MGF 633: Investments

Risk and Return

(BKM Chapter 5)
Buffett Warns Investors To Avoid
Borrowing Money To Buy Stocks
• In his letter to shareholders, Buffett cites own experience
with Berkshire's shares as "the strongest argument I can
muster against ever using borrowed money to own stocks,"
as quoted by CNBC.

• In the intervening years, Buffett said Berkshire's stock has

endured four periods in which it endured big declines:
down 59% in 1973-1975, down 37% in 1987, down 49%
in 1998-2000, and down 51% in 2008-2009. "There is
simply no telling how far stocks can fall in a short period,"
he writes, as quoted by CNBC.
Objectives

• Interest rates
• Concepts of return and risk
• Calculate return and risk
• Concepts of real return
• Historical evidence on the relation between risk and return
• Concepts of risk averse
INTEREST RATE
Inflation and Real Returns
• Historically (after 1926) the inflation rate has been about 3%.

• Assume i = inflation, then

1 + rnominal
rreal = −1
1+ i
rreal  rnominal − i
• You invest $1 in a stock with a one-year return of 10%. The one-year
inflation rate is 4%. What is the stock’s real return rate?
• As the inflation rate increases, investors will demand higher nominal
rates of return
• If E(i) denotes current expectations of inflation, then we get the Fisher
Equation:
rn = rr + E ( i )
Determination of the Equilibrium Real
Rate of Interest
Interest rates with different holding
horizons
• Zero Coupon Bond:
• Par = $100
• Maturity = T
• Price = P
• Total risk free return

100
rf (T ) = −1
P(T )
Interest rates with different holding
horizons
Interest rates with different holding
horizons
• EAR (effective annual rate): Percentage increase in funds
invested over a 1-year horizon
1
– 1 + 𝐸𝐴𝑅 = [1 + 𝑟𝑓 (𝑇)] 𝑇

• APR (annual percentage rate): Annualizing using simple

interest
(1+𝐸𝐴𝑅)𝑇 −1
– 𝐴𝑃𝑅 =
𝑇

• Continuous compounding rate:

– 𝑟𝑐𝑐 = ln(1 + 𝐸𝐴𝑅)
Interest rates with different holding
horizons
T-Bill and Inflation (1926-2015)
History of T-bill Rates, Inflation and Real
Rates for Generations, 1926-2015
But, inflation is back…
RETURN AND RISK
General Perception on Risk and Return
-- Looking Ahead
• A broker tells Peter, “ if you buy Stock XYZ, you will earn
10% under normal circumstances.”
– This means expected return E (r ) = 10%

• Peter asks, “What is the chance for this return?”

– This implies the realization of uncertainty or risk.

• The broker says, “Well. It is hard to say. The probability

for this return is around 70%.”

• Peter asks, “How much will I lose if this does not occur?”
What are Returns?
• When we speak of “returns”, we always mean holding
period returns (HPR).
– Stocks: capital gain plus dividend yield
– Bonds: capital gain plus current yield
P1 − P0 D1 P1 − P0 + D1
– E.g.: HPR = + =
P0 P0 P0
• Suppose,
P0 = Beginning price = $40
P1 = Ending price = $48
D1 = Dividend paid during period 1 = $2
then, 48 − 40 + 2
HPR = = 0.25
40
Example
Expected Return: Scenario or Subjective Returns
s
E (r ) =  p s r s
1

p(s) = probability of a state

r(s) = return if a state occurs
possible states: 1, 2, 3, … s
Expected Returns: Example
State of economy Probability Return r in state
1. Very bad 0.10 -0.05
2. Bad 0.20 0.05
3. Average 0.40 0.15
4. Good 0.20 0.25
5. Very good 0.10 0.35

E(r) = (0.10)×(-0.05) + (0.20) ×(0.05) + (0.40) ×(0.15)

+ (0.20) ×(0.25) + (0.10) ×(0.35)
E(r) = 0.15
 Estimate E(r) Using Historical Data – Looking Back

• Arithmetic Average:
1 n
r =  s =1 r ( s )
n
• Using the following numbers to calculate arithmetic average:

Year Return
 
 
 −
 
 
 Historical Returns (1)
• Real return for U.S securities:

Period T-bills T-bonds Stocks

1802 - 1870 5.1% 4.8% 7.0%
1871 - 1925 3.2% 3.7% 6.6%
1926 - 2001 0.7% 2.1% 6.9%
1802 - 2001 2.9% 3.5% 6.9%

• Investing a dollar in 1926:

Security Type Start Date Investment Amount Real Worth 2001
T-bills 1926 $1.00 $1.70
Stocks 1926 $1.00 $159.33
Historical Returns (1926-2015)
Return Differences

• Return differences between stocks and bonds

– From 1802-2001 stocks out performed T-bills by over
4% per year.
– From 1926-2001 stocks outperformed T-bills by over
6% a year.
• Why would anyone invest in bonds instead of stocks?
Risk - Scenario or Subjective Measure
• Risk: the uncertainty of a return and the potential for
financial loss

• Measuring risk: Standard deviation (σ) is the most popular

measure.

( ) ( ) (
 = E r s − E( r ) =  p s  r s − E( r )
2
2

s
)
2

 = 2
Risk - Scenario or Subjective Measure
• Risk: the uncertainty of a return and the potential for
financial loss

• Measuring risk: Standard deviation (σ) is the most common

used measure.

 2 = E rs − E (r ) =  ps * rs − E (r )
2 2

 = 2 Probability Return of a state

Expected Returns: Example
State of economy Probability Return r in state
1. Very bad 0.10 -0.05
2. Bad 0.20 0.05
3. Average 0.40 0.15
4. Good 0.20 0.25
5. Very good 0.10 0.35

E(r) = (0.10)×(-0.05) + (0.20) ×(0.05) + (0.40) ×(0.15)

+ (0.20) ×(0.25) + (0.10) ×(0.35)
E(r) = 0.15
Risk - Scenario or Subjective Measure
• Risk: the uncertainty of a return and the potential for
financial loss

• Measuring risk: Standard deviation (σ) is the most common

used measure.

 2 = E rs − E (r ) =  ps * rs − E (r )
2 2

 = 2
Probability Return of a state

• Using numbers in previous example:

 2 = [0.1*(-0.05 - 0.15)2 + 0.2*(0.05 - 0.15)2...+ 0.1*(0.35 - 0.15)2]
= 0.01199
 = [0.01199]1/2 = 0.1095
Time Series Analysis of Past Rates of Return

• However, true means and variances are unobservable

– Possible scenarios like the one in the examples are
unknown

• Means and variances must be estimated

Estimate σ - Looking Back
• We use sample estimates as approximations for the true
variances and standard deviations.
1

n   2
ˆ =
2
 r ( s ) − r 
n −1 s =1  

2
ˆ = ˆ

Notice division by n-1 rather than n with historical data.

Estimate σ - Looking Back
• We use sample estimates as approximations for the true
variances and standard deviations.
1

n   2
ˆ =
2
 r ( s ) − r 
n −1 s =1  

2
ˆ = ˆ

Notice division by n-1 rather than n with historical data.

• Historical σ:
Period: 1926 - 2001 T-bills T-bonds Stocks
Average Real Returns 0.70% 2.10% 6.90%
Standard Deviation 4.10% 10.70% 20.30%
The Normal Distribution 1

Mean =  SD = 

The Normal Distribution 2

Mean =  SD = 

The Normal Distribution 3
• Investment management is easier with normal returns:
– Symmetric Returns → Standard deviation is a good
measure of risk

– Symmetric Returns → Portfolio returns will be as well

– Only mean and standard deviation needed to estimate

future scenarios
Other risk measures
• What if excess returns are not normally distributed?
– Skewness and kurtosis
• Value at Risk (VaR)
– Loss corresponding to a very low percentile of the
entire return distribution, such as the fifth or first
percentile return
• Expected Shortfall (ES)
– Also called conditional tail expectation (CTE), focuses
on the expected loss in the worst-case scenario (left tail
of the distribution)
– More conservative measure of downside risk than VaR
Other risk measures
• Lower Partial Standard Deviation (LPSD)
and the Sortino Ratio
• Similar to usual standard deviation, but uses only
negative deviations from the risk-free return, thus,
addressing the asymmetry in returns issue
• Sortino Ratio (replaces Sharpe Ratio)
• The ratio of average excess returns to LPSD
 Source: Liang and Park (2006)
Other measures of risk
• Semi-deviation (SEM): similar to standard deviation except we consider the
deviation from the mean only when return is negative

– 𝑆𝐸𝑀 = 𝐸 𝑀𝑖𝑛 𝑟 − 𝜇 , 0 2

• Value-at-risk (VaR): summarize the total risk in a portfolio using a single

number. Usually in the form of following statement: we are (1 − 𝛼) percent
certain that we will not lose more than VaR(𝛼, 𝜏) dollar in 𝜏 days.
−1
– VaR 𝑡 𝛼, 𝜏 = −𝐹𝑅,𝑡 (𝛼)

• Expected shortfall (ES): VaR does not provide information on how big the loss
could be once it is breached. ES tries to measure this quantity. ES is the average
loss greater or equal to VaR.

– ES𝑡 𝛼, 𝜏 = −𝐸𝑡 𝑅𝑡+𝜏 |𝑅𝑡+𝜏 ≤ −𝑉𝑎𝑅𝑡 𝛼, 𝜏

• Tail risk (TR): while ES represents the mean of losses larger than VaR, TR
measures the deviation of losses larger than VaR from mean.
2
– TR 𝑡 𝛼, 𝜏 = 𝐸𝑡 𝑅𝑡+𝜏 − 𝐸𝑡 𝑅𝑡+𝜏 |𝑅𝑡+𝜏 ≤ −𝑉𝑎𝑅𝑡 𝛼, 𝜏
Tail risk
• Usually refers to the left side of a probability distribution which represents
extreme negative events. (Nasdaq)

S&P 500 Index - 30 Year Historical Chart. source: macrotrends

Historic Returns on Risky Portfolios:
Treasury Bills and Bonds
Daily S&P 500 Return : 1926 - 2007
Monthly S&P 500 Return : 1926 - 2007
Annual S&P 500 Return : 1926 - 2007
 More about history…

Portfolio Statistics 1926-2005 1966-2005 1981-2005

World avg. return 11.46 12.12 13.45
large stocks SD 18.57 17.72 17.84
U.S. avg. return 12.15 11.64 13.65
large stocks SD 20.26 16.97 16.02
U.S. avg. return 17.95 14.98 12.27
Small stocks SD 38.71 29.58 20.24
World avg. return 6.14 9.40 11.22
bond SD 9.09 9.56 10.89
Long-term avg. return 5.68 8.17 10.28
U.S. treasury SD 8.09 9.97 10.80
U.S. T-bills avg. return 3.75 5.98 5.73
SD 3.15 2.84 3.15
Historical Returns Around the World, 1900-2000
How Do Investors View “Risk”?

• Consider the following investment options

– Option A: Invest $1000 today and receive $1100 after
one year with certainty
– Option B: Invest $1000 today and one year later toss a
coin:
• If Heads, receive $2,000
• If Tails, receive $200

• Which option would you prefer?

 Why?
• Expected Return:
– Option A: E(r) = (1100 - 1000)/1000 = 10%
– Option B: Expected payoff = 0.5*2000 + 0.5*200 =
$1100.
• E(r) = (1100 - 1000)/1000 = 10%
• Risk:
– Option A: σ = 0
– Option B: σ2 = 0.5(1 - 0.1)²+ 0.5(-0.8 - 0.1)²= 81%
Another Set of Choices

• Option A: Invest $1000 today and receive $1100 after

one year with certainty

• Option B: Invest $1000 today and one year later toss a

coin:
• If Heads, receive $2000
• If Tails, receive $400
What are the expected rates of return and σ now?

• Expected Return:
– Option A: E(r) = (1100 - 1000)/1000 = 10%
– Option B: Expected payoff = 0.5(2000) + 0.5(400)
= $1200. E(r) = (1200 - 1000)/1000 = 20%
• Risk:
– Option A: σ = 0
– Option B: σ2 = 0.5(1 - 0.2)²+ 0.5(-0.6 - 0.2)²=
64%
Suppose option B was modified as:

Option B: Invest $1000 today and one year later toss a

coin:
– If Heads, receive $2000
– If Tails, receive $800
What can we learn from the responses?

• Rate of return in option A is risk free.

• Investors are generally risk averse
• Risk averse investors require a risk premium to
induce them to invest in risky assets
– consistent with historical returns
• Key Question: What is the required risk premium for a
given asset?
– Risk of the asset
– Investor risk aversion (or tolerance)
 Risk Premium and Excess Return
• Excess return:
– It is the difference between the actual rate of return
and the risk-free rate.
• Risk premium is the reward for bearing risk.
– It is the difference between the expected return and the
risk-free rate.
Equity Premium Puzzle

• Historically, rstock − rt-bill ≈ 6%

– It’s called Equity Premium.

• Many economists think 6% is too big.

– Yes, economists agree that stocks are riskier.
– But not risky enough to justify 6% per year.
– It is a puzzle—given the historical return data—why
everyone isn’t holding 100% stocks and 0% bills or
bonds.
 Sharpe Ratio (Nobel winner 1990, William F. Sharpe)
• Sharpe ratio is a basic measure of portfolio performance,
obtained by dividing the average return in excess of risk
free rate by the standard deviation of excess return.
• Use numbers in the earlier example, and assume that risk
free rate was 1.2%
Year Return
 
 
 −
 
 

Sharpe ratio = Risk premium/SD of excess return

E (r − rf )
=
var(r − rf )
History of Excess Return
Portfolio Statistics 1926-2005 1981-2005
World avg. excess return 7.71 7.73
large stocks SD of excess return 18.9 18.33
Sharpe ratio 0.41 0.42
U.S. avg. excess return 8.39 7.92
large stocks SD of excess return 20.54 16.12
Sharpe ratio 0.41 0.49
U.S. avg. excess return 14.2 6.54
Small stocks SD of excess return 39.31 20.7
Sharpe ratio 0.36 0.32
World avg. excess return 2.39 5.49
bond SD of excess return 8.97 11.58
Sharpe ratio 0.27 0.47
Long-term avg. excess return 1.93 4.55
U.S. treasury SD of excess return 7.91 11.01
Sharpe ratio 0.24 0.41