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So, in order to now move on a little bit,

we're going to think in terms of return.
We are going to focus for
the next few minutes in terms of risk.
And the important thing
here is to first and
foremost, in finance these two
things go always together.
You cannot really separate
return from risk.
These are like two sides of the same coin.
You can only interpret properly
a given amount of return
only if you're thinking of
the risk that investors
are exposed to when they expect or
they get those return.
So, before we start with risk,
let's keep one thing in mind.
We can measure the return of
an asset in two different ways.
As a matter of fact, there are three
different definitions of mean returns.
One of which we will read directly
from the technical note but
we will not actually
cover in this session.
So, let's say there's more than one
way of calculating mean returns, and
there's more than one
way of calculating risk.
Before we start with thinking about
possible definitions of risk and for
our purposes, we're going to cover two.
One thing that is important and
I will highlight again at the end and
that is that there are very
many definitions of risk.
In finance, we may think about two or
three ways of summarizing mean returns and
again, those different ways
of summarizing mean returns.
They sort of design to answer different
questions and they give you, obviously,
a different answers, numerical and
in terms of interpretation.
And exactly the same thing is about risk,
with one difference.
There are many more ways to
assess the risk of an asset,
than there are to assess
the mean return of an asset.
And the reason for this is obvious.
If I ask ten people to evaluate the
performance of an asset over ten years,
all of them will actually
give me the same number.
They will look at the value of
the asset at the beginning.

They will look at the value

of the asset at the end.
They will look at the cash flows
that they got in between, and
they will calculate either the mean return
or the return between the beginning and
the end of the period.
But there's no controversy there.
Ten people looking at the same data
will come up with exactly the same
return obtained by being invested in
the asset over that ten year period.
If I were to ask those ten people to give
me an idea of the risk of the asset,
then I might get ten
completely different answers.
Some people might focus on variability.
Some people might focus on losses.
Some people might focus on
how large those losses were.
Some other people would focus on
how frequently those losses happen.
And so,
we open a little bit of Pandora's box.
We don't really know what
is going to come out.
And that is important that you know from
the beginning that when we assess the risk
of an asset,
there are multiple ways of doing so.
Of all those ways, we're going to focus
on the two that are what we typically
call the standard, a modern corporate
finance ways of assessing risk and
that is, just so that you get the names,
what we call volatility sometimes also
called the standard deviation
of returns and beta.
Beta is a very widely used variable.
Very famous, quote unquote, and we're
going to encounter beta later on when
we explore the cost of capital in the
third and fourth sessions of this course.
But again, before we actually define and
calculate the standard deviation
of returns or volatility and beta,
keep in mind that we can actually assess
the risk of the four assets we've been
working on, or any other asset,
in many, many, many different ways.
Now, modern portfolio theory
sort of goes back to early 50s.
And in the early 50s, a guy by the name
of Harry Markowitz that eventually
won the Nobel Prize in economics,
precisely, for these contributions
to the risk of individual assets and
to the risk of the portfolio.
What Markowitz actually proposed is
that one way we can think of the risk of

an individual asset is by
the variability of the asset, and
that is technically speaking what we
call the standard deviation of returns.
So, you may or may not know but if I
give you a very long series of returns,
I can actually look at
the distribution of returns.
I can calculate the mean
of that distribution and
that would be the arithmetic mean
that we already talked about, and
I can calculate the standard deviation,
which, basically,
gives you an idea of dispersion
around that arithmetic mean return.
So, I could look at some asset like, for
example, a one-year treasury bill in
which, if we look at all the historical
returns, we calculate the mean return, and
we look at the dispersion
around those mean returns.
Well, that dispersion is
not going to be very large.
And the reason it's not going to be very
large is simply because you didn't get
very high returns and
you didn't get very low returns.
You get returns that are more or less
clustered closely around that mean return.
Now, let's suppose that I give you instead
the distribution of returns of an emerging
markets like Russia.
Well, you calculate
the arithmetic mean return but
then you get returns that are very
far away on the positive side and
very far away from the negative
side from that mean return.
That means that you get
a lot more dispersion.
You get a lot more variability.
Why is that important?
Well, because, one way of
thinking about this volatility or
standard deviation of returns is
simply as a measure of uncertainty.
In the case of the one-year treasury bill,
history tells me that I'm not going to
make a lot of money, and
I'm not going to lose a lot of money.
It's that I have returns that are more or
less predictable within
a fairly narrow range.
But if I look at the history
of the Russian market,
that actually will tell me that
I have a huge uncertainty.
Because there are periods in which I
could have more than doubled my money and

there are periods in which I could

actually lost more than half of my money.
And that uncertainty is precisely what
the standard deviation tends to capture.
That volatility, that uncertainty, that
variability is something that, in finance,
we do not spend a lot of time trying to
think of the actual meaning of a number.
And another way to put that
is to say that, typically,
we use volatility in relative terms.
What does that mean?
Well, let's go back to our data set.
That's the calculation of
the volatility numbers and
let me remind you of one thing.
Let me remind you that the numbers
that we have here are total returns.
The numbers that we have
here are dollar returns.
We have the arithmetic mean returns
already calculated, and what this numbers
basically mean, and remember we're
not doing any formulas here.
You have the formulas in the technical
note that compliments this
particular session.
But if you look at the number for
the US, it's 17.9%, 28% for
Spain, 64% for Egypt and
about 20% for the world market.
And what I was meaning before when
I said that we usually used these
variable in relative terms is
that we compare the 18% for
the US with the 28% with Spain and
we say, well, returns in Spain tend
to fluctuate more and they're more
uncertain than they are in the US.
We compare the 28% of Spain
with 64% of Egypt and we say,
well, just look at the returns.
Returns in Egypt tend to be far more
variable than they are in Spain and
that they are in the US.
In other words, we never tried,
and as much as for example,
for the geometric mean return.
We gave a very clear and
precise definition of what
each of those numbers meant.
For example, the 7.7% for
the world market was the mean
annual compound rate at which
a capital invested evolved over time.
We give a very precise definition.
We're not going to do that for
the standard deviation.
And more often than not,
that's the way we used it.

The higher the number,

the more uncertainty,
the more variability in the data.
And so, do not stress to,
in trying to interpret well,
but what does 28% one mean?
Well, if you actually look at the formula
that we use to calculate a standard
deviation, strictly speaking, what
that is and hold on to your seat here.
This is the square root of the average
quadratic deviation with respect to
the arithmetic mean return.
Now, you can as well forget that.
You're not going to use
the definition in that way.
What matters to you is
that 28 is higher than 18.
64 is higher than 28 and 17.
And 20 is lower than 64 and that gives
you an idea of relative variability,
relative volatility of the markets
that we're actually discussing.
So, that is as far as
the interpretation of the volatility or
standard deviation goes.
The higher this number,
the more dispersion around the mean,
the more variability in the data,
the more uncertainty we have about
the returns that we observed, but
obviously, the more uncertainty we have
about the returns that we expect
from this particular asset.
And again, we're not really
going to go much further in
terms of trying to explain
what we mean by volatility.
We're going to stay with the fact that
the higher this number is, then the more
uncertainty you're going to have about
the expected returns that that asset might
actually give you, particularly from
the point of view of your pocket.
More uncertainty means more uncertainty
in terms of what capital you're going
to have at the end of any given period and
how that capital is going to
be fluctuating over time.
Now, one more thing, and then we move onto
the next measure of risk, which is beta.
And another thing with volatility is,
the reason that sometimes we use it in
relative terms is because
if you work in finance,
you would have some numbers
in the back of your head.
So, for example, historical volatility in
annual terms of the US equity market is
between 17 and 20%, depending on

the periods that you actually look at, but

if you have that number
in the back of your head,
and someone shows you an equity market
with a volatility of 60%, well,
you know that that market
is actually very volatile.
You're going to have a lot of uncertainty,
but if someone actually brings you
an asset with a volatility,
annual volatility of 5%,
then you know that this is very stable
asset, at least compared to the US market.
So, the way that we typically
use volatility is again,
not only in relative terms, but
also in relative terms after having
a few numbers in the back of our head.
So, again, two numbers that you may
want to put in the back of your head,
is historical volatility of the US
equity market, between 17 and 20%.
Historical volatility of the US
bond market, between 8 and
11%, again depending on
the periods that you look at.
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