6%
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Range of Portfolio Returns
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
0
.
0
%
1
0
.
0
%
2
0
.
0
%
3
0
.
0
%
4
0
.
0
%
5
0
.
0
%
6
0
.
0
%
7
0
.
0
%
8
0
.
0
%
9
0
.
0
%
1
0
0
.
0
%
Weight Invested in Asset A
E
x
p
e
c
t
e
d

R
e
t
u
r
n

o
n

T
w
o

A
s
s
e
t

P
o
r
t
f
o
l
i
o
EXPECTED PORTFOLIO RETURNS
EXAMPLE OF A THREE ASSET PORTFOLIO
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

K. Hartviksen
Relative
Weight
Expected
Return
Weighted
Return
Stock X 0.400 8.0% 0.03
Stock Y 0.350 15.0% 0.05
Stock Z 0.250 25.0% 0.06
Expected Portfolio Return = 14.70%
RISK IN PORTFOLIOS
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

MODERN PORTFOLIO THEORY - MPT
Prior to the establishment of Modern Portfolio Theory (MPT), most
people only focused upon investment returnsthey ignored risk.

With MPT, investors had a tool that they could use to dramatically
reduce the risk of the portfolio without a significant reduction in the
expected return of the portfolio.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EXPECTED RETURN AND RISK FOR PORTFOLIOS
STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING COVARIANCE
) )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B B A A p
COV w w w w + + = o o o
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

[8-11]
Risk of Asset A
adjusted for weight
in the portfolio
Risk of Asset B
adjusted for weight
in the portfolio
Factor to take into
account comovement
of returns. This factor
can be negative.
EXPECTED RETURN AND RISK FOR PORTFOLIOS
STANDARD DEVIATION OF A TWO-ASSET PORTFOLIO USING CORRELATION
COEFFICIENT
) )( )( )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B A B B A A p
w w w w o o o o o + + =
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

[8-15]
Factor that takes into
account the degree of
comovement of returns.
It can have a negative
value if correlation is
negative.
GROUPING INDIVIDUAL ASSETS INTO
PORTFOLIOS
The riskiness of a portfolio that is made of different risky
assets is a function of three different factors:
the riskiness of the individual assets that make up the portfolio
the relative weights of the assets in the portfolio
the degree of comovement of returns of the assets making up
the portfolio
The standard deviation of a two-asset portfolio may be
measured using the Markowitz model:
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

B A B A B A B B A A p
w w w w o o o o o
,
2 2 2 2
2 + + =
RISK OF A THREE-ASSET PORTFOLIO
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

The data requirements for a three-asset portfolio grows
dramatically if we are using Markowitz Portfolio selection formulae.

We need 3 (three) correlation coefficients between A and B; A and
C; and B and C.
A
B C

a,b

b,c

a,c

C A C A C A C B C B C B B A B A B A C C B B A A p
w w w w w w w w w o o o o o o o o o o
, , ,
2 2 2 2 2 2
2 2 2 + + + + + =
RISK OF A FOUR-ASSET PORTFOLIO
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

The data requirements for a four-asset portfolio grows dramatically
if we are using Markowitz Portfolio selection formulae.

We need 6 correlation coefficients between A and B; A and C; A
and D; B and C; C and D; and B and D.
A
C
B D

a,b

a,d

b,c

c,d

a,c

b,d

COVARIANCE
A statistical measure of the correlation of the
fluctuations of the annual rates of return of different
investments.

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

) - )( ( Prob
_
,
1
_
, i B i B
n
i
i i A AB
k k k k COV

=
=
[8-12]
CORRELATION
The degree to which the returns of two stocks co-
move is measured by the correlation coefficient ().
The correlation coefficient () between the returns on
two securities will lie in the range of +1 through - 1.
+1 is perfect positive correlation
-1 is perfect negative correlation
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y


B A
AB
AB
COV
o o
=
[8-13]
COVARIANCE AND CORRELATION
COEFFICIENT
Solving for covariance given the correlation
coefficient and standard deviation of the two assets:
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

B A AB AB
COV o o =
[8-14]
IMPORTANCE OF CORRELATION
Correlation is important because it affects the degree
to which diversification can be achieved using various
assets.
Theoretically, if two assets returns are perfectly
positively correlated, it is possible to build a riskless
portfolio with a return that is greater than the risk-free
rate.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

AFFECT OF PERFECTLY NEGATIVELY CORRELATED
RETURNS
ELIMINATION OF PORTFOLIO RISK
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Time 0 1 2
If returns of A and B are
perfectly negatively correlated,
a two-asset portfolio made up
of equal parts of Stock A and B
would be riskless. There would
be no variability
of the portfolios returns over
time.
Returns on Stock A
Returns on Stock B
Returns on Portfolio
Returns
%
10%
5%
15%
20%
EXAMPLE OF PERFECTLY POSITIVELY CORRELATED
RETURNS
NO DIVERSIFICATION OF PORTFOLIO RISK
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Time 0 1 2
If returns of A and B are
perfectly positively correlated,
a two-asset portfolio made up
of equal parts of Stock A and B
would be risky. There would be
no diversification (reduction of
portfolio risk).
Returns
%
10%
5%
15%
20%
Returns on Stock A
Returns on Stock B
Returns on Portfolio
AFFECT OF PERFECTLY NEGATIVELY CORRELATED
RETURNS
ELIMINATION OF PORTFOLIO RISK
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Time 0 1 2
If returns of A and B are
perfectly negatively correlated,
a two-asset portfolio made up
of equal parts of Stock A and B
would be riskless. There would
be no variability
of the portfolios returns over
time.
Returns
%
10%
Returns on Portfolio
5%
15%
20%
Returns on Stock B
Returns on Stock A
AFFECT OF PERFECTLY NEGATIVELY CORRELATED
RETURNS
NUMERICAL EXAMPLE
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

% 10 % 5 . 2 % 5 . 7
) % 5 (.5 ) % 15 (.5 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
Weight of Asset A = 50.0%
Weight of Asset B = 50.0%
Year
Return on
Asset A
Return on
Asset B
Expected
Return on the
Portfolio
xx07 5.0% 15.0% 10.0%
xx08 10.0% 10.0% 10.0%
xx09 15.0% 5.0% 10.0%
Perfectly Negatively
Correlated Returns
over time
% 10 % 5 . 7 % 5 . 2
) % 15 (.5 ) % 5 (.5 ) (
n
1 i
= + =
+ = =

=
i i p
ER w ER
DIVERSIFICATION POTENTIAL
The potential of an asset to diversify a portfolio is dependent upon
the degree of co-movement of returns of the asset with those other
assets that make up the portfolio.
In a simple, two-asset case, if the returns of the two assets are
perfectly negatively correlated it is possible (depending on the
relative weighting) to eliminate all portfolio risk.
This is demonstrated through the following series of spreadsheets,
and then summarized in graph format.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EXAMPLE OF PORTFOLIO COMBINATIONS AND
CORRELATION
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 1
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 17.5%
80.00% 20.00% 6.80% 20.0%
70.00% 30.00% 7.70% 22.5%
60.00% 40.00% 8.60% 25.0%
50.00% 50.00% 9.50% 27.5%
40.00% 60.00% 10.40% 30.0%
30.00% 70.00% 11.30% 32.5%
20.00% 80.00% 12.20% 35.0%
10.00% 90.00% 13.10% 37.5%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Perfect
Positive
Correlation
no
diversification
Both
portfolio
returns and
risk are
bounded by
the range set
by the
constituent
assets when
=+1
EXAMPLE OF PORTFOLIO COMBINATIONS AND
CORRELATION
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0.5
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 15.9%
80.00% 20.00% 6.80% 17.4%
70.00% 30.00% 7.70% 19.5%
60.00% 40.00% 8.60% 21.9%
50.00% 50.00% 9.50% 24.6%
40.00% 60.00% 10.40% 27.5%
30.00% 70.00% 11.30% 30.5%
20.00% 80.00% 12.20% 33.6%
10.00% 90.00% 13.10% 36.8%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Positive
Correlation
weak
diversification
potential
When =+0.5
these portfolio
combinations
have lower
risk
expected
portfolio return
is unaffected.
EXAMPLE OF PORTFOLIO COMBINATIONS AND
CORRELATION
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% 0
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 14.1%
80.00% 20.00% 6.80% 14.4%
70.00% 30.00% 7.70% 15.9%
60.00% 40.00% 8.60% 18.4%
50.00% 50.00% 9.50% 21.4%
40.00% 60.00% 10.40% 24.7%
30.00% 70.00% 11.30% 28.4%
20.00% 80.00% 12.20% 32.1%
10.00% 90.00% 13.10% 36.0%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

No
Correlation
some
diversification
potential
Portfolio
risk is
lower than
the risk of
either
asset A or
B.
EXAMPLE OF PORTFOLIO COMBINATIONS AND
CORRELATION
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -0.5
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 12.0%
80.00% 20.00% 6.80% 10.6%
70.00% 30.00% 7.70% 11.3%
60.00% 40.00% 8.60% 13.9%
50.00% 50.00% 9.50% 17.5%
40.00% 60.00% 10.40% 21.6%
30.00% 70.00% 11.30% 26.0%
20.00% 80.00% 12.20% 30.6%
10.00% 90.00% 13.10% 35.3%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Negative
Correlation
greater
diversification
potential
Portfolio risk
for more
combinations
is lower than
the risk of
either asset
EXAMPLE OF PORTFOLIO COMBINATIONS AND
CORRELATION
Asset
Expected
Return
Standard
Deviation
Correlation
Coefficient
A 5.0% 15.0% -1
B 14.0% 40.0%
Weight of A Weight of B
Expected
Return
Standard
Deviation
100.00% 0.00% 5.00% 15.0%
90.00% 10.00% 5.90% 9.5%
80.00% 20.00% 6.80% 4.0%
70.00% 30.00% 7.70% 1.5%
60.00% 40.00% 8.60% 7.0%
50.00% 50.00% 9.50% 12.5%
40.00% 60.00% 10.40% 18.0%
30.00% 70.00% 11.30% 23.5%
20.00% 80.00% 12.20% 29.0%
10.00% 90.00% 13.10% 34.5%
0.00% 100.00% 14.00% 40.0%
Portfolio Components Portfolio Characteristics
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Perfect
Negative
Correlation
greatest
diversification
potential
Risk of the
portfolio is
almost
eliminated at
70% invested in
asset A
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Diversification of a Two Asset Portfolio
Demonstrated Graphically

The Effect of Correlation on Portfolio Risk:
The Two-Asset Case
Expected Return
Standard Deviation
0%
0% 10%
4%
8%
20% 30% 40%
12%
B

AB
= +1
A

AB
= 0

AB
= -0.5

AB
= -1
IMPACT OF THE CORRELATION COEFFICIENT
Figure 8-7 (see the next slide) illustrates the relationship
between portfolio risk () and the correlation coefficient
The slope is not linear a significant amount of diversification is
possible with assets with no correlation (it is not necessary,
nor is it possible to find, perfectly negatively correlated
securities in the real world)
With perfect negative correlation, the variability of portfolio
returns is reduced to nearly zero.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

EXPECTED PORTFOLIO RETURN
IMPACT OF THE CORRELATION COEFFICIENT
Risk, Return and Portfolio Theory
8 - 7 FIGURE


15



























10





















5















0
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

o
f

P
o
r
t
f
o
l
i
o

R
e
t
u
r
n
s

Correlation Coefficient ()
-1 -0.5 0 0.5 1

ZERO RISK PORTFOLIO
We can calculate the portfolio that removes all risk.
When = -1, then




Becomes:

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

B A p
w w o o o ) 1 ( =
[8-16]
) )( )( )( )( ( 2 ) ( ) ( ) ( ) (
,
2 2 2 2
B A B A B A B B A A p
w w w w o o o o o + + =
[8-15]
AN EXERCISE TO PRODUCE THE
EFFICIENT FRONTIER USING THREE
ASSETS
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

AN EXERCISE USING T-BILLS, STOCKS AND
BONDS
Base Data: Stocks T-bills Bonds
Expected Return(%) 12.73383 6.151702 7.0078723
Standard Deviation (%) 0.168 0.042 0.102
Correlation Coefficient Matrix:
Stocks 1 -0.216 0.048
T-bills -0.216 1 0.380
Bonds 0.048 0.380 1
Portfolio Combinations:
Combination Stocks T-bills Bonds
Expected
Return Variance
Standard
Deviation
1 100.0% 0.0% 0.0% 12.7 0.0283 16.8%
2 90.0% 10.0% 0.0% 12.1 0.0226 15.0%
3 80.0% 20.0% 0.0% 11.4 0.0177 13.3%
4 70.0% 30.0% 0.0% 10.8 0.0134 11.6%
5 60.0% 40.0% 0.0% 10.1 0.0097 9.9%
6 50.0% 50.0% 0.0% 9.4 0.0067 8.2%
7 40.0% 60.0% 0.0% 8.8 0.0044 6.6%
8 30.0% 70.0% 0.0% 8.1 0.0028 5.3%
9 20.0% 80.0% 0.0% 7.5 0.0018 4.2%
10 10.0% 90.0% 0.0% 6.8 0.0014 3.8%
Weights Portfolio
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

Historical
averages for
returns and risk for
three asset
classes
Historical
correlation
coefficients
between the asset
classes
Portfolio
characteristics for
each combination
of securities
Each achievable
portfolio
combination is
plotted on
expected return,
risk () space,
found on the
following slide.
ACHIEVABLE PORTFOLIOS
RESULTS USING ONLY THREE ASSET CLASSES
Attainable Portfolio Combinations
and Efficient Set of Portfolio Combinations
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
0.0 5.0 10.0 15.0 20.0
Standard Deviation of the Portfolio (%)
P
o
r
t
f
o
l
i
o

E
x
p
e
c
t
e
d

R
e
t
u
r
n

(
%
)
Efficient Set
Minimum Variance
Portf olio
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

The plotted points are
attainable portfolio
combinations.
The efficient set is that set of
achievable portfolio
combinations that offer the
highest rate of return for a
given level of risk. The solid
blue line indicates the efficient
set.
ACHIEVABLE TWO-SECURITY PORTFOLIOS
MODERN PORTFOLIO THEORY
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

8 - 9 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
13

12







11






10






9







8






7

6
0 10 20 30 40 50 60
This line
represents
the set of
portfolio
combinations
that are
achievable by
varying
relative
weights and
using two
non-
correlated
securities.
DOMINANCE
It is assumed that investors are rational, wealth-
maximizing and risk averse.
If so, then some investment choices dominate others.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

INVESTMENT CHOICES
THE CONCEPT OF DOMINANCE ILLUSTRATED
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

A B
C
Return
%
Risk
10%
5%
To the risk-averse wealth maximizer, the choices are clear, A dominates B,
A dominates C.
A dominates B
because it offers
the same return
but for less risk.
A dominates C
because it offers a
higher return but
for the same risk.
20% 5%
EFFICIENT FRONTIER
THE TWO-ASSET PORTFOLIO COMBINATIONS
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

A is not attainable
B,E lie on the
efficient frontier and
are attainable
E is the minimum
variance portfolio
(lowest risk
combination)
C, D are
attainable but are
dominated by
superior portfolios
that line on the line
above E
8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
EFFICIENT FRONTIER
THE TWO-ASSET PORTFOLIO COMBINATIONS
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

8 - 10 FIGURE
E
x
p
e
c
t
e
d

R
e
t
u
r
n

%

Standard Deviation (%)
A
E
B
C
D
Rational, risk
averse
investors will
only want to
hold
portfolios
such as B.

The actual
choice will
depend on
her/his risk
preferences.
DIVERSIFICATION
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

DIVERSIFICATION
We have demonstrated that risk of a portfolio can be
reduced by spreading the value of the portfolio across,
two, three, four or more assets.
The key to efficient diversification is to choose assets
whose returns are less than perfectly positively
correlated.
Even with random or nave diversification, risk of the
portfolio can be reduced.
This is illustrated in Figure 8 -11 and Table 8 -3 found on
the following slides.
As the portfolio is divided across more and more securities, the
risk of the portfolio falls rapidly at first, until a point is reached
where, further division of the portfolio does not result in a
reduction in risk.
Going beyond this point is known as superfluous
diversification.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

DIVERSIFICATION
DOMESTIC DIVERSIFICATION
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

8 - 11 FIGURE
14

12







10






8






6







4






2

0
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

Number of Stocks in Portfolio
0 50 100 150 200 250 300
Average Portfolio Risk
January 1985 to December 1997
DIVERSIFICATION
DOMESTIC DIVERSIFICATION
Number of
Stocks in
Portfolio
Average
Monthly
Portfolio
Return (%)
Standard Deviation
of Average
Monthly Portfolio
Return (%)
Ratio of Portfolio
Standard Deviation to
Standard Deviation of a
Single Stock
Percentage of
Total Achievable
Risk Reduction
1 1.51 13.47 1.00 0.00
2 1.51 10.99 0.82 27.50
3 1.52 9.91 0.74 39.56
4 1.53 9.30 0.69 46.37
5 1.52 8.67 0.64 53.31
6 1.52 8.30 0.62 57.50
7 1.51 7.95 0.59 61.35
8 1.52 7.71 0.57 64.02
9 1.52 7.52 0.56 66.17
10 1.51 7.33 0.54 68.30
14 1.51 6.80 0.50 74.19
40 1.52 5.62 0.42 87.24
50 1.52 5.41 0.40 89.64
100 1.51 4.86 0.36 95.70
200 1.51 4.51 0.34 99.58
222 1.51 4.48 0.33 100.00
Source: Cleary, S. and Copp D. "Diversification with Canadian Stocks: How Much is Enough?" Canadian Investment Review (Fall 1999), Table 1.
Table 8-3 Monthly Canadian Stock Portfolio Returns, January 1985 to December 1997
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

TOTAL RISK OF AN INDIVIDUAL ASSET
EQUALS THE SUM OF MARKET AND UNIQUE RISK
This graph illustrates
that total risk of a stock
is made up of market
risk (that cannot be
diversified away
because it is a function
of the economic
system) and unique,
company-specific risk
that is eliminated from
the portfolio through
diversification.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

[8-19]
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

(
%
)

Number of Stocks in Portfolio
Average Portfolio Risk

Diversifiable
(unique) risk
Nondiversifiable
(systematic) risk
risk ) systematic - (non Unique risk c) (systemati Market risk Total + =
[8-19]
INTERNATIONAL DIVERSIFICATION
Clearly, diversification adds value to a portfolio by
reducing risk while not reducing the return on the
portfolio significantly.
Most of the benefits of diversification can be
achieved by investing in 40 50 different positions
(investments)
However, if the investment universe is expanded to
include investments beyond the domestic capital
markets, additional risk reduction is possible.
(See Figure 8 -12 found on the following slide.)
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

DIVERSIFICATION
INTERNATIONAL DIVERSIFICATION
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

8 - 12 FIGURE










100






80






60







40






20

0
P
e
r
c
e
n
t

r
i
s
k

Number of Stocks
0 10 20 30 40 50 60
International stocks
U.S. stocks
11.7
SUMMARY AND CONCLUSIONS
In this chapter you have learned:
How to measure different types of returns
How to calculate the standard deviation and
interpret its meaning
How to measure returns and risk of portfolios and
the importance of correlation in the diversification
process.
How the efficient frontier is that set of achievable
portfolios that offer the highest rate of return for a
given level of risk.
R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

CONCEPT REVIEW QUESTIONS
Risk, Return and Portfolio Theory
T
h
u
r
s
d
a
y
,

D
e
c
e
m
b
e
r

0
5
,

2
0
1
3

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

CONCEPT REVIEW QUESTION 1
EX ANTE AND EX POST RETURNS
What is the difference between ex ante and ex post
returns?

R
i
s
k
,

R
e
t
u
r
n

a
n
d

P
o
r
t
f
o
l
i
o

T
h
e
o
r
y

COPYRIGHT
Copyright 2007 John Wiley & Sons
Canada, Ltd. All rights reserved.
Reproduction or translation of this work
beyond that permitted by Access
Copyright (the Canadian copyright
licensing agency) is unlawful. Requests
for further information should be
addressed to the Permissions
Department, John Wiley & Sons Canada,
Ltd. The purchaser may make back-up
copies for his or her own use only and not
for distribution or resale. The author and
the publisher assume no responsibility for
errors, omissions, or damages caused by
the use of these files or programs or from
the use of the information contained
herein.
Risk, Return and Portfolio Theory