FINA 6112 Investment and Portfolio Analysis
Lecture 3: Risk-return tradeoff &
Diversification
LUO Dan
A Way To Model Risk Appetite in Investment
• We assume each investor assigns a utility to a portfolio
" !
! = " # # $ ! A!
!
– 𝑈: Utility value.
– 𝐸 𝑟 : Expected return.
– 𝐴: Index of the investor’s risk aversion.
– 𝜎 ! : Variance of returns.
– ½: scaling factor
• 𝐴 > 0: Risk-averse
• There must be a tradeoff between return and risk.
1
Holding Period Return
• Holding period return over one period
𝑃'() + 𝐷𝑖𝑣'() 𝑃'() − 𝑃' 𝐷𝑖𝑣'()
𝑅'() = −1= +
𝑃' 𝑃' 𝑃'
"!"# #"!
– Capital gain:
"!
$%&
– Dividend yield: !"#
"!
• How do we deal with dividends?
– Compounding: all dividends are immediately reinvested and used
to purchase additional shares of the same stock or security.
– If a stock has realized returns RQ1, . . . ,RQ4 each quarter, then its
annual realized return, Rannual, is computed as follows:
%)*)"!""#!$ )+),%)*)"!% -,%)*)"! & -,%)*)"! ' -,%)*)"! ( -
2
Exercise: Holding Period Return
Problem
– What is the realized annual return for BFI stock in
2018?
Date Price($) Dividend($)
12/31/2017 6.73 0
3/31/2018 5.72 0
6/30/2018 4.81 0
9/30/2018 5.2 0
12/31/2018 2.29 0
Solution
– 2.29/6.73 − 1 = −66%
3
Exercise: Holding Period Return
Problem
– What is the realized annual return for BFI stock in
2022?
Date Price($) Dividend($)
12/31/2021 58.69 blank
1/31/2022 61.44 0.26
4/30/2022 63.94 0.26
7/31/2022 48.5 0.26
10/31/2022 54.88 0.29
12/31/2022 53.31 blank
4
Exercise: Holding Period Return
Solution
Date Price($) Dividend($) Return
Blank
12/31/2021 58.69 blank
1/31/2022 61.44 0.26 5.13%
4/30/2022 63.94 0.26 4.49%
7/31/2022 48.5 0.26 −23.74%
10/31/2022 54.88 0.29 13.75%
12/31/2022 53.31 blank −2.86%
• With compounding: 𝑅!"!! = −7.43% √
𝑅!*!! = 1 + 5.13% 1 + 4.49% 1 − 23.74% 1 + 13.75% 1 − 2.86% − 1
• Without compounding: 𝑅 = −7. 34% ×
𝑅 = (53.31 + 0.26 + 0.26 + 0.26 + 0.29)/58.69 − 1
5
Risk and Return
• How would $100 have grown if it were placed in one of the
following investments?
– Cash: save money in a checking account offering zero interest
– Treasury Bills: An investment in three-month Treasury bills
– Corporate Bonds: Long-term, AAA-rated U.S. corporate bonds
with maturities of approximately 20 years
– World Portfolio: International stocks from all the world’s major
stock markets in North America, Europe, and Asia
– Standard & Poor’s 500: 90 U.S. stocks up to 1957 and 500 after
that. Leaders in their industries and among the largest firms
traded on U.S. Markets
– Small stocks: Securities traded on the NYSE with market
capitalizations in the bottom 20%
6
Value in 2020 of $100 Invested in 1925
• What is the real return of holding cash?
• What is the real return of holding S&P 500?
7
Value in 2020 of $100 Invested in 1925
• What is the real return of holding cash?
!""#
– Since the price level in 2020 is !$$
times as much as that in 1925, $100
!$$
in 2020 is equivalent to $100× !""# in 1925. So, the real return is
100
100×
1558 − 1
100
• What is the real return of holding S&P 500?
– Holding S&P 500, we end up with $1.273m in 2020. So, the real return is
100
$1.273m×
1558 − 1
100
8
Risk and Return
• Finding
– Small stocks had the highest long-term returns, while T-Bills had
the lowest long-term returns
– Small stocks had the largest fluctuations in price, while T-Bills had
the lowest
• Few people ever make an investment for so long
– More realistic investment horizons and different initial investment
dates can greatly influence each investment's risk and return
9
Value of $100 Invested in Alternative
Investment for Differing Horizons
Source: Chicago Center for Research in Security Prices, Standard and Poor’s, M SCI, and
Global Financial Data.
10
Empirical Distribution
• The probability distribution plotted using historical
data
11
Empirical Distribution
• Average Return
! ! !
#$#$ $( #! $%$#" $%$!$%$#! )$#$ ! #"
! ! " #!
• Standard Deviation
$ !
"" ( &" !"& )
!
#$% % &&"#" !"! #"#$# $%& ! #"#
! "!"$ ""#"$
Return Volatility
Investment Average Annual Return
(Standard Deviation)
Small stocks 18.7% 39.2%
S&P 500 12.0% 19.8%
Corporate bonds 6.2% 6.4%
Treasury bills 3.4% 3.1%
12
The Tradeoff Between Risk and Return
• The Returns of Large Portfolios
13
The Tradeoff Between Risk and Return
• The Returns of individual stocks
Source: CRSP
14
The Returns of Individual Stocks
• There is no precise relationship between volatility and
average returns for individual stocks
– The positive relationship is much looser than that for large
portfolios.
• Larger stocks tend to have lower volatility than smaller
stocks
• All stocks tend to have higher risk and lower returns than
large portfolios
15
The Structure of Risks
• Systematic Risk
– affects all securities
– Correlated across assets
• Idiosyncratic or asset-specific Risk
– affects a particular asset
– Uncorrelated across assets
• Idiosyncratic risks are averaged away in a large portfolio.
!"!"#A%&%A'()*+%I-.
!"!/&0N(O0*34*"#A0R0#A0#67*"A0#6%8()*+%I-I.*9*
:';<0N*34*=<I0N&(6%3#I
16
Exercise: Casino Business
Problem
– Roulette wheels are very common in casinos. They are typically
marked with the numbers 1 through 36 plus 0 and 00. Each of
these outcomes is equally likely every time the wheel is spun.
– For one bet, you can place $1 on any one number, and if it is
correct, the payoff is 35:1;
§ You will receive $36 if you win ($35 plus your original $1) and
nothing if you lose.
– Suppose you place a $1 bet on your favorite number. What is the
casino’s expected profit and its standard deviation for this single
bet?
– If there are 9 million bets each month, what is the range that the
casino’s profit likely falls in?
17
Exercise: Casino Business
Solution
• Because there are 38 numbers on the wheel, the odds of winning are
1/38. The casino loses $35 if you win, and makes $1 if you lose. The
casino’s expected profit is
! !"#$%&&' ( !) * +,' - ! !.+/' 0 !+1 * +,' - !.)' ( .2P2/45
• That is, for each dollar bet, the casino earns 5.26 cents on average.
For a single bet, the SD is
!""#$%&''( ) "* + ,-( . " !,/ ! 010/!2( ! P ",4 + ,-( . "* ! 010/!2( ! ) 5/142
18
Exercise: Casino Business
• Since each bet’s outcome is independent, the SD of the casino’s
average profit per dollar bet is only
!"#A%
!"&'()*+,)-.+/0112 P P !4#4456
67 4447 444
• There is roughly 95% chance the casino’s profit per dollar bet will be in
the interval
0.0526 ± 2×0.0019 = 0.0488 𝑡𝑜 0.0564
• Given $9 million in bets placed, the casino’s monthly profits will almost
always be between $439,000 and $508,000, which is very little risk.
• If you bet many times, you will lose almost surely!
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Idiosyncratic vs. Systematic Risk
• Asset values fluctuate because new information arrives.
– Idiosyncratic risk, induced by news that affects only an individual
firm
– Systematic Risk, induced by news that affects all firms
Which of the following risks are likely to be idiosyncratic, and
which are likely to be systematic?
a. The risk that the founder and CEO retires
b. The risk that oil prices rise, increasing production costs
c. The risk that a product design is faulty, and the product must be
recalled
d. The risk that the economy slows, reducing demand for the firm’s
products
20
Idiosyncratic vs. Systematic Risk
• Idiosyncratic risk
– Business risk: the operational efficiency of the business.
– Financial risk: the robustness of the firm’s capital structure
– Fraud risk: the authenticity of accounting information
– Litigation risk: the results of lawsuits
• Systematic Risk
– Macro risk: pandemic, monetary policy
– Technology risk: superconductor, nuclear fusion
– Political risk: U.S. election, China’s anti-corruption activities
– Climate risk: sea level, the chance of typhoon
21
Diversifiable Risk
• When many assets are combined in a large portfolio, the
idiosyncratic risks of each asset will be diversified but
systematic risk will not.
• Consider two types of firms:
– Type S firms are affected only by systematic risk
§ There is a 50% chance the economy will be strong and type S
stocks will all earn a return of 40%
§ There is a 50% chance the economy will be weak and their
return will all be −20%
– Type I firms are affected only by idiosyncratic risk
§ Their returns are equally likely to be 40% or −20%, based on
factors specific to each firm
22
Diversifiable Risk
23
Risk Premium Depends on Systematic Risk
• If the diversifiable risk of a stock was compensated with an
additional risk premium, then what will an investor do?
– Investors could buy the stock, earn the additional premium, and
simultaneously diversify and eliminate the risk
– Investors’ purchases of the stock pushes up the stock price and
reduces its expected return
– So, the risk premium will be lower.
• This opportunity to earn something for nothing would
quickly be exploited and eliminated
• The risk premium for diversifiable risk is zero and is
determined by only its systematic risk.
24
The Tradeoff Between Risk and Return
• A stock’s volatility is not a so useful measure. What is
useful?
Source: CRSP
25
Measuring Systematic Risk
• Efficient Portfolio
– A portfolio that contains only systematic risk
– Nondiversifiable: no way to reduce the volatility of the portfolio
without lowering its expected return
• Market Portfolio
– A portfolio that contains all shares and securities in the market
– Later, we will show that the market portfolio is efficient under
certain assumptions.
– The S&P 500 is often used as a proxy for the market portfolio
26
Measuring Systematic Risk
• Sensitivity to Systematic Risk: Beta (β)
– The expected percent change in the excess return of a security for
a 1% change in the excess return of the market portfolio
Problem
– Suppose the market portfolio tends to increase by 52% when the
economy is strong and decline by 21% when the economy is
weak.
– What is the beta of a type S firm whose return is 55% on average
when the economy is strong and −24% when the economy is
weak?
– What is the beta of a type I firm that bears only idiosyncratic, firm-
specific risk?
27
Exercise: Beta
Solution
– The systematic risk of the strength of the economy
produces a 52% − (−21%) = 73% change in the return
of the market portfolio.
– The type S firm’s return changes by 55% − (−24%) =
79% on average.
!"#
– So, the type S firm’s beta is !! $ $ %&'()&
!*#
– The type I firm will have the same expected return,
whether the economy is strong or weak, so its beta is
0
𝛽) = = 0.
73%
28
Measuring Systematic Risk
• A security’s beta is related to how sensitive its underlying
revenues and cash flows are to general economic
conditions
• Stocks in cyclical industries are likely to be more sensitive
to systematic risk and have higher betas than stocks in
less sensitive industries
• What industries are not so cyclical? What are more
cyclical?
29
Betas for Individual Stocks
• With Respect to the S&P 500 based on Monthly Data for 2017-2022
Company Ticker Industry Equity Beta
Campbell Soup CPB Packaged Foods 0.27
Walmart Stores WMT Superstores 0.41
Newmont Mining NEM Gold 0.49
Consolidated Edison ED Utilities 0.52
Procter & Gamble PG Household Products 0.56
McDonald’s MCD Restaurants 0.78
Coca-Cola KO Soft Drinks 0.83
United Parcel Service UPS Air Freight and Logistics 0.91
Starbucks SBUX Restaurants 1.05
Apple AAPL Computer Hardware 1.06
Foot Locker FL Apparel Retail 1.30
General Motors GM Automobile Manufacturers 1.49
Prudential Financial PRU Insurance 1.53
NVIDIA NVDA Semiconductors 1.53
Macy’s M Department Stores 1.61
Wynn Resorts Ltd. WYNN Casinos and Gaming 1.92
United Airlines UAL Airlines 1.97
Systemic Risk
• Different from systematic risk.
– Systemic risk is the possibility that an event at the company level
could trigger severe instability or collapse of an entire industry or
economy.
– Idiosyncratic shocks result in systematic problems.
• A major contributor to the GFC in 2008.
– Started with a relative idiosyncratic shock: collapse of subprime
mortgages
– Amplified to a recession of the whole economy
31
Systemic Risk: AIG’s Story
• [Link]
• AIG to the whole finance industry
– If AIG went bankrupt, the investors who held the CDS would likely go
bankrupt as well.
– These bankruptcies would cause financial strain on these investors’
creditors, causing a domino effect on financial institutions throughout the
world
• The finance industry to the whole economy
– Financial Intermediaries are necessary for many financing activities.
– The strain on the finance industry causes a tightening of financial
conditions making it harder for non-financial companies to receive loans.
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