Fundamental Of Fundamental Of InvestmentInvestment

Chapter OneChapter One

A Brief History of Risk and A Brief History of Risk and ReturnReturn

““If you want to make If you want to make money , go where the money , go where the money is money is ““

Joseph KennedyJoseph Kennedy

1.11.1 ReturnsReturns

Dollar Returns:Dollar Returns: If you buy an asset of any type, your If you buy an asset of any type, your

gain or ( loss) from that investment is gain or ( loss) from that investment is called the return on your investment. called the return on your investment. This return will have two components:This return will have two components:

1.1. You may receive some cash directly You may receive some cash directly while you own the investmentwhile you own the investment

2.2. The value of the asset you purchase The value of the asset you purchase may change. You may have a capital may change. You may have a capital gain or lossgain or loss

ExampleExample

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

Moreover, Harley pays dividend of Moreover, Harley pays dividend of $1.85/ share !!$1.85/ share !!

The total dollar returnThe total dollar return

The return on an investment The return on an investment measured in dollars that accounts measured in dollars that accounts for all cash flows and capital gains for all cash flows and capital gains or losses.or losses.

Total dollar return= Dividend Total dollar return= Dividend income + Capital Gain ( Loss)income + Capital Gain ( Loss)

Percentage returnsPercentage returns

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

Percentage ReturnsPercentage Returns

Dividend Yield: the annual stock Dividend Yield: the annual stock dividend as a percentage of the dividend as a percentage of the initial stock priceinitial stock price

Dividend Yield = D Dividend Yield = D t+1 t+1 / P/ Ptt Capital Gains Yield: The change in Capital Gains Yield: The change in

stock price as a percentage of the stock price as a percentage of the initial stock price.initial stock price.

Capital Gains Yield= ( PCapital Gains Yield= ( Pt+1t+1 –– P Ptt)/P)/Ptt

Percentage ReturnsPercentage Returns

Total percent Return: The return on Total percent Return: The return on an investment measured as a an investment measured as a percentage that accounts for all cash percentage that accounts for all cash flows and capital gains or losses.flows and capital gains or losses.

Percentage Return= Dividend Yield Percentage Return= Dividend Yield + Capital Gains Yield.+ Capital Gains Yield.

1.21.2 The Historical RecordThe Historical Record

• Asset category :Asset category :1.1. Large company stocks: the large Large company stocks: the large

company stock portfolio is based on company stock portfolio is based on S&P(500) Index, which contains S&P(500) Index, which contains 500 of the largest companies ( in 500 of the largest companies ( in terms of total market value of terms of total market value of outstanding stock ) In the USA.outstanding stock ) In the USA.

2.2. Small company stocks: this is a Small company stocks: this is a portfolio composed of stock of portfolio composed of stock of smaller companies in the NYSE.smaller companies in the NYSE.

1.21.2 The Historical RecordThe Historical Record

3. Long term corporate Bonds. This is 3. Long term corporate Bonds. This is a portfolio of high quality bonds with a portfolio of high quality bonds with 20 years to maturity.20 years to maturity.

4. Long term government bonds. This 4. Long term government bonds. This is a portfolio of government bonds is a portfolio of government bonds with 20 years to maturity.with 20 years to maturity.

5. Treasury Bills. This is a portfolio of 5. Treasury Bills. This is a portfolio of treasury bills ( T-bills ) for short with treasury bills ( T-bills ) for short with a three month maturitya three month maturity

NoteNote

Small company investment did the Small company investment did the best over all .best over all .

Investment in stocks is the best Investment in stocks is the best whether for big or small companies whether for big or small companies but for a long period of time.but for a long period of time.

Risk PremiumsRisk Premiums

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

Risk PremiumsRisk Premiums

Risk free rate : the rate of return on Risk free rate : the rate of return on a riskless investmenta riskless investment

Risk premium : the extra return on a Risk premium : the extra return on a risky asset over the risk free rate, risky asset over the risk free rate, the reward for bearing risk.the reward for bearing risk.

Risky assets earn a risk premium! Risky assets earn a risk premium! There is a reward for bearing this There is a reward for bearing this risk .risk .

1.41.4 Return VariabilityReturn Variability

Variance: a common measure of Variance: a common measure of VolatilityVolatility

Standard Deviation: the square root of Standard Deviation: the square root of the Variance.the Variance.

Variance measures the average squared Variance measures the average squared difference between the actual return and difference between the actual return and the average one. The bigger the number the average one. The bigger the number is , the more the actual returns tend to is , the more the actual returns tend to differ from the average return.differ from the average return.

Normal DistributionNormal Distribution

A systematic, bell shaped frequency A systematic, bell shaped frequency distribution thatdistribution that’’s completely s completely defined by its average and standard defined by its average and standard Deviation. .Deviation. .

High risk . High return and high High risk . High return and high variance and S.Dvariance and S.D

Low risk . Low return and low Low risk . Low return and low variance and S.D.variance and S.D.

1.51.5 More on Average More on Average ReturnsReturns

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?

1.51.5 More on Average More on Average ReturnsReturns

Geometric average return answers Geometric average return answers the question the question ““ what was your what was your average compound return per year average compound return per year over a particular period?over a particular period?””

The arithmetic average return The arithmetic average return answers the question answers the question ““ what was what was your return in an average year over your return in an average year over a particular period?a particular period?””

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 %

Arithmetic Average return Arithmetic Average return or Geometricor Geometric

The good news is that there is a The good news is that there is a simple way of combining two simple way of combining two averages, which we will call the averages, which we will call the BlumeBlume’’s Formulas Formula……

R(T)= T-1/N-1 X G.average+N-T/N-R(T)= T-1/N-1 X G.average+N-T/N-1X Arith. Average 1X Arith. Average

Example !!Example !!

1.61.6 Risk and ReturnRisk and Return

If the investors are unwilling to bear If the investors are unwilling to bear any risk at all, and they are willing to any risk at all, and they are willing to forgo the use of the money for a while, forgo the use of the money for a while, so they can earn a risk free rate, so they can earn a risk free rate, because the Risk free rate represents because the Risk free rate represents compensation for just waiting. Its compensation for just waiting. Its often called the often called the Time value of money Time value of money

If the investors are willing to bear risk If the investors are willing to bear risk , then we can expect to earn a risk , then we can expect to earn a risk premium , at least on averagepremium , at least on average

1.61.6 Risk and ReturnRisk and Return

The more risk we are willing to bear, The more risk we are willing to bear, the greater is the risk premium .the greater is the risk premium .

Time value of money is the Time value of money is the compensation for waiting , and the compensation for waiting , and the risk premium is the compensation for risk premium is the compensation for worrying.worrying.

There are two important points here There are two important points here

1. Risky assets don1. Risky assets don’’t always pay more t always pay more than risk free investmentsthan risk free investments

1.61.6 Risk and ReturnRisk and Return

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

* Drawing is required . * Drawing is required .

Risk and Return

@2002 by the McGraw- Hill Companies Inc.All rights reserved.McGraw Hill / Irwin