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Basic Risk and Return Concept
Risk refers to the chance that some unfavorable event will occur. There is risk
whenever future outcomes are not completely certain. In finance, risk is associated
with the variability of an asset’s return. Hence, if there is possibility that the actual
return of an asset could differ from the expected return, then, the investment involves
risk. The greater the variability, the higher the risk. While actual return may be above
or below than the expected return, it should be noted that risk is usually associated
to the probability of loss or earning less than expected.
1. Risk and Return Relationship
Investment risk is related to the probability that the actual return is less than the
expected return and the greater the chance of low or negative returns, the riskier the
investment.
Generally, investors are risk averse, which means as much as possible investor will
try to avoid risk. However, it is possible to persuade the investors will be persuaded
to take the risk when they will be compensated for it.
Risk and return have direct relationship to each other. If the investment involves
lower risk, you can expect that it will also give you lower returns. On the other hand,
if the investment involves higher risk, you can expect that such investment will give
you higher returns; otherwise, you will not plunge in that particular investment.
Returns are higher for high risk investments as compared to low risk investments and
the difference is considered a risk premium to compensate the investors for taking
the risk.
2. Using Probability and Probability Distribution in Evaluating Investments
Probability and probability distribution can be used in evaluating investments by
computing the expected return. As an illustration, assume that two investment
projects are available to Mr. Martinez who has P100,000 investible funds. He is
considering the following:
a. Investment in XO Products, Inc., a manufacturer and distributor of computer
terminals and equipment for a rapidly growing data transmission industry; or
b. Investment in Tagum Electric Company which supplies an essential service.
The rates of return probability distribution for the two companies are as follows:
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XO PRODUCTS, INC.
State of the Probability Rate of Return Expected Rate
Economy of Occurrence (%) of return
(a) (b) (a x b)
Boom 0.30 100 30
Normal 0.40 15 6
Recession 0.30 (70) (21)
Expected Value of Outcome= 15%
Tagum Electric Company
State of the Probability Rate of Return Expected Rate
Economy of Occurrence (%) of return
(a) (b) (a x b)
Boom 0.30 20 6
Normal 0.40 15 6
Recession 0.30 10 3
Expected Value of Outcome= 15%
Based on the payoff matrix presented above, both companies have the same
expected return of 15%. Suppose the investor wishes to invest his money to only one
company, which of the two companies would he invest in? Perhaps, we might suggest
that Mr. Martinez can just invest to any of the two companies since both will give the
same expected return.
If we will only consider the expected value criteria, the suggestion to invest to any of
the companies may seem to be appropriate. However, if we will take a closer look of
the variability of the possible outcomes, we might offer a different proposition.
The range of probable returns for XO Products is from +100% to -70%. This means
that if the economy is in a boom state, it can give the investor earnings of as much
as 100%; however, if the economy is in recession state, investor can incur a loss in
as much as 70% of the investment. On the other hand, the probable returns for
Tagum Electric Company is from +20% to +10%. This means that if the economy is
in a boom state, it can give the investor earnings of 20%, which is far lower than what
XO Products can offer. However, the good thing about Tagum Electric Company is
that even if the economy is in recession, the investor can still earn 10% of his
investment as compared to XO Products where investor will already incur a loss.
We can say that range of returns of XO Products is more dispersed as compared to
Tagum Electric Company. It can be recalled that risk is associated with the variability
of an investment’s return. Hence, we can conclude that XO Products is riskier as
compared to Tagum Electric Company because of the variability of its returns.
Using the expected return criteria, we suggested that investor can just invest to any
of the companies since they have the same expected rate of return of 15%. However,
after evaluating the variability of the returns, we have concluded that XO Products is
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riskier than Tagum Electric Company. With this, a risk averse investor would normally
decide that it would be better to invest to Tagum Electric Company because it will
give the same expected return at a lower risk.
Expected Portfolio Returns
In the previous section, the expected return computed is applicable for a standalone
investment. However, stock investments are usually held in a portfolio. For example,
an investor who has P100,000 investable funds decides to diversify his investment
and purchased three stocks allocated as follows:
Percentage Amount Allocation
Jollibee Foods Corporation (JFC) P50,000 50%
Ayala Land Inc. (ALI) 25,000 25%
DITO Telecommunity Corporation (DITO) 25,000 25%
Total P100,000 100%
Assuming that the rate of return for each stock in the portfolio is as follows: JFC: 10%;
ALI: 15% and DITO: 5%, the expected return of this portfolio can be computed as
follows:
Percentage Rate of Expected
Allocation Return Rate of Return
(a) (b) (a x b)
JFC 50% 10% 5.00%
ALI 25% 15% 3.75%
DITO 25% 5% 1.25%
Expected Portfolio Return 10.00%
The expected portfolio return is the weighted average of the expected returns
from the individual assets in the portfolio.
Another Illustration – Computation for Expected Portfolio Returns
Robinsons Land Corporation is evaluating two opportunities, each having the same
initial investment. The project’s risk and return characteristics are shown below:
Project E Project F
Expected return 0.10 0.20
Proportion invested in each project 0.50 0.50
The expected return of a portfolio combining Project E and Project F is computed
as follows:
Percentage Rate of Expected
Allocation Return Rate of Return
(a) (b) (a x b)
Project E .50 0.10 0.05
Project F .50 0.20 0.10
Expected Portfolio Return 0.15 or 15%
The expected portfolio returns can also be computed using the following formula:
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n
řp=∑wi ři
i=1
Where:
řp = expected portfolio return
wi= proportion of portfolio invested in asset, i
ři = expected return of asset, i
n = the number of assets in the portfolio
Substituting the formula, the expected portfolio return can be alternatively computed
as follows:
řp = (0.50) (0.10) + (0.50) (0.20) = 0.15 or 15%
Standard Deviation
In the previous sections, it was noted that the riskiness of an investment can be
gauged with the variability of its returns. While we can observe the variability of
returns by considering how scattered or narrow the range is, it would be a big help if
we can quantify the risk. In this section, we will discuss how we can quantify risk
using standard deviation.
Standard deviation, σ (pronounced as “sigma”), is a statistical measure of the
variability of a probability distribution around its expected value. It can be used as a
measure of the amount of absolute risk associated with the outcome.
Standard deviation also measures the tightness of a probability distribution. A tight
probability distribution is one in which the set of possible returns is close to the
expected value of the return. If the probability distribution is tight, then the range of
the difference between the highest and lowest value in the distribution is relatively
small. Thus, the smaller the standard deviation, the tighter the probability
distribution, the smaller the range of returns and the lower the risk.
There are two types of probability distribution: symmetrical distribution and skewed
distribution.
Symmetrical distribution – one in which each half of the distribution is a mirror image
of the other half.
Skewed distribution – one in which half of the distribution is not a mirror image of the
other half.
It is to be noted that standard deviation is an appropriate risk measure of variability
only if the probability distribution is reasonably symmetrical. Also, when you are to
compare different investments using standard deviation, the size of the initial
investments and the expected value of their probability distributions should be equal
to make the risk comparison; otherwise, the use of standard deviation may be
misleading.
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The standard deviation is calculated as follows:
1. Compute the expected value (ř).
2. Subtract the expected value from each possible return to obtain the
deviations (ri - ř).
3. Square each deviation (ri - ř)2.
4. Multiply each squared deviation by its probability of occurrence,
pi(ri - ř)2 then add. The result is called the variance (σ2), which is the
standard deviation squared.
5. Take the square root of the variance to get the standard deviation.
Where:
pi=probability of outcome
ri= return or value of outcome
n = total number of possible outcomes
Computation of Standard Deviation of XO Products, Inc.
Using in data from the previous section, the standard deviation can be computed
using the steps enumerated:
(1) The expected rate of return as previously computed is 15% (ǩ).
(2) (3) (4)
ki – ǩ (ki – ǩ)2 (ki – ǩ)2 pi
100% - 15% = 85% 7,225% (7,225%) (0.30) = 2,167.5%
15% - 15% = 0 0 (0) (0.40) = 0.0
-70% - 15% = -85% 7,225% (7,225%) (0.30) = 2,167.5%
Variance = 4,335.0%
(5) Standard deviation (σ) =√4,335% = 65.84%
Hence, XO Product’s standard deviation is 65.84%. For this to be meaningful, try to
compute the standard deviation of Tagum Electric Company. Show your computation
in the “Let’s Check” section of this manual.
Calculation of Expected Portfolio Returns and Portfolio Standard Deviation
The computation for expected portfolio returns was already presented in the previous
section. In this section, computation of the standard deviation shall be discussed with
an illustration presented below:
Suppose the following projections are available for three alternative stock investments.
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State of the Probability Rate of Return if State Occurs
Economy of Occurrence Stock A Stock B Stock C
Boom 0.40 10% 15% 20%
Recession 0.60 8% 4%
0%
Required:
1. What would be the expected return on a portfolio with equal amounts invested in
each of the three stocks (Portfolio 1)?
2. What would be the expected return if half of the portfolio were in A and the
remainder to be equally divided between B and C (Portfolio 2)?
3. Compute the standard deviation of Portfolio 1 and Portfolio 2?
4. Based on the portfolio standard deviation computation, which portfolio would
you recommend pursuing? Justify your decision.
Solution:
1. Expected Return on Portfolio 1 (wherein: A=1/3; B=1/3; C=1/3)
1.1 Compute first the portfolio expected return of each state.
a. Portfolio Expected Return (Boom)
= (1/3)(10%) + (1/3)(15%) + (1/3)(20%)
= 3.33% + 5% + 6.67%
= 15%
b. Portfolio Expected Return (Recession)
= (1/3)(8%) + (1/3)(4%) + (1/3)(0)
= 2.67% + 1.33% + 0
= 4%
1.2 Then, expected return on Portfolio 1 can be computed using the formula
given in the previous section, to wit:
n
řp=∑wi ři
i=1
Expected Return on Portfolio 1 (řp1) = (.40)(15%) + (.60)(4%)
= 6% + 2.4%
= 8.4%
2. Expected Return on Portfolio 2 (wherein: A=50%; B=25%; C=25%)
2.1 Computation of the portfolio expected return of each state.
a. Portfolio Expected Return (Boom)
= (.50)(10%) + (.25)(15%) + (.25)(20%)
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= 13.75%
b. Portfolio Expected Return (Recession)
= (.50)(8%) + (.25)(4%) + (.25)(0)
= 5%
2.2 Computation of the expected return on Portfolio 2:
Expected Return on Portfolio 2 (řp2) = (.40)(13.75%) + (.60)(5%)
= 5.5% + 3%
= 8.5%
3. Portfolio Standard Deviation Computation
3.1 Standard Deviation – Portfolio 1
σ = √. 40 𝑥 (15% − 8.4%)² + .60 𝑥 (4% − 8.4%)²
= √. 40 𝑥 (. 004356) + .60 𝑥 (. 001936)
= √. 002905
= 5.4%
3.2 Standard Deviation – Portfolio 2
σ = √. 40 𝑥 (13.75% − 8.5%)² + .60 𝑥 (5% − 8.5%)²
= √. 40 𝑥 (. 002756) + .60 𝑥 (. 001225)
= √. 0018375
= 4.3%
4. Based on the portfolio standard deviation computation, it would be better to invest
to Portfolio 2 since it has a lower standard deviation which implies that this Portfolio
is less risky compared to Portfolio 1.
Coefficient of Variation
Coefficient of variation (CV) is another useful measure of risk. It is a standardized
measure of the risk per unit of return; calculated as:
Coefficient of Variation (CV) = Standard Deviation (σ)
Expected return (ř)
The coefficient of variation of XO Products and Tagum Electric Company is
computed as follows:
For XO Products: CV = 65.84% = 4.39
15%
For Tagum Electric Company: CV = 3.87% = .26
15%
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The coefficient of variation provides a more meaningful basis for comparison when
expected returns on two or more alternatives are not the same. Based on the above
computations, XO Products is almost 17% riskier than Tagum Electric Company.
Portfolio Risk (σp)
Portfolio risk is the variability of returns of the portfolio as a whole. The riskiness of the
portfolio may be less than the riskiness of any individual assets contained in the
portfolio because of diversification.
Diversification is investing in more than one type of asset to reduce risk. It could also
be investment in several different assets of the same type, but this would be less
effective. Diversification reduces risk by combining assets such as, securities with
different risk-return characteristics.
The amount of risk reduction achieved through diversification depends on the
correlation of the individual assets’ returns with one another. This could be measured
by computing for the correlation coefficient (ρ or rho). This is a relative statistical
measure of correlation in the degree and direction of change between two variables.
It ranges from + 1.0 to – 1.0.
Generally:
• If ρ = + 1.0, the two variables move in the same direction exactly to the same
degree and are perfectly positively correlated.
• If ρ = - 1.0, the two variables move in opposite directions exactly to the same
degree and are perfectly negatively correlated.
• If ρ = 0, the two variables are uncorrelated or independent to each other.
Risk reduction can be achieved through diversification if the returns of the assets
combined in a portfolio are not perfectly positively correlated. Hence, greater benefits
are achieved with less positive or more negative correlation among asset returns.
The following formula could be used to solve for the standard deviation of portfolio
returns for a two-asset portfolio:
σp= √w₁² σ₁² + w₂² σ₂² + 2 w₁ w₂ ρ₁, ₂ σ₁ σ₂
where:
w₁ = proportion invested in asset 1
w₂ = proportion invested in asset 2
σ₁ = standard deviation of asset 1
σ₂ = standard deviation of asset 2
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ρ₁, ₂ = correlation coefficient between asset 1 and asset 2
Illustration. Assume that the investor decided to invest in a 2-asset portfolio allocating
50% of the total investment to each asset. The information of the assets are as follows:
Asset 1 Asset 2
Standard deviation (σ) 8% 8%
Case 1: Correlation coefficient (ρ₁, ₂) = + 1.0
σp= √(0.5)² (0.08)² + (0.5)² (0.08)² + 2 (0.5)(0.5)(1.0)(0.08)(0.08)
σp= √0.0016 + 0.0016 + 0.0032
σp= √0.0064
σp = 0.08
Case 2: Correlation coefficient (ρ₁, ₂) = + 0.2
σp= √(0.5)² (0.08)² + (0.5)² (0.08)² + 2 (0.5)(0.5)(0.2)(0.08)(0.08)
σp= √0.0016 + 0.0016 + 0.00064
σp= √0.00384
σp = 0.062
As observed, risk reduction occurs through diversification when the assets combined
are not perfectly positively correlated. With a low correlation of +0.2, the portfolio risk
is reduced from 0.08 to 0.062.
Risk Preferences
Investors want to be compensated for the risk associated with an investment. The
greater the risk, the more the demanded return. The actual amount of compensation
demanded is referred as the required rate of return. Such required rate of return is
influenced by the individual decision maker’s attitude towards risk.
Decision makers may be classified into the following groups:
• Risk averse investors – those that require higher rates of return on higher-risk
securities. The are not willing to pay an amount as much as the expected value
of an uncertain investment.
• Risk-neutral – those that are willing to pay the expected value.
• Risk-takers – those that are willing to pay more than the expected value.
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Illustration for Risk Averse, Risk-Neutral and Risk Taker Decision Makers
The following data are available for Project A and Project B.
State of the Rate of Return if State Occurs
Economy Probability Project A Project B
1 Weak 0.2 P 800 P 200
2 Moderate 0.6 1,000 1,000
3 Strong 0.2 1,200 1,800
Expected value (ř) 1,000 1,000
Standard deviation (σ) 126 506
Coefficient of variation (cv) 0.13 0.51
Decisions based on attitude towards risk:
• A risk averse investor would select project A because it involves the same
expected return as Project B but has a less risk.
• A risk-neutral investor would be indifferent between the two investments.
• A risk-taker investor would prefer Project B because although the expected of
each project is equal, Project B has a greater potential return and more risk.
Hence, if the economy is strong, the maximum return for Project B is P1,800 as
compared to Project A with only P1,200.
Risk and Return Portfolio
In the previous sections, risk and return analysis focus only on both a single asset and
a portfolio or collection of two or more assets. It is noteworthy to mention that there is
what we call portfolio theory. Portfolio theory involves selection of efficient portfolios.
An efficient portfolio provides the highest return for a given level of risk or the least risk
for a given level of return. While portfolio theory originated in the context of financial
assets such as investment in equity shares, the general concepts also apply to
physical assets such as the capital budgeting projects.
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