Risk and Return

Risk and Return

• Return on Investment- make money on investment, two components that contribute to our returns (dividends and stock price appreciation)

• Percentage return= capital gains yield and dividend yield

• Distribution is to look at a distribution of either standard deviation or variance

• Stocks with greater standard deviation have will likely fall further from our expected return

• The greater the volatility the greater the risk

• The volatility of stocks is much higher than the volatility of bonds and T-bills

• Risk increases so does return

• More volatile the stock the higher the return

• Portfolios (diversifying risk)-

o Reduce volatility by grouping assets into portfolios

• Example- the returns for a portfolio of all drug companies will have much less volatility than that of a single drug company

• Example- portfolio for all companies would be less risky than one sector

• Two types of risk

o Firm specific risk- can be diversified with a portfolio

o Market level risk, Non-diversifiable risk- cannot be eliminated

• Companies can’t control market level risk

• As we include more stocks in the portfolio the volatility of returns lessens

• More stocks the less risk there is of falling below of return expectations

• How does diversification work

• If two stocks are perfectly positively correlated, diversification has no effect on risk

• Want less than perfect correlation

• Any risks that can be diversified away will not be compensated

Measuring Risk: Beta

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