Contemporary Investments: Chapter 2 Chapter 2 FUNDAMENTALS OF RISK AND RETURN What are the sources of investment returns? How are investment returns measured?

Contemporary Investments: Chapter 2

Chapter 2 FUNDAMENTALS OF RISK AND

RETURN• What are the sources of investment returns?

• How are investment returns measured?

• What is investment risk and how is it measured?

• How are risk and return measured for portfolios of assets?

• Why does diversification benefit investors?

• What is the relationship between risk and required return?


Sources of investment returns• Income

• Interest

• Dividends

• Price changes: Capital gains or Capital losses

• Paper gains and losses

• Ex-ante and ex-post returns


Measuring investment returns• Calculating holding period returns

• Breaking down returns between income and capital gains

• Calculating expected returns

• Inflation adjusted returns

• International returns

• Total return indexes


Investment History –The Agony of Bond Investors: 1965-1981


Figure 2.1 – Total Return Index for Johnson & Johnson: 1991-2001


Summarizing returns

• Arithmetic mean

• Annualizing the arithmetic mean

• Geometric mean

• Comparing the geometric and arithmetic means


Investment risk

• A definition of risk: uncertainty of return

• Types (sources) of risk

• Default, Credit, Tax, Interest Rate, Market, Event, Liquidity, Foreign Exchange

• Measuring risk

• Calculating a standard deviation

• Annualizing a standard deviation


Figure 2.2 – Probability of Possible Return


Figure 2.3 – Stock and T-Bill Returns: 1982-2001


Figure 2.4 – Monthly Returns for 3M and Starbucks


Risk, return and investment selection

• Portfolio risk and return

• Finding the mean return of a portfolio

• Finding the standard deviation of a portfolio

• Correlation coefficient


Figure 2.5 – Monthly Returns for Dow Chemical and Verizon Communication


Diversification

• Naïve versus efficient diversification

• Diversifiable versus non-diversifiable risk

• Diversifiable or unsystematic risk

• Non-diversifiable or systematic risk

• Beta

• Risk and required return


Figure 2.6 – Real and Nominal Returns on T-Bills: 1981-2001


Figure 2.7 – Yields on T-Bills, T-Bonds, and Baa Corporate Bonds: 1988-2002

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Contemporary Investments: Chapter 2 Chapter 2 FUNDAMENTALS OF RISK AND RETURN What are the sources of investment returns? How are investment returns measured?