Module 2:

Risk and return

Course Coordinator: Dr. Noor Ulain Rizvi
Specific Learning Objectives
After completing the module, you should be able to:
• Calculate the total return, return relative, and cumulative wealth index.
• Compute the mean of a return series.
• Explain the rationale for using standard deviation as the principal
measure of risk.

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Introduction
For earning returns investors must almost invariably bear some risk. In general, risk
and return go hand in hand. While investors like returns they abhor risk. Investment
decisions, therefore, involve a tradeoff between risk and return. Since risk and return
are central to investment decisions, we must clearly understand what risk and return
are and how they should be measured.

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 What is risk and return?
Return: represents the reward for undertaking investment.
The return of an investment consists of two components:
• Current Return: the periodic cash flow (income), such as dividend or interest,
generated by the investment.
• Capital Return: Reflected in the price change called the capital return—it is simply
the price appreciation (or depreciation) divided by the beginning price of the asset.

Total return = Current return + Capital return

Risk refers to the possibility that the actual outcome of an investment will differ
from its expected outcome.

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Return

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Measuring historical return

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Measuring historical return
To illustrate, consider the following information about a certain equity share:
• Price at the beginning of the year : $ 60
• Dividend paid toward the end to the year : $ 2.40
• Price at the end of the year : $ 66

The rate of return on this share is calculated as follows:

Question: Out of this 14%, how much is the capital gain percentage? Ans: 10%
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Measuring historical return
To illustrate, consider the following information about a certain equity share:
• Price at the beginning of the year : $ 60
• Dividend paid toward the end to the year : $ 2.40
• Price at the end of the year : $ 69

Answer: 0.19 or 19 percent

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 Relative return
This is required when a cumulative wealth index or a geometric mean has to be
calculated, because in such calculations negative returns cannot be used.

C is the cash payment received during the period, PE is the ending price of the
investment, and PB is the beginning price.

Put differently
Return relative = 1 + Total return in decimals
In our example the return relative is: 1 + 0.19 = 1.19
Note that even though the total return may be negative, the return relative cannot
be negative. At worst it is zero.
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 Cumulative Wealth Index
A return measure like total return reflects changes in the level of wealth.
For some purposes it is more useful to measure the level of wealth (or price) rather
than the change in the level of wealth. To do this, we must measure the cumulative
effect of returns over time, given some stated initial amount, which is typically one
dollar.
The cumulative wealth index captures the cumulative effect of total returns. It is
calculated as follows:

where CWIn is the cumulative wealth index at the end of n years, WI0 is the
beginning index value which is typically one dollar and Ri is the total return
for year i ( i = 1,…n).

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 Cumulative Wealth Index
To illustrate, consider a stock which earns the following returns over a five-
year period: R1 = 0.14, R2 = 0.12, R3 = –0.08, R4 = 0.25, and R5 = 0.02.

The cumulative wealth index at the end of the five-year period, assuming a
beginning index value of one dollar, is:
CWI5 = 1 (1.14) (1.12) (0.92) (1.25) (1.02) = 1.498

Thus, one rupee invested at the beginning of year 1 would be worth $ 1.498 at the
end of year 5.

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While total return, relative return and wealth index are useful measures of return for a
given period, in investment analysis we also need statistics that summaries a series of total
returns.
The two most popular summary statistics are:

• arithmetic mean

• geometric mean

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Arithmetic Mean

where is the arithmetic mean, Ri is the value of the total return (i = 1, … n) and n
is the number of total returns.

When you want to know the central tendency of a series of returns, the
arithmetic mean is the appropriate measure.

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 Arithmetic Mean
To illustrate, suppose the total returns from stock A over a five-year period are as
follows:

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Geometric Mean
When you want to know the average compound rate of growth that has occurred
over multiple periods, the arithmetic mean is not appropriate.
This point may be illustrated with a simple example.

Consider a stock whose price is $ 100 at the end of the year 0. The price declines to
80 at the end of year 1 and recovers to 100 at the end of year 2. Assuming that
there is no dividend payment during the two-year period, the annual returns and
their arithmetic mean are as follows:

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se ns
ake
n m
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 Geometric Mean
Though the return over the two-year period is NIL , the arithmetic mean works
out to 2.5 percent.
So, this measure of average return can be misleading!

In a multi-period context, the geometric mean describes accurately the “true”

average return. The geometric mean is defined as follows:

where GM is the geometric mean return, Ri is the total return for period i (i = 1,….,n),
and n is the number of time periods.

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Fractional exponents: https://www.youtube.com/watch?v=ZbocrrjRiR0
Geometric Mean
To illustrate, consider the total return and return relative for stock A over a 5- year
period:

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Geometric Mean
Interpretation:
The geometric mean reflects the compound rate of growth over time. In the above
illustration stock A has generated a compound rate of return of 8.9 percent over a
period of 5 years. This means that an investment of one rupee produces a
cumulative ending wealth of $

Notice that the geometric mean is lower than the arithmetic mean [9.6 percent] .

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Question
Estimate arithmetic mean and geometric mean from the data on the next slide.

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Data on the S&P CNX Nifty

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Data on the S&P CNX Nifty

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Real returns
The returns discussed so far are nominal returns, or money returns. To
convert nominal returns into real returns, an adjustment has to be
made for the factor of inflation:

Example: The total return for an equity stock during a year was
18.5 percent. The rate of inflation during that year was 5.5
percent. Thus, the real (inflation-adjusted) total return was:

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Risk

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Meaning
Risk refers to the possibility that the actual outcome of an investment will differ

from its expected outcome. More specifically, most investors are concerned about
the actual outcome being less than the expected outcome. The wider the range of
possible outcomes, the greater the risk.

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Types of risk
Types of Risk Modern portfolio theory looks at risk from a different
perspective. It divides total risk as follows.
Total risk of a security = Unique risk + Market risk

Unique risk: portion of total risk which stems from firm-specific factors.
Events of this nature primarily affect the specific firm and not all firms in
general. Hence, the unique risk of a stock can be washed away by
combining it with other stocks. In a diversified portfolio, unique risks of
different stocks tend to cancel each other—a favourable development in one
firm may offset an adverse happening in another and vice versa. Hence,
unique risk is also referred to as diversifiable risk or unsystematic risk.

Example: the development of a new product, a labour strike, or the emergence of a new competitor.
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Types of risk
The market risk of a security represents that portion of its risk which is attributable
to economy-wide factors. Since these factors affect all firms to a greater or lesser
degree, investors cannot avoid the risk arising from them, however diversified their
portfolios may be. Hence, it is also referred to as systematic risk (as it affects all
securities) or non-diversifiable risk.

Example: growth rate of GDP, the level of government spending, money supply, interest rate structure, and
inflation rate. 26
Measuring historical risk
Risk refers to variability or dispersion. If an asset’s return has no variability, it is
riskless. Suppose you are analysing the total return of an equity stock over a period
of time.
Apart from knowing the mean return, you would also like to know about the
variability in returns.

Variance and Standard Deviation: The most commonly used measure of

risk in finance is variance or its square root the standard deviation. The
variance and the standard deviation of a historical return series are defined
as follows:

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Measuring historical risk

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Measuring historical risk
To illustrate, consider the returns from a stock over a 6-year period:
R1 = 15%, R2 = 12%, R3 = 20%, R4 = –10%, R5 = 14%, and R6 = 9%

Calculate the Standard Deviation & Variance

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Measuring historical risk

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Measuring historical risk
Looking at the above calculations, we find that:
• The differences between the various values and the mean value are squared. This
means that values which are far away from the mean value have a much more
impact on standard deviation than values which are close to the mean value.
• The standard deviation is obtained as the square root of the average of squared
deviations. This means that the standard deviation and the mean are measured
in the same units and hence the two can be directly compared.

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Which is superior?
The choice between the two is solely a matter of convenience.
Standard deviation is generally more convenient as it is in the same
units as the rate of return.

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Criticism of Variance (& S D) as a Measure of Risk

Variance considers all deviations, negative as well as positive.

Investors, however, do not view positive deviations unfavourably - in

fact, they welcome it. Hence some researchers have argued that only
negative deviations should be considered while measuring risk.
Markowitz, the father of portfolio theory, himself had recognised this
limitation and suggested a measure of downside risk called semi-
variance.

Semi-variance is calculated the way variance is calculated, except that it considers only negative deviations.
Markowitz, however, chose variance because analytically it can be handled easily.

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Risk Aversion and Required Returns

You are lucky to be invited by the host of a television game show. After the usual
introduction, the host shows two boxes to you. He tells you that one box contains
$ 10,000 and the other box is empty. He does not tell you which one is which.
The host asks you to open any one of the two boxes and keep whatever you find
in it. You are not sure which box you should open. Sensing your vacillation, he
says he will offer you a certain $ 3,000 if you forfeit the option to open a box. You
don’t accept his offer. He raises his offer to $ 3,500. Now you feel indifferent
between a certain return of $ 3,500 and a risky (uncertain) expected return of $
5,000. This means that a certain amount of $ 3,500 provides you with the same
satisfaction as a risky expected value of $ 5,000. Thus your certainty equivalent ($
3,500) is less than the risky expected value ($ 5,000).
Empirical evidence suggests that most individuals, if placed in a similar situation,
would have a certainty equivalent which is less than the risky expected value.

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Risk Aversion and Required Returns

The relationship of a person’s certainty equivalent to the expected monetary

value of a risky investment defines his attitude toward risk. If the certainty
equivalent is less than the expected value, the person is risk-averse; if the
certainty equivalent is equal to the expected value, the person is risk-
neutral; finally, if the certainty equivalent is more than the expected value,
the person is risk-loving.
In general, investors are risk-averse. This means that risky
investments must offer higher expected returns than less risky
investments to induce people to invest in them.
Remember, however, that we are talking about expected returns; the
actual return on a risky investment may well turn out to be less than
the actual return on a less risky investment.
Put differently, risk and return go hand in hand.
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Suggested reading
• Chapter- 4 of the book titled ‘Investment Analysis and Portfolio
Management’ by Prof. Prasanna Chandra

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Extra concepts
The geometric mean is always less than the arithmetic mean, except when all the return values being
considered are equal. The difference between the geometric mean and the arithmetic mean depends
on the variability of the distribution. The greater the variability, the greater the difference between the
two means.

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