2.
1 What is Return
Return is the primary motivating force that drives investment. It represents the reward for
undertaking investment. Since the game of investing is about returns (after allowing for risk),
measurement of realized (historical) returns is necessary to assess how well the investment
manager has done. In addition, historical returns are often used as an important input in
estimating future (prospective) returns.
2.2 Measuring Return
Rate of Return The rate of return on an investment for a period (which is usually a period of
one year) is defined as follows:
A n n u a l income + (E n d in g price B e g in n in g p rice )
Rate of re tu rn =
B e g in n in g P rice
To illustrate, consider the following information about a certain equity share:
Price at the beginning of the year : Rs.60.00
Dividend paid toward the end to the year : Rs.2.40
Price at the end of the year : Rs.66.00
The rate of return on this share is calculated as follows:
2.40 66.0 60.00
60.00 = 0.14 or 14 p e rce n t
The return of an investment consists of two components:
Current Return The first component that often comes to mind when one is thinking about
return is the periodic cash flow (income), such as dividend or interest, generated by the
investment. Current return is measured as the periodic income in relation to the beginning price
of the investment.
Capital Return The second component of return is reflected in the price change called the
capital return—it is simply the price appreciation (or depreciation) divided by the beginning
price of the asset. For assets like equity stocks, the capital return predominates.
Thus, the total return for any security (or for that matter any asset) is defined as: Total return =
Current return + Capital return
The current return can be zero or positive, whereas the capital return can be negative, zero, or
positive.
The rate of return of 14 percent in the example above may be broken down as follows:
2.40 66.00−60.00
+ =4 % Current Yield+10 % Capital Gain
60.00 60
MEASURING HISTORICAL RETURN
Arithmetic Mean The most popular summary statistic is the arithmetic mean. Hence the word mean
refers to the arithmetic mean, unless otherwise specified. The arithmetic mean of a series of total returns
is defined as:
n
Ri
R = i 1
n
where R is the arithmetic mean, Ri is the value of the total return (i = 1, … n) and n is the
number of total returns.
To illustrate, suppose the total returns from stock A over a five year period are as follows:
Year Total return (percentage)
1 19.0
2 14.0
3 22.0
4 –12.0
5 5.0
The arithmetic mean for stock A is
19 14 22 12 5 = 9.6%
R =
5
We can also use Geometric mean to measure the return of an investment (Reading
Assignment)
PORTFOLIO RETURN AND RISK
Investors generally hold a portfolio of securities. So, while individual returns and risks are important, what
matters finally is the return and risk of the portfolio. We will now look at portfolio return and risk in more
formal terms.
Portfolio Expected Return The expected return on a portfolio is simply the weighted average of the expected
returns on the individual securities in the portfolio:
n
E(R f ) ¿ ∑ WiE ( Ri )
i=1
where E(Rp) is the expected return on the portfolio, wi is the weight of security i in the portfolio, E(Ri)
is the expected return on security i, and n is the number of securities in the portfolio.
Example A portfolio consists of four securities A, B, C, and D with expected returns of 12
percent, 15 percent, 18 percent, and 20 percent respectively. The proportions of portfolio value
invested in these securities are 0.20, 0.30, 0.30, and 0.20 respectively. The expected return on the
portfolio is:
E(Rp) = 0.20 (12%) + 0.30 (15%) + 0.30 (18%) + 0.20 (20%) = 16.3%
Risk The rate of return from investments like equity shares, real estate, silver, and gold can vary
rather widely. The risk of an investment refers to the variability of its rate of return: How much
do individual outcomes deviate from the expected value? A simple measure of dispersion is the
range of values, which is simply the difference between the highest and the lowest values.
Other measures used commonly in finance are as follows:
Variance : This is the mean of the squares of deviations of individual returns
around their average value
Standard deviation : This is the square root of variance
Beta : This reflects how volatile is the return from an investment relative
to market swings
Portfolio Risk Just as the risk of an individual security is measured by the variance (or standard
deviation) of its return, the risk of a portfolio too is measured by the variance (or standard
deviation) of its return.
Although the expected return on a portfolio is the weighted average of the expected returns on
the individual securities in the portfolio, portfolio risk (measured by the variance or standard
deviation) is not the weighted average of the risks of the individual securities in the portfolio (except
when the returns from the securities are uncorrelated)
MEASUREMENT OF COMOVEMENTS IN SECURITY RETURNS
To develop the equation for calculating portfolio risk we need information on weighted individual security
risks and weighted comovements between the returns of securities included in the portfolio.
Comovements between the returns of securities are measured by covariance (an absolute measure) and
coefficient of correlation (a relative measure).
Covariance Covariance reflects the degree to which the returns of the two securities vary or change
together. A positive covariance means that the returns of the two securities move in the same direction
whereas a negative covariance implies that the returns of the two securities move in opposite direction. The
covariance between any two securities i and j is calculated as follows:
Cov (Ri, Rj) = p1 [Ri1 – E(Ri)] [Rj1 – E(Rj)]
+ p2 [Ri2 – E(Ri)] [Rj2 – E(Rj)]
+.
.
+ pn [Rin – E(Ri)] [Rjn – E(Rj)]
where p1, p2 … pn are the probabilities associated with states 1, … n, Ri1, … Rin are the returns
on security i in states 1, … n, Rj1, … Rjn are the returns on security j in states 1… n and E(Ri),
E(Rj) are the expected returns on securities i and j.
The expected return on security 1 is:
E(R1) = 0.10 (– 10%) + 0.30 (15%) + 0.30 (18%) + 0.20 (22%) + 0.10 (27%) = 16% The
expected return on security 2 is:
E(R2) = 0.10 (5%) + 0.30 (12%) + 0.30 (19%) + 0.20 (15%) + 0.10 (12%) = 14%
State of Probability Return on Deviation of Return on Deviation of Product of the
nature Security 1 security 1 Security 2 security 2 deviation times
from its mean from its mean probability
1 0.10 -10% -26% 5% -9% 23.4
2 0.30 15% -1% 12% -2% 0.6
3 0.30 18% 2% 19% 5% 3.0
4 0.20 22% 6% 15% 1% 1.2
5 0.10 27% 11% 12% -2% -2.2
Sum= 26.0
Thus the covariance between the returns on the two securities is 26.0
Coefficient of Correlation Covariance and correlation are conceptually analogous in the sense that both of
them reflect the degree of comovement between two variables. Mathematically, they are related as follows:
Cov( Ri , Rj)
Cor (Ri,Rj) =ρ σiσj
where Cor (Ri, Rj) = i j is the correlation coefficient between the returns on securities i and j, Cov (Ri, Rj) =
i j is the covariance between the returns on securities i and j, and (Ri), (Rj) = i , j are the standard
deviations of the returns on securities i and j.
Thus, the correlation coefficient is simply covariance divided by the product of standard deviations.
The correlation coefficient can vary between –1.0 and +1.0. A value of –1.0 means perfect negative
correlation or perfect comovement in the opposite direction; a value of 0 means no correlation or
comovement whatsoever; a value of +1.0 means perfect correlation or perfect comovement in the same
direction.
Fig 2.1 Graphical Portrayal of Various Types of Correlation Relationships