CHAPTER SIX The Returns and Risks from Investing CHAPTER SIX The Returns and Risks from Investing Cleary / Jones Investments: Analysis and Management

Learning Objectives n To define “return” and state its two components n To explain the relationship between return and risk n To identify the sources of risk n To describe the different methods of measuring returns

Learning Objectives n To describe the different methods of measuring risk n To discuss the returns and risks from investing in major financial assets in the past

Asset Valuation n Function of both return and risk –At the centre of security analysis n 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

Return Components n Returns consist of two elements: –Yield: Periodic cash flows such as interest or dividends (income return) n “Yield” measures relate income return to a price for the security –Capital Gain Or Loss: Price appreciation or depreciation n The change in price of the asset n Total Return = Yield +Price Change

Risk Sources n Interest Rate Risk –Affects market value and resale price n Market Risk –Overall market effects n Inflation Risk –Purchasing power variability n Business Risk n Financial Risk –Tied to debt financing n Liquidity Risk –Time and price concession required to sell security n Exchange Rate Risk n Country Risk –Potential change in degree of political stability

Risk Types n Two general types: –Systematic (market) risk n Pervasive, affecting all securities, cannot be avoided n Interest rate or market or inflation risks –Nonsystematic (unique) risk n Unique characteristics specific to a security n Total Risk = General Risk + Specific Risk

Measuring Returns n Total Return compares performance over time or across different securities n Total Return is a percentage relating all cash flows received during a given time period, denoted CF t +(P E - P B ), to the start of period price, P B

Measuring Returns n Total Return can be either positive or negative –When cumulating or compounding, negative returns are a problem n A Return Relative solves the problem because it is always positive

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

Measuring International Returns n International returns include any realized exchange rate changes –If foreign currency depreciates, returns are lower in domestic currency terms n Total Return in domestic currency =

Measures Describing a Return Series n TR, RR, and CWI are useful for a given, single time period n What about summarizing returns over several time periods? –Arithmetic mean and Geometric mean n Arithmetic mean, or simply mean,

Arithmetic Versus Geometric n 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 n Geometric mean reflects compound, cumulative returns over more than one period

Geometric Mean n Geometric mean defined as the n-th root of the product of n return relatives minus one, or G = n Difference between Geometric mean and Arithmetic mean depends on the variability of returns, s

Adjusting Returns for Inflation n Returns measures are not adjusted for inflation –Purchasing power of investment may change over time –Consumer Price Index (CPI) is possible measure of inflation

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

Risk Premiums n Premium is additional return earned or expected for additional risk –Calculated for any two asset classes n Equity risk premium is the difference between stock and risk-free returns n Bond default premium is the difference between the return on long term corporate bonds and long term government bonds

Risk Premiums n Equity Risk Premium, ERP, =

The Risk-Return Record n Since 1938, cumulative wealth indexes show stock returns dominate bond returns –Stock standard deviations also exceed bond standard deviations n Annual geometric mean return for the time period between 1938 and 1997 for Canadian common stocks is 10.9% with standard deviation of 16.2%