1. Fundamental Of Investment
Chapter One

2. A Brief History of Risk and Return
“If you want to make money , go where the money is “
Joseph Kennedy

3. 1.1 Returns Dollar Returns:
If you buy an asset of any type, your gain or ( loss) from that investment is called the return on your investment. This return will have two components:
You may receive some cash directly while you own the investment
The value of the asset you purchase may change. You may have a capital gain or loss

4. Example
Suppose you purchased 100 shares of stocks in Harley-Davidson on January 1 . At that time, Harley was selling for about $37/share so the shares cost you $3700, at the end of the year , you want to see how you did with your investment??
Moreover, Harley pays dividend of $1.85/ share !!

5. The total dollar return
The return on an investment measured in dollars that accounts for all cash flows and capital gains or losses.
Total dollar return= Dividend income + Capital Gain ( Loss)

6. Percentage returns
It’s usually more convenient to summarize information about return in percentage terms than in dollar terms, because that way you return doesn’t depend on how much you actually invested. With percentage returns the question we want to answer is how much do we get from each dollar invested?

7. Percentage Returns
Dividend Yield: the annual stock dividend as a percentage of the initial stock price
Dividend Yield = D t+1 / Pt
Capital Gains Yield: The change in stock price as a percentage of the initial stock price.
Capital Gains Yield= ( Pt+1 – Pt)/Pt

8. Percentage Returns
Total percent Return: The return on an investment measured as a percentage that accounts for all cash flows and capital gains or losses.
Percentage Return= Dividend Yield + Capital Gains Yield.

9. 1.2 The Historical Record Asset category :
Large company stocks: the large company stock portfolio is based on S&P(500) Index, which contains 500 of the largest companies ( in terms of total market value of outstanding stock ) In the USA.
Small company stocks: this is a portfolio composed of stock of smaller companies in the NYSE.

10. 1.2 The Historical Record
3. Long term corporate Bonds. This is a portfolio of high quality bonds with 20 years to maturity.
4. Long term government bonds. This is a portfolio of government bonds with 20 years to maturity.
5. Treasury Bills. This is a portfolio of treasury bills ( T-bills ) for short with a three month maturity

11. Note Small company investment did the best over all .
Investment in stocks is the best whether for big or small companies but for a long period of time.

12. Risk Premiums
The government borrows money by issuing debt securities , which comes in different forms. Focusing on the treasury bills because these investments have a very short investment life and because the government can always raise taxes or print money to pay its bills. In short run there is no risk associated with buying them..

13. Risk Premiums
Risk free rate : the rate of return on a riskless investment
Risk premium : the extra return on a risky asset over the risk free rate, the reward for bearing risk.
Risky assets earn a risk premium! There is a reward for bearing this risk .

14. 1.4 Return Variability Variance: a common measure of Volatility
Standard Deviation: the square root of the Variance.
Variance measures the average squared difference between the actual return and the average one. The bigger the number is , the more the actual returns tend to differ from the average return.

15. Normal Distribution
A systematic, bell shaped frequency distribution that’s completely defined by its average and standard Deviation. .
High risk . High return and high variance and S.D
Low risk . Low return and low variance and S.D.

16. 1.5 More on Average Returns
Suppose you buy a particular stock for $100. unfortunately the first year you own it . It falls to $50. the second year you own it rises back to $100. leaving you where you started.
What was your average return on this investment?

17. 1.5 More on Average Returns
Geometric average return answers the question “ what was your average compound return per year over a particular period?”
The arithmetic average return answers the question “ what was your return in an average year over a particular period?”

18. Calculating Geometric average return
Suppose a particular investment had annual returns of 10, 12 , 3 , -9 % over the last four years.
The geometric average return over this four year period is calculated as (1.1 x 1.12 x 1.03 x -0.09)1/4 -1 = 3.66 %

19. Arithmetic Average return or Geometric
The good news is that there is a simple way of combining two averages, which we will call the Blume’s Formula…
R(T)= T-1/N-1 X G.average+N-T/N-1X Arith. Average
Example !!

20. 1.6 Risk and Return
If the investors are unwilling to bear any risk at all, and they are willing to forgo the use of the money for a while, so they can earn a risk free rate, because the Risk free rate represents compensation for just waiting. Its often called the Time value of money
If the investors are willing to bear risk , then we can expect to earn a risk premium , at least on average

21. 1.6 Risk and Return
The more risk we are willing to bear, the greater is the risk premium .
Time value of money is the compensation for waiting , and the risk premium is the compensation for worrying.
There are two important points here
1. Risky assets don’t always pay more than risk free investments

22. 1.6 Risk and Return
2. Not all the risks are compensated , some risks are cheaply and easily avoidable , and there is no expected reward for bearing them. It’s only those risks that cant be easily avoided that are compensated ( On Average !)
* Drawing is required .

23. Risk and Return McGraw Hill / Irwin
@2002 by the McGraw- Hill Companies Inc.All rights reserved.