Risk and Return

Shobhit Aggarwal
9th November
IIM Udaipur
 What is risk?
Risk is uncertainty about future returns
Why do we worry about it as long as
expected return is same?
Because investors are risk-averse
A: 50% chance of getting 10 lakh and 50%
chance of getting 0
B: 75% chance of getting 10 lakh and 25%
chance of paying 10 lakh
C: A sure cash flow of 5 lakh
 What is risk?
So if investors are risk-averse, how
does someone incentivize them to
take on more risk?
By providing more returns
How much more return should be
given for the risk we undertake?
 Risk-return relationship
How much more return should be
given for the risk we undertake?
Should we get rewarded for all risk we
take?
How do we measure risk?
Can we reduce the risk that we undertake?
Is all risk similar in nature?
Look at the newspaper headlines
 Portfolio return of 1 stock
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

DR(BOB)
 Portfolio returns of 2 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

AVG(2)
 Portfolio returns of 5 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

AVG(5)
 Portfolio returns of 10 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

AVG(10)
 Portfolio returns of 20 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

AVG(20)
 Portfolio returns of 50 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

AVG(50)
 Portfolio returns 1 stock and 50 stocks
18.0%

12.0%

6.0%

Average returns 0.0%

-6.0%

-12.0%

-18.0%

Date

DR(BOB) AVG(50)
 Portfolio Standard Deviation
3.0%

2.0%

Std. Dev.

1.0%

0.0%

No. of stocks
 Limits to diversification
There seems to be a limit to
diversification
Transaction costs
Stock-picking ability
Natural limit to diversification due to
economy
 Risk-return relationship
How much more return should be
given for the risk we undertake?
Should we get rewarded for all risk we
take?
How do we measure risk?
Can we reduce the risk that we undertake?
Is all risk similar in nature?
Look at the newspaper headlines

Use risk-return models

CAPM and its intuitive understanding
 Risk-return relationship
How do the returns and risk of a two-
stock portfolio change when you add
a new stock to it?
The correlation of the returns of the new
stock with the returns of the portfolio
determines this
+
= + +2
 Risk-return relationship
Calculate the portfolio risk and return for a
equally weighted two stock portfolio if the
returns of stocks A and B are 10% and 15%
each, their standard deviations are 16% and
20% respectively, the coefficient of
correlation between the two is one.
How do the return and standard deviation
change if we increase the weight from 0 to 1?
How does this relationship change if the
correlation coefficient decreases from 1 to -1?
 Risk-return relationship

Portfol
io
Return

Standard Deviation of Portfolio

Return ()
 Risk-return relationship
What happens in a 3 stock portfolio?
What happens in a n-stock portfolio?
What happens if we consider all the
risky assets available in the market?
 Risk-return relationship

Portfol
io
Return

Standard Deviation of Portfolio

Return ()
 Risk-return relationship
If there were no transaction costs and
everyone believed that they do not
have superior stock-picking ability,
how diversified would everyone be?
How will people who have a risk
appetite different from others invest
according to their risk appetite in this
world?
 Risk-return relationship

Retur
n

Rf

Portfolio
Risk
 Risk-return relationship
In this world, will the market give extra
returns for any risk that is not
correlated with the market return?
Do we really need the assumption of
all investors being fully diversified or
only the marginal investor?
Who is a marginal investor?
One who has a large number of shares
One who trades these shares frequently
 Good risk-return model
Applies to all assets
Tells us which risks we will be awarded
for
Must be standardized for comparison
across different investment alternatives
Must be able to translate into expected
returns
Must work well to explain both past and
future returns
 Risk-free Rate
All cash flows are certain
No default risk
No reinvestment risk
No interest rate risk
No loss of purchasing power due to
inflation
 Market Risk Premium
Historical risk premiums
Calculate average index value for 90 days
for a time period X years ago
Calculate average index value for 90 days
for the most recent time period
Calculate the cumulative average growth
rate for X years. This becomes your
market return
Take a difference with risk-free rate to
estimate market risk premium