# 03

Document Sample

```					   Module 3
Risk and Return

Learning Objectives
•   Calculate total and annualized capital gain and loss
•   Calculate yield
•   Calculate average annual gain
•   Calculate rate of return
•   Calculate real return
•   Explain why standard deviation measures risk
•   Calculate standard deviation
•   Explain how beta measures risk
•   Explain the risk characteristics of the major asset classes
•   Explain investment risk
•   Explain the relationship between risk and return
•   Evaluate return per risk using the Sharpe ratio
•   Calculate and evaluate risk and return for specific investments
True or False?
• Most investors know exactly how much they
make
• The investment with the most return is the
one to go after
• You can’t predict when investments will tank

Capital Gain
• Why do we invest?
• To make money on our money.

Capital Gain

Try some
• You bought AT&T at \$32.77 per share and
sell at \$59.32 per share. What is your total
holding gain?
• You buy Microsoft at \$42.41 per share and
sell at \$52.94 per share. What is your total
holding gain?

Try one on the web
Smart Money Website

Buy GE at the end of the month
January 2000 and sell GE at the end of
the month January 2003.

What if you held one investment for three
years and another for one year?

Try some
• You buy Microsoft for \$54.97 on the last day
of July 1998 and sell on the last day of July
2000 for \$69.81. Calculate your annualized
gain.
• You buy Intel for \$23.01 on the last day of
September 1997 and sell on the last day of
July 2000 for \$66.73. Calculate your
annualized gain.
It’s not always a gain--

The same stocks
• You buy AT&T for \$40.65 per share at the
end of November 1998 and sell in July 2000
for \$30.94. Calculate your annualized gain or
loss.
• You buy Microsoft for \$116.75 per share at
the end of December 1999 and sell in July
2000 for \$69.81. Calculate your annualized
gain or loss.
Return - Income or Yield

Let’s look at how stocks give yield
•Exxon Mobil (Ticker symbol XOM)
•General Motors (Ticker symbol GM)
•Johnson and Johnson (Ticker symbol JNJ)
•Practice more on your own. Being able to
calculate return is important.
Use finance.yahoo.com

20/20 hindsight is great but what
• Stock returns will differ depending on when you
bought or sold the stock.
• How can you know what a stock will do in the
• There’s no sure way but investors look at the
average return over a period of time to predict what
will happen in the future.
• The average takes away some of the ups and downs
of stock prices.    Copyright Leslie Lum
McDonald's and 3M
Annual Return
70%

60%
McDonald's
50%     3M

40%

30%

20%

10%

0%
1996          1997              1998           1999   2000
-10%
Best Performer for Year

-20%

Calculating year-to-year returns
Yearly Rate of Return =               2000Close  1999Close  2000Dividend
1999Close

McDonald's Dividend McDonald's annual 3M year Dividend 3M's annual return
year end                return       end close
close price                            price (\$)
(\$)

1995     22.42     0.132                        58.56    1.88
1996     22.54     0.152     (22.54 - 22.42 +   75.23    1.92     (75.23 - 58.56 +

0.152) 22.42 = 1%                       
1.92) 58.56 = 32%
1997     23.72     0.161     (23.72 - 22.54 +   76.14    2.12     (76.14 - 75.23 +

0.161) 22.54 = 6%                        
2.12) 75.23 = 4%
1998     38.16     0.176           62%          67.73    2.2            -8%
1999     40.05     0.198            5%          95.56    2.24           44%
2000     34.00     0.215           -15%         119.87   2.32           28%

Calculate the average annual return
McDonald's              3M's
Annual Return           Annual Return
1995
1996                        1%                    32%
1997                        6%                     4%
1998                       62%                    -8%
1999                        5%                    44%
2000                      -15%                    28%
Total                      59%                   100%
Average annual return                      12%                    20%
(Total number of
returns or 5)

McDonald's and 3M
Annual Return
70%

60%
McDonald's
50%        3M                              MCD Range
77%
40%                                       Minimum -15%
Maximum 62%
30%                                                      3M Range 52%
Minimum -8%
20%       3M Average 20%                                 Maximum 44%
MCD Average 12%
10%

0%
1996           1997              1998          1999           2000
-10%
Best Performer for Year

-20%
Calculate average annual return
KMB      Dividends    TJX        Dividends          MHK        APC      Dividends
Dec-01      59.81       1.12      40.04         0.22            55.01      57.43      0.225
Dec-00      70.69       1.08      27.75        0.155           27.375      71.08        0.2
Dec-99     65.438       1.04     20.438        0.135           26.375     34.125        0.2
Dec-98       54.5          1         29        0.115           42.063     30.875      0.188
Dec-97     49.313       0.96     17.188        0.531           21.938     30.344      0.152
Dec-96     47.625                11.844                        14.667     32.375

Real Return
The effect of inflation

Inflation Rate
20%

15%

10%

5%

0%
1931      1936     1941   1946   1951   1956   1961   1966   1971   1976   1981   1986   1991   1996   2001
-5%

-10%

-15%
Source: bea.gov

How does inflation affect your
investment?

Which is the best return?

Year       Nominal Return
1980           14%
1996            6%
1974           10%

After inflation, the 6% return is
the best!!
Year   Nominal Return   Inflation Rate   Real Return
1980       14%              12.5%          1.3%
1996        6%               3.3%          2.6%
1974       10%              12.3%           -2%

Figure out what the best real return is
Inflation

1981           9%
1982           4%
1983           4%
1984           4%
1985           4%   T-Bills in 1981 at 15%
1986           1%
1987
1988
4%
4%
Corporate Bonds in 1988 at 14%
1989           5%
1990           6%   Government Bonds in 1998 at 13%
1991           3%
1992           3%
1993           3%
1994           3%
1995           3%
1996           3%
1997           2%
1998           2%
1999           3%
2000           3%
Risk
• True or false?
– You can go through
without selecting risky
investments
– You can’t manage risk

It’s July 2000 and you’re trying to decide
• Costco’s average monthly return for the past
5 years is 3%
• Starbuck’s average monthly return for the
past 5 years is 3%
• Which do you choose?

Given two stocks with the same
return, pick the stock with less
volatility
Starbucks           Costco
Average Monthly            3%                3%
Return
Standard Deviation         15%               10%
Maximum Monthly            32%               20%
Return
Minimum Monthly            -38%             -41%
Return

Standard deviation is used to measure
risk

Here is the formula
(Optional)
xi
Av e rage X                        Individual
N                    values


S tandard de v iation  
 (X i  X ) 2
N

Number of
values

Let’s do it for Family B—
(Optional)
1. Each shoe size    2. Square the
(X) minus the        result.
Family B average.
12         12 – 8 = 4               16
5          5 – 8 = -3               9
11         11 – 8 = 3               9
4          4 – 8 = -4               16

3. Total               50
4. Divide this by
the number of
people (4).                   12.5
5. Take the square
root.                         3.54

Family B has more variability

Which is the most volatile?
Do calculations before looking at answers.

KMB      Dividends    TJX        Dividends     MHK        APC      Dividends
Dec-01      59.81       1.12      40.04         0.22       55.01      57.43      0.225
Dec-00      70.69       1.08      27.75        0.155      27.375      71.08        0.2
Dec-99     65.438       1.04     20.438        0.135      26.375     34.125        0.2
Dec-98       54.5          1         29        0.115      42.063     30.875      0.188
Dec-97     49.313       0.96     17.188        0.531      21.938     30.344      0.152
Dec-96     47.625                11.844                   14.667     32.375

Beta
Beta is another measure of risk.
Based on the concept that
market risk or overall volatility
of the market is not something
an investor can control.
Beta measures movement of the
stock in relation to the market.

High Beta Stock - Yahoo - Beta 3.6

100%
Yahoo Monthly Returns (1966-2001)

80%

Beta                                                       Beta = Slope or
60%                          Rise over Run
y = 3.6119x + 0.0317                                          36% divided by 10%
R2 = 0.3468                   40%

20%                      36%

0%                10%
-20%      -15%      -10%        -5%             0%       5%        10%      15%       20%

-20%

-40%
S&P 500 Monthly Returns 1996-2001

Low Beta Stock - Anheuser Busch - Beta = 0.26

15%
Anheuser Busch Monthly Returns 1996-2001

Beta
10%

y = 0.2609x + 0.0158
2
R = 0.0452
5%

2.6%
10%
0%
-20%      -15%        -10%        -5%             0%     5%         10%          15%

-5%

Beta = Slope or
Rise over Run
-10%        2.6% divided by 10%

-15%

S&P 500 Monthly Returns 1996-2001

Do these betas match your
Amazon                               2.96
General Motors                       1.13
Philip Morris                        0.35
Bank of America                      1.27
WalMart                              0.88

Estimate these betas and then go
to the web for betas
(finance.yahoo.com)
Company              Ticker Symbol Industry
British Petroleum    BP            Energy company. You might know
its BP gas stations.
Fox Entertainment    FOX           Purveyor of television and movies.
Kroger               KR            Large supermarket chain.
Network Appliances   NTAP          Technology (data storage) company.
Amgen                AMGN          Biotechnology company.

Let’s put it all together
Major asset classes: Risk & Return
Annual Return on Cash
(Treasury Bill Total Return 1971-2000)

50%

45%

40%

35%

30%

25%

20%
About 70% of returns fall within one
standard deviation of the average
15%

10%
Standard Deviation 2.7%
Average 6.7%
5%

0%
1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000
Source: Global Financial Data, www.globalfindata.com

Annual Return on Bonds
(Total Return Government Bonds 1971-2000)
50%

40%

30%
About 70% of returns fall within one
standard deviation of the average

20%
Standard
Deviation
9.3%

10%                                                                                              Average 9.9%

0%
1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000
-10%

Source: Global Financial Data                                                         Copyright Leslie Lum
Annual Return on Stocks
(Total Return S&P 500 1971-2000)
50%

40%

30%
Standard
Deviation
16.5%
20%

Average 14.5%

10%

0%
1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000
-10%

About 70% of returns fall within one
standard deviation of the average
-20%

-30%

Source: Global Financial Data
Distribution of Annual Total Returns
20
T-Bills
Average Return 6.7%
18               T-Bills                                                                       Standard Deviation 2.7%
Bonds
16
Stocks
Bonds
Average Return 9.9%
14
Standard Deviation
9.3%
12

10
Stocks
Average Annual Return
8                             14.5%
Standard Deviation 16.5%

6

4

2

0
Less than      -25% to    -20% to    -15% to   -10% to   -5% to   0 to   5% to   10% to   15% to    20% to    25% to
-25%          -20%       -15%       -10%       -5%       0%     5%      10%     15%      20%       25%       30%

Source: Global Financial Data
The more return you need, the more risk you take.
The more risk you take, the more return you need.
Major Asset Classes (1971-2000)

18%

16%
Stocks
Average Annual Return 14.5%
14%
Standard Deviation 16.5%

12%
Return
(Annual Return)
10%
Bonds
Average Return 9.9%
8%                                                   Standard Deviation 9.3%

6%

4%
T-Bills
Average Return 6.7%
2%               Standard Deviation 2.7%

0%
0%    2%            4%           6%            8%           10%          12%       14%           16%

Risk
(Standard Deviation)

Plot the risk return graph for
these. Does the risk return
relationship hold? What is the best
stock for you?
Citigroup     Caterpillar   Motorola    Oracle         Amgen
Standard           10%           10%          13%            20%           12%
Deviation
Average           3.2%         1.0%         0.6%        4.7%          3.4%
Monthly
Return

Plot the risk return graph

Return
(Average
Return)

Risk
(Standard
Deviation)
Try another risk return graph

American    Philip         AOL          British     BUD
Airlines    Morris                      Petroleum
Standard          11%            10%          21%          7%          6%
Deviation
Average          0.2%        1.7%            6.3%        1.5%         2.0%
Monthly
Return

Return per Risk
• Investment 1 gives a 15% return
with a 25% risk.
• Investment 2 gives a 12% return
with an 18% risk.
• Which one is better?

Sharpe Ratio
• Creates a measure of
return for every unit of
risk
• Used to measure
portfolios of
investments
• The higher the ratio the
more return you’re
getting for every unit of
Which is better for return per risk?
ARK Small Cap Fund 0.48
Franklin Small Cap            0.01
Fidelity Small Cap            0.07
Bank of America               1.27
Fremont Small Cap             0.29

How should you deal with volatility?