Risk & Return - Basic Understanding

8/3/2019 Risk & Return - Basic Understanding

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RiskReturn&

By Yousuf Zahid

Sunday, January 8, 2011

[email protected]


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Statistics Refresher

Standard Deviation Dispersion

Average difference of observations from their mean value

Variance Square root of SD

Measure of relative dispersion and used to check consistency

Correlation Inter-relationship between two variables

Positive, negative or zero relationship

Covariance Correlation (+/-) times SD of each of the two variables


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Example 1

1 year ago, Stock A was $10 per share

Current trading at $9.50 per share

Shareholders receive dividend of $1

What return was earned over the past year?

$1.00 + ($9.50 - $10.00 )

$10.00= 5%

The Way of the Return


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Example 2

What is the return on an investment that costs $1,000

and is sold after 1 year for $1,100?

Dollar return

Percentage return

$ Received - $ Invested

$1,100 - $1,000 = $100

$ Return / $ Invested

$100 / $1,000 = 10%



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1 year ago, 100 shares of Wal-Mart bought at $4,500

Over last year, $27 received in dividends (or 27 cents per share)

At year end, stock sells for $4,800

How did you do?

$27 + ($4,800 - $4,500) = $327

Dollar gain $327 with percentage gain at 7.3%


Example 3


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Not at all recommended

Mark Twain suggested otherwise

Warren Buffet strongly disagrees

Simply put, diversify


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Risk ReturnUncertainty of

an outcome

Expected to

be realized


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Inversely related

Variability

The Trade-off


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Investor Genre

Risk Avoider

or Averse

Risk Seeker


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Shares, Securities, Assets

Government treasuries

e.g. T-Bills

Mutual funds Including

properties

Including

precious metals

& commodities


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How toMeasure Risk

Behavioral

Sensitivity Probability

Quantitative

StandardDeviation

Coefficient ofVariation

Single investment


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Sensitivity AnalysisVariability of outcomes sensedthrough a range

And through economic conditions

Probability DistributionWhat percent chance is there?

Probability assigned to return rate

Standard Deviation of ReturnObserving risk on dispersion ofreturns

Absolute so misleading

Coefficient of VariationConverts SD of expected into

relative values

Best for portfolio

RiskMeasurement


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All about portfolios


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Holding stocksin isolation

Holdingportfolio in

several stocks

Individual

stocks risk

diversified

The obvious

is inevitable

Why a Portfolio?


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Portfolio Risk

Standard deviation

Relative importance

Interaction between two assets

Portfolio Return

Aggregation of returns

Expected rate of return

Relative share in the portfolio

Portfolio investment is diversification


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Portfolio

AssetReturns

PerfectPositive

Trade-off

PerfectNegative

Risk removed

Zero

Correlation Effect

+

Positively correlated assets tend

to move up and down together

Negatively correlated assets tend

to move in opposite directions


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Contribution of an asset to overall riskRisk judged at portfolio level only

Highly risky asset may act as portfolio risk stabilizerPNC


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Systematic Risk

Overall market risk that cannot be diversified away

E.g. interest rate policy, tax rates, deficit financing, inflation & forex

Non-systematic Risk

Firm specific and avoidable by diversification

E.g. Strike, R&D expert resigns, competitor & weak supply-chain

Risks to Portfolio


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Risk & Return - Basic Understanding

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