Investment Income

and Risk

LEARNING OUTCOMES:
At the end of this lesson, the students will be able
to do the following:
Explain the concept of return and risk.

Differentiate between historical returns and expected returns.

Appreciate the importance of statistical tools in decision making.

INTRODUCTION:

Welcome to the first lesson of Module 1 student! A return is the ultimate objective for any investor.
But a relationship between return and risk is a key concept in finance. As finance and investments areas are
built upon a common set of financial principles, the main characteristics of any investment are investment
return and risk. So, enjoy and have fun reading this lesson!

ACTIVITY: Fill me up.

In this activity, you will calibrate your understanding on how well you comprehend the words written
in the green boxes on the left. You will write a word or a phrase on the corresponding boxes on the right side
which describes the first thing that will come out in your mind when you hear these words. There will be three
answers in each word. Present your answer to the class.
1.)
2.)
3.)

1.) Return
2.)
3.)
Risk

Probability

1.)
2.)
3.)
ANALYSIS: Let’s see what you’ve got!
“Do you think the words
are related to investing?”

ABSTRACTION:

Investment income and risk

A return is the ultimate objective for any investor. But a relationship between
return and risk is a key concept in finance. As finance and investments areas are built
upon a common set of financial principles, the main characteristics of any investment
are investment return and risk.

Return on investment and expected rate of return

General definition of return is the benefit associated with an investment. In most
cases the investor can estimate his/ her historical return precisely.

Many investments have two components of their measurable return:

 a capital gain or loss;
 some form of income.
The rate of return is the percentage increase in returns associated with the
holding period:

Rate of return = Income + Capital gains / Purchase price (%) (2.1)

For example, rate of return of the share (r) will be estimated:

D + (Pme - Pmb)
R = ------------------------------- (%) (2.2)

Pmb

Here D - dividends;
Pmb - market price of stock at the beginning of holding period;
Pme - market price of stock at the end of the holding period.
 The rate of return, calculated in formulas 2.2 and 2.3 is called holding period
return, because its calculation is independent of the passages of the time. All the
investor knows is that there is a beginning of the investment period and an end. The
percent calculated using this formula might have been earned over one month or other
the year. Investor must be very careful with the interpretation of holding period returns
in investment analysis. Investor can‘t compare the alternative investments using
holding period returns, if their holding periods (investment periods) are different.
Statistical data which can be used for the investment analysis and portfolio formation
deals with a series of holding period returns. For example, investor knows monthly
returns for a year of two stocks. How he/ she can compare these series of returns? In
these cases arithmetic average return or sample mean of the returns (ř) can be
used:
n

 ri
i=1

ř = ---------, (2.3)
n

here ri - rate of return in period i;

n - number of observations.

But both holding period returns and sample mean of returns are calculated
using historical data. However what happened in the past for the investor is not as
important as what happens in the future, because all the investors ‘decisions are
focused to the future, or to expected results from the investments. Of course, no one
investor knows the future, but he/ she can use past information and the historical data
as well as to use his knowledge and practical experience to make some estimates about
it. Analyzing each particular investment vehicle possibilities to earn income in the
future investor must think about several „scenarios“ of probable changes in macro
economy, industry and company which could influence asset prices ant rate of return.
Theoretically it could be a series of discrete possible rates of return in the future for the
same asset with the different probabilities of earning the particular rate of return. But
for the same asset the sum of all probabilities of these rates of returns must be equal to
1 or 100 %. In mathematical statistics it is called simple probability distribution.
The expected rate of return E(r) of investment is the statistical measure of
return, which is the sum of all possible rates of returns for the same investment
weighted by probabilities:
 n

E(r) =  hi  ri , (2.4)
i=1

Here hi - probability of rate of return;

ri - rate of return.
In all cases than investor has enough information for modeling of future
scenarios of changes in rate of return for investment, the decisions should be based on
estimated expected rate of return. But sometimes sample mean of return (arithmetic
average return) are a useful proxy for the concept of expected rate of return. Sample
mean can give an unbiased estimate of the expected value, but obviously it‘s not
perfectly accurate, because based on the assumption that the returns in the future will
be the same as in the past. But this is the only one scenario in estimating expected rate
of return. It could be expected, that the accuracy of sample mean will increase, as the
size of the sample becomes longer (if n will be increased). However, the assumption,
that the underlying probability distribution does not change its shape for the longer
period becomes more and more unrealistic. In general, the sample mean of returns
should be taken for as long time, as investor is confident there has not been significant
change in the shape of historical rate of return probability distribution.

Investment risk
Risk can be defined as a chance that the actual outcome from an investment
will differ from the expected outcome. Obvious, that most investors are concerned that
the actual outcome will be less than the expected outcome. The more variable the
possible outcomes that can occur, the greater the risk. Risk is associated with the
dispersion in the likely outcome. And dispersion refers to variability. So, the total risk
of investments can be measured with such common absolute measures used in
statistics as
• variance;
• standard deviation.
Variance can be calculated as a potential deviation of each possible investment
rate of return from the expected rate of return:
n

²(r) =  hi   ri - E(r) ² (2.5)

i=1
 To compute the variance in formula 2.5 all the rates of returns which were
observed in estimating expected rate of return (ri) have to be taken together with their
probabilities of appearance (hi).
The other an equivalent to variance measure of the total risk is standard
deviation which is calculated as the square root of the variance:

(r) = √  hi ri - E(r)² (2.6)

In the cases than the arithmetic average return or sample mean of the returns
(ř) is used instead of expected rate of return, sample variance (²r ) can be calculated:
n

 (rt - ř) ²
t=1

²r = -------------------- (2.7)

n– 1

Sample standard deviation (r) consequently can be calculated as the

square root of the sample variance:

r = √ ²r (2.8)

Variance and the standard deviation are similar measures of risk and can be
used for the same purposes in investment analysis; however, standard deviation in
practice is used more often.

Variance and standard deviation are used when investor is focused on

estimating total risk that could be expected in the defined period in the future. Sample
variance and sample standard deviation are more often used when investor evaluates
total risk of his /her investments during historical period – this is important in
investment portfolio management.
APPLICATION: Answer the questions below brief but concise.

1. Why methods and tools of the statistics

are so important in investment decision
making.
2. Distinguish between historical returns and
expected returns.

Congratulations! Job well done! Now

onwards to the next lesson. Good luck!