Practice investment management pim3 ch02 ch 1 concept of investing

CHAPTER TWO UNDERSTANDING RISK AND RETURN Practical Investment Management Robert A Strong Outline  Return      Holding Period Return Yield and Appreciation The Time Value of Money Compounding Compound Annual Return South-Western / Thomson Learning © 2004 2-2 Outline  Risk  Risk vs Uncertainty  Dispersion and the Chance of Loss  The Problem with Losses • Big Losses • Small Losses • Risk and the Time Horizon  Risk Aversion • Risk Aversion and Rational People • Risk and Time  Partitioning Risk South-Western / Thomson Learning © 2004 2-3 Outline  More on the Relationship between Risk and Return  The Direct Relationship  Risk, Return, and Dominance South-Western / Thomson Learning © 2004 2-4 Introduction  A dollar today is worth more than a dollar tomorrow  A safe dollar is worth more than a risky dollar  People have different degrees of risk aversion Some are more willing to take a chance than others  A tradeoff exists between risk and return South-Western / Thomson Learning © 2004 2-5 Holding Period Return  The simplest measure of return is the holding period return Holding period = return Ending _ Beginning + value value South-Western / Thomson Learning © 2004 Income Beginning value 2-6 Holding Period Return Example : Buy 100 shares at $25 per share Dividend of $0.10 per share Sell the shares at $30 per share Time Holding period return = South-Western / Thomson Learning © 2004 $30 - $25 + $0.10 $25 = 20.4% 2-7 Holding Period Return  Holding period return is independent of the passage of time  When comparing investments, the periods should all be of the same length  When there are stock splits or other corporate actions, care should be taken to ensure that the correct value is used for calculating the holding period return South-Western / Thomson Learning © 2004 2-8 Yield and Appreciation Current yield is annual income divided by current price Dividend yield is used for stocks whose income comes exclusively from dividends Example : For a stock selling for $40 and expected to pay $1 in dividends over the next year , current yield = $1 / $40 = 2.5% South-Western / Thomson Learning © 2004 2-9 Yield and Appreciation Appreciation is the increase in value of an investment independent of its yield It excludes accrued interest, as well as increases in value which are due to additional deposits Example : When a stock bought at $95 rises to $97.50, it has appreciated by $2.50, or $2.50 / $95 = 2.6% South-Western / Thomson Learning © 2004 - 10 Risk and Time  While the returns over a long horizon may be more uncertain, history suggests that over long periods of time, the likelihood that the investment will lose money is less South-Western / Thomson Learning © 2004 - 27 Partitioning Risk  Undiversifiable risk is risk that must be borne by virtue of being in the market It is also known as systematic risk or market risk, and is measured by beta  Diversifiable risk is also known as unsystematic risk  Total risk = undiversifiable risk + diversifiable risk South-Western / Thomson Learning © 2004 - 28 Partitioning Risk  Business risk - the variability in a firm's sales, or its ability to sell its product  Financial risk - associated with the financial structure of the firm  Purchasing power risk - the possibility that the rate of return on an investment will be insufficient to offset the rise in the cost of living South-Western / Thomson Learning © 2004 - 29 Partitioning Risk  Interest rate risk - the chance of a loss in portfolio value due to an adverse change in interest rate  Foreign exchange risk - the possibility of loss due to adverse changes in the relative values of world currencies South-Western / Thomson Learning © 2004 - 30 Partitioning Risk  Political risk - the possibility that a government will interfere with a firm's preferred manner of conducting business  Social risk - the potentially adverse impact changing public attitudes can have on a firm's ability to sell its product South-Western / Thomson Learning © 2004 - 31 Partitioning Risk Insert Figure 2-5 here South-Western / Thomson Learning © 2004 - 32 Partitioning Risk Insert Figure 2-6 here South-Western / Thomson Learning © 2004 - 33 The Direct Relationship between Risk and Return Insert Figure 2-7 here South-Western / Thomson Learning © 2004 - 34 The Direct Relationship between Risk and Return  Empirical financial research reveals clear evidence of the direct relationship between systematic risk and expected return, i.e riskier securities earn higher returns on average South-Western / Thomson Learning © 2004 - 35 The Direct Relationship between Risk and Return Insert Figure 2-8 here South-Western / Thomson Learning © 2004 - 36 Risk, Return, and Dominance  An investment alternative shows dominance over another if it offers the same expected return for less risk, or if the security has a higher expected return than another security of comparable risk  Equivalent assets should sell for the same price This is known as the law of one price South-Western / Thomson Learning © 2004 - 37 Risk, Return, and Dominance Insert Figure 2-9 here South-Western / Thomson Learning © 2004 - 38 Review  Return      Holding Period Return Yield and Appreciation The Time Value of Money Compounding Compound Annual Return South-Western / Thomson Learning © 2004 - 39 Review  Risk  Risk vs Uncertainty  Dispersion and the Chance of Loss  The Problem with Losses • Big Losses • Small Losses • Risk and the Time Horizon  Risk Aversion • Risk Aversion and Rational People • Risk and Time  Partitioning Risk South-Western / Thomson Learning © 2004 - 40 Review  More on the Relationship between Risk and Return  The Direct Relationship  Risk, Return, and Dominance South-Western / Thomson Learning © 2004 - 41 ... Number 1- 50 $1, 000 $11 0 1- 50 Resulting Payoff $200 51- 100 $ 90 51- 100 Table 2.4-$89,000 Four Risky 10 0 Alternatives Avg $10 0 Avg $10 0 South-Western / Thomson Learning © 2004 Number 1- 90 $ Avg Payoff... take a chance than others South-Western / Thomson Learning © 2004 - 24 Risk Aversion and Rational People Choice Choice Choice Choice _ Resulting Resulting Resulting Number Number Payoff Payoff... bond which matures in years'' time, and has a redemption value of $1, 000? The interest rate is 9 .19 % P × ( + 0.0 919 )4 = $1, 000  P = $703.50 South-Western / Thomson Learning © 2004 - 12 The Time