6-1 Rate of Return

​ ​ ​ ​ ​ ​ ​

Module 6-1: Rate of Return

This first section is largely a bridge from Module 5 into Module 6. The professor reviews
realized returns, but the important new distinction is between realized return and expected
return, and how expected return connects to the firm's cost of capital.

1. Expected Return vs. Realized Return

The professor distinguishes two perspectives in time.

Expected return — before the investment

Before investors buy shares, they have an expectation about the return they require or hope
to earn.

The professor also calls this:

●​ Required rate of return

●​ Expected return
●​ Ex ante return

The important idea is that investors have alternatives. Instead of investing in your company,
they could invest in:

●​ another company's shares,

●​ government bonds,
●​ Treasury bills,
●​ or other investments.

By choosing your company, they give up those alternatives. That's the opportunity cost of
investing their capital.

Realized return — after the investment

Once the investment has actually occurred, we can observe what the investor really earned.

The professor calls this:

●​ Realized return
●​ Rate of return
●​ Ex post return

It consists of two sources:

This matches the slides, which define total investment return as income (dividends or
interest) plus capital gains or losses.

2. The Really Important Connection:

Investor vs. Manager
This is probably the most important conceptual point in 6-1.

The same percentage is viewed differently depending on whose perspective we're taking:

Investor's Perspective Company's/Manager's Perspective

Required/expected rate of return Cost of capital

Return investor requires for providing Cost to company of obtaining/using that

money money

Opportunity cost of investing in the Opportunity cost of capital for the project
company

Suppose shareholders require 12% to invest in a company of a particular risk.

From the investor's perspective:

"I require 12% because I could invest my money elsewhere."

From management's perspective:

"Using shareholders' capital effectively costs us 12%."

Therefore:

The slides define the cost of capital as the return shareholders could expect from investing in
equally risky securities.
This also connects directly back to Module 5: that's why we discount project cash flows
using the opportunity cost of capital.

3. Calculating Realized Return

The professor reviews the calculation from the previous module:

4. Loblaws Example
The slides give:

●​ Beginning price = $63.01

●​ Ending price = $103.64
●​ Dividend = $1.40
So almost all of the investor's realized return came from capital appreciation, rather than
dividends.

5. Why This Matters for Module 6

Up until now, much of the course has effectively treated the discount rate as something we
are given.

For example:

"Calculate NPV using a 15% opportunity cost of capital."

Module 6 starts addressing the deeper question:

Where does that required return come from?

Investors require compensation for giving up alternative investments, and importantly, their
required return depends on risk.

The slides explicitly state that the opportunity cost of an investment should reflect its risk.

That sets up the rest of Module 6:

Higher risk means investors will generally demand a higher expected return for supplying
their capital.

6-1 Key Takeaways

●​ Expected return / ex ante return = what investors expect before investing.
●​ Realized return / ex post return = what investors actually earn after investing.
●​ Realized return comes from dividends + capital gains/losses.
●​ The investor's required rate of return becomes the company's cost of capital.
●​ That required return reflects the opportunity cost of giving up equally risky
alternative investments.
●​ Module 6 will now explain how risk affects the return investors require, and
ultimately why different investments should have different costs of capital.
6-2 Capital Market History
​ ​ ​ ​ ​ ​ ​

Module 6-2: Historical Returns, Risk

Premium & Expected Return
This section begins answering the question raised in 6-1: How do we determine the return
investors expect before they invest?

The professor starts by looking at historical returns on different types of investments and
then uses those returns to introduce risk premiums and expected returns.

1. Using Market Indices as Benchmarks

Managers can use market indices to understand the returns investors have historically
earned from different types of investments.

Examples discussed by the professor include:

●​ S&P/TSX Composite Index — a broad Canadian stock-market index

●​ Dow Jones Industrial Average — 30 large U.S. companies
●​ S&P 500 — a portfolio of 500 large U.S. stocks
●​ Portfolios of Treasury bills
●​ Portfolios of government bonds

An index essentially represents a portfolio of securities. This allows managers and

investors to examine the historical performance of an asset class rather than relying on the
experience of a single investment.

2. Comparing Treasury Bills, Bonds, and Common

Stocks
The professor compares three broad investment categories:

Investment Relative Reason

Risk

Treasury bills Lowest Short-term government securities with highly predictable

cash flows

Long-term Middle Cash flows are more certain than stocks, but their longer
bonds maturity introduces additional uncertainty
 Common Highest Future share prices and dividends are uncertain
stocks

The fundamental relationship is that investors expect greater returns when they accept
greater risk.

Treasury bills are treated as risk-free in the course because they are government securities
with essentially no default risk. Investors know what they will receive at the end of the
investment period.

Common stocks are much riskier because neither the future selling price nor future
dividends are known with certainty.

Long-term bonds fall between these two. Their coupon payments and principal repayment
are known, but longer-term investments are subject to greater volatility. Corporate bonds
may also carry default risk.

3. Historical Risk and Return

The professor uses historical data from approximately 1970–2020 to illustrate the
relationship between risk and return.

If $100 had been invested in each asset class:

Investment Value by Average Annual Return

2020
 Treasury bills $714.70 5.6%

Long-term bonds $3,458.35 7.0%

Common stocks $8,276.44 10.0%

The important point is not simply the specific historical percentages. It is the pattern:

Treasury bills → lowest risk and lowest return

Long-term bonds → intermediate risk and return

Common stocks → highest risk and highest return

Historically, investors have therefore been compensated for accepting greater uncertainty.

4. Maturity Premium
The professor briefly distinguishes between the returns on Treasury bills and long-term
government bonds.

In the historical example:

●​ Treasury bills returned 5.6%

●​ Long-term government bonds returned 7.0%

Both are government securities, so the professor attributes the additional return on the
long-term bonds to their longer maturity.

The difference of 1.4 percentage points is described as the maturity premium.

The idea is that investors generally require additional compensation for committing their
money for a longer period and accepting the additional volatility associated with long-term
securities.

5. Risk Premium
The major new concept in this section is the risk premium.

An investor could choose the relatively safe Treasury bill investment. If the investor instead
chooses a riskier investment, the investor expects additional compensation for accepting
that extra risk.

That additional compensation is the risk premium.

In the professor's historical example:

●​ Common stocks returned 10.0%

●​ Treasury bills returned 5.6%

Therefore, the historical risk premium on common stocks is:

In other words, investors historically received an additional 4.4% per year for accepting the
additional risk associated with common stocks rather than investing in Treasury bills.

The general principle is straightforward: the greater the additional risk, the greater the
risk premium investors will require.

6. Estimating Expected Return

Now the professor connects historical returns to the expected return discussed in 6-1.

An investor considering common stocks could instead invest in Treasury bills and earn the
risk-free return. Therefore, the investor's expected return from stocks needs to compensate
them for:

●​ the return they are giving up by not choosing the risk-free investment; and
●​ the additional risk they are accepting by investing in stocks.

The professor therefore estimates the expected return on the stock market by taking the
current risk-free rate and adding the historical market risk premium.

Example: 2020

In 2020:

●​ Treasury bill rate = 0.40%

●​ Historical market risk premium = 4.4%

The expected return on common stocks would therefore be:

So an investor would expect approximately 4.8% to compensate for both the opportunity
cost of giving up the risk-free investment and the additional risk of investing in stocks.

Example: 1981

In 1981:

●​ Treasury bill rate = 15%

●​ Historical market risk premium = 4.4%

Therefore:

The required return is much higher because the investor's alternative is much more
attractive. If an investor could earn 15% on Treasury bills, a risky stock investment would
need to offer substantially more than 15% to compensate for its additional risk.

This is another application of opportunity cost: what investors can earn elsewhere
influences what they require from your company.

7. Historical Returns vs. Expected Returns

There is an important distinction here.

The 10% historical stock return is not simply assumed to be the expected return today.

Instead, the professor uses the historical difference between stock and Treasury bill returns
— the 4.4% historical market risk premium — and adds that premium to the current
risk-free rate.

So, in the 2020 example, even though stocks historically returned 10%, the estimated
expected return was only 4.8% because Treasury bill rates in 2020 were only 0.4%.

This demonstrates that the expected return can change over time as the risk-free rate
changes.
8. Bringing It Back to the Manager
The professor now reconnects this to the central relationship established in 6-1:

The return investors require becomes the company's cost of capital.

If a manager is considering a risk-free project, investors do not need additional

compensation for market risk. Therefore, the appropriate required return would simply be the
risk-free rate.

If a manager is considering an average-risk project, the appropriate cost of capital would

correspond to the expected return on the market portfolio — the risk-free rate plus the
market risk premium.

The problem is that most projects do not fit perfectly into either category. A project might be
riskier or less risky than the average market investment.

That creates the question the professor leaves us with at the end of 6-2:

How do we determine the appropriate required rate of return for a project whose risk
differs from the overall market?

That is where the next section is heading.

6-2 Key Takeaways

●​ Investors can choose among investments with different levels of risk.
●​ Treasury bills are treated as the risk-free benchmark in this course.
●​ Historically, greater risk has been associated with greater average returns.
●​ A risk premium is the additional return investors require for accepting additional risk.
●​ The historical stock-market risk premium in the professor's example is 4.4%.
●​ Expected stock-market return can be estimated using the current risk-free rate plus
the historical market risk premium.
●​ The investor's required return becomes the cost of capital from the manager's
perspective.
●​ The appropriate cost of capital should reflect the risk of the investment or project
being undertaken.
6-3 Measuring Risk
​ ​ ​ ​ ​ ​ ​

Module 6-3: Measuring Risk — Expected

Return, Variance & Standard Deviation
This section introduces the statistical tools used to measure risk. The professor's main focus
is on standard deviation, but to calculate it we first need to understand expected return and
variance.

The central idea is fairly intuitive: risk is uncertainty about what return you will actually
receive. The more widely the possible returns can vary around the expected return, the
riskier the investment.

1. How Finance Measures Risk

The professor introduces two measures:

●​ Variance — measures the average squared deviation of possible returns from the
expected return.
●​ Standard deviation — the square root of variance.

For this course, standard deviation is the primary measure of risk.

A larger standard deviation means returns are more widely dispersed around what we
expect to earn. In practical terms, there is more uncertainty about the actual outcome.

A smaller standard deviation means the possible outcomes are clustered more closely
around the expected return, so the investment is considered less risky.

2. Historical Risk vs. Expected Risk

Just as we distinguished between historical and expected returns, we can distinguish
between historical and expected risk.

Historical standard deviation measures how much actual returns varied in the past.

Expected standard deviation measures how much we anticipate future returns could vary
around the expected return.

The professor emphasizes that while historical information is useful, finance is ultimately
interested in the future. Investors need to decide what return and risk they expect before
making the investment.
3. Historical Average Return
If we have historical returns from several years, the average historical return is simply the
arithmetic average.

For example, if annual returns were 8%, 12%, and 10%, the historical average return would
be:
This is essentially how the historical average returns discussed in 6-2 were calculated for
Treasury bills, bonds, and common stocks.

But expected returns are different because they haven't happened yet. We therefore need
to forecast possible outcomes and assign probabilities to them.

4. Expected Return
Expected return is essentially a probability-weighted average of the possible returns.

The professor illustrates this using a two-coin game. Each coin has:

●​ Heads = +20% return

●​ Tails = −10% return

Flipping two coins creates four possible outcomes:

Outcome Return Probability

Head + 40% 25%

Head

Head + Tail 10% 25%

Tail + Head 10% 25%

Tail + Tail −20% 25%

The probabilities must total 100%.

To calculate expected return, multiply each possible return by its probability and add the
results:
Therefore, the expected return from the game is 10%.

What does 10% actually mean?

It does not mean you will earn 10%.

In fact, 10% is only one of the possible outcomes in this particular example.

Instead, it means that 10% is the probability-weighted average of all the possible
outcomes.

This is why it is an expected return rather than a guaranteed return.

5. Now We Need to Measure the Risk

Knowing the expected return isn't enough.

Suppose two investments both have an expected return of 10%.

Investment A might have possible returns of 9%, 10%, and 11%.

Investment B might have possible returns of −20%, 10%, and 40%.

They may have the same expected return, but Investment B clearly has much more
uncertainty.

That is what variance and standard deviation allow us to measure.

The question becomes:

How far away from the expected return could our actual outcomes be?

6. Variance
To calculate variance, we look at how far each possible return is from the expected return.
For the coin example, the expected return is 10%.

​
So the variance is 450 when the returns are being expressed in percentage points, as the
professor does in the example.

7. Standard Deviation
Variance is useful mathematically, but its units are squared, which makes it less intuitive.

Standard deviation solves that problem by taking the square root of variance.

Conceptually, a higher standard deviation means there is greater variability in the possible
returns and therefore greater risk.
8. Connecting Risk Back to the Three
Asset Classes
The professor then returns to the three portfolios from 6-2.

The pattern is very clear.

Treasury bills have the lowest historical return but also the lowest standard deviation.

Government bonds fall in the middle.

Common stocks have the highest historical return and by far the highest standard
deviation.

This gives us one of the fundamental principles of finance:

Higher risk → higher expected return.

Investors generally will not voluntarily accept substantially greater uncertainty unless they
expect to be compensated with a greater return.

9. One Important Distinction

The professor is not saying:

If you take more risk, you will earn more money.

That would eliminate the meaning of risk.

Instead, the relationship is:

If investors are being asked to accept more risk, they will require a higher
expected return as compensation.

The actual realized return could ultimately be much higher or much lower than expected.

That's exactly why we need standard deviation in the first place.

10. How 6-2 and 6-3 Fit Together

In 6-2, we established that investors require a risk premium for investing in risky securities.

Now, in 6-3, we have introduced a way of actually measuring that risk.

Standard deviation tells us how much uncertainty or variability exists around an investment's
expected return.

So we're building toward the larger question:

If different investments have different amounts of risk, how much additional expected
return should investors require for taking that risk?

That's the bridge into the next part of the module.

6-3 Key Takeaways

●​ Risk is the variability or uncertainty of investment returns.
●​ The two measures introduced are variance and standard deviation.
●​ Standard deviation is the primary measure of risk used in this course.
●​ Expected return is a probability-weighted average of possible future returns.
●​ Variance measures the probability-weighted squared deviations from the expected
return.
●​ Standard deviation is the square root of variance.
●​ Higher standard deviation = greater risk.
●​ Historical data show the general positive relationship between risk and return:
Treasury bills have low risk/low return, bonds fall in the middle, and stocks have high
risk/high return.
●​ Higher risk does not guarantee a higher realized return; investors instead require a
higher expected return as compensation for accepting greater risk.
6-4 Risk and Return of Securities
​ ​ ​ ​ ​ ​ ​

Module 6-4: Expected Return and Risk of

Individual Securities
In 6-3, the professor introduced expected return, variance, and standard deviation using the
coin-toss example. In 6-4, he applies exactly the same concepts to a more realistic
investment decision: choosing between individual stocks when future economic
conditions are uncertain.

The central question is:

How can an investor estimate the expected return and risk of a stock before actually
investing in it?

1. Estimating Future Returns Using Economic

Scenarios
Because expected returns are ex ante, they haven't happened yet. Investors therefore need
to forecast possible future outcomes.

The professor suggests thinking about different possible states of the economy, such as:

●​ Recession
●​ Normal economic conditions
●​ Economic expansion or boom

For each economic state, we need two pieces of information:

1.​ The probability that the economic state will occur

2.​ The return the stock is expected to generate if that state occurs
The probabilities could come from economic forecasts, while the expected stock returns
might be based on how that stock has historically behaved under similar economic
conditions.

Once we have those two pieces of information, we can estimate both the stock's expected
return and its risk.

2. Auto Stock vs. Gold Stock Example

The professor considers two possible investments: an auto stock and a gold stock.

There are three possible economic states, each with an equal probability of one-third:

Economic Probability Auto Stock Return Gold Stock Return

State

Recession 33.3% −8% 20%

Normal 33.3% 5% 3%

Boom 33.3% 18% −20%

The two stocks react very differently to economic conditions.

The auto stock is economically sensitive. It performs poorly during a recession but very
well during an expansion.

The gold stock moves in almost the opposite direction. It performs strongly during a
recession but poorly during an economic expansion.

This opposite behaviour will become particularly important when the professor gets into
diversification later in the module.

3. Expected Return on the Auto Stock

To estimate the expected return, we multiply each possible return by the probability of that
outcome occurring.

For the auto stock:

So the expected return on the auto stock is 5%.

Again, this does not mean the investor will actually earn 5%. Depending on what happens to
the economy, the realized return could be −8%, 5%, or 18%.

The 5% is the probability-weighted expected return.

4. Expected Return on the Gold Stock

We perform exactly the same calculation for the gold stock:

So:

Stoc Expected Return

k

Auto 5%

Gold 1%

If we looked only at expected return, the auto stock would appear preferable.

But expected return is only half of the decision. We also need to determine the risk
associated with earning that return.
5. Calculating Risk
As established in 6-3, the professor uses standard deviation as the measure of risk.

The process is:

1.​ Calculate the stock's expected return.

2.​ Find the difference between each possible return and the expected return.
3.​ Square each difference.
4.​ Multiply each squared difference by the probability of that outcome.
5.​ Add the results to obtain variance.
6.​ Take the square root of variance to obtain standard deviation.

6. Risk of the Auto Stock

We already know that the expected return on the auto stock is 5%.

The possible returns are −8%, 5%, and 18%.

Recession

\left(\frac13\right)(-8%-5%)^2

\left(\frac13\right)(-13)^2
56.33​
]

Normal economy

[​
\left(\frac13\right)(5%-5%)^2=0​
]

Boom
[

\left(\frac13\right)(18%-5%)^2

\left(\frac13\right)(13)^2
56.33​
]

Adding the probability-weighted squared deviations gives the variance:

[​
56.33+0+56.33\approx112.67​
]

The professor reports approximately 112.55, reflecting rounding in the

probabilities/calculations used in the lecture.

We then take the square root:

[​
\sigma_A=\sqrt{112.55}\approx\boxed{10.6%}​
]

Therefore, the auto stock has:

●​ Expected return = 5%
●​ Standard deviation = 10.6%

7. Risk of the Gold Stock

The gold stock has an expected return of 1%, with possible returns of 20%, 3%, and −20%.

The same procedure is followed.

Recession

[​
\left(\frac13\right)(20%-1%)^2​
]
Normal economy

[​
\left(\frac13\right)(3%-1%)^2​
]

Boom

[​
\left(\frac13\right)(-20%-1%)^2​
]

The professor calculates variance as approximately:

[​
268.39​
]

Taking the square root:

[​
\sigma_G=\sqrt{268.39}\approx\boxed{16.4%}​
]

Therefore, the gold stock has:

●​ Expected return = 1%
●​ Standard deviation = 16.4%

8. Comparing the Two Stocks

Now we have enough information to compare them:

Auto Gold
Stock Stock

Expected Return 5.0% 1.0%

Standard Deviation 10.6% 16.4%

Relative Risk Lower Higher

This produces a particularly straightforward result.

The auto stock has both:

 ●​ a higher expected return, and
●​ a lower standard deviation.

If choosing between these stocks individually, the auto stock therefore looks considerably
more attractive.

The gold stock offers a lower expected return while exposing the investor to greater
variability in possible returns.

9. But Don't Write Off the Gold Stock Yet

There is something important hiding in the example.

Look again at how the stocks behave:

Economy Auto Gold

Recessio −8% +20%

n

Normal +5% +3%

Boom +18% −20%

When the auto stock performs badly, the gold stock performs well.

When the auto stock performs well, the gold stock performs badly.

So even though gold looks worse as an individual investment, combining the two stocks
may produce something interesting.

Their returns may offset one another.

That is the intuition behind diversification: the risk of an investment considered by itself is
not necessarily the same as the risk that investment contributes to a portfolio.

The professor hasn't yet done that calculation in this section, but the example is setting us
up for it.

10. 6-3 vs. 6-4

The calculations in 6-4 aren't actually new. They are the same calculations introduced in 6-3.
The difference is the application:

6-3: Learn how expected return and standard deviation work.

6-4: Apply them to individual securities whose returns depend on different possible
economic outcomes.

The basic sequence to remember for a question like this is:

Possible economic states → probabilities → possible stock returns → expected return

→ variance → standard deviation → compare risk and return.

6-4 Key Takeaways

●​ Expected returns are ex ante and therefore must be estimated before the investment
occurs.
●​ One approach is to identify possible future economic states and assign probabilities
to each.
●​ Expected return is calculated using the probability-weighted returns from those
different states.
●​ Standard deviation measures the risk associated with those possible returns.
●​ In the professor's example, the auto stock has an expected return of 5% and
standard deviation of 10.6%.
●​ The gold stock has an expected return of 1% and standard deviation of 16.4%.
●​ Considered individually, the auto stock has the more attractive risk-return
combination.
●​ However, the two stocks react very differently to economic conditions, which
foreshadows the importance of diversification and portfolio risk.
6-5 - Risk of Portfolios
​ ​ ​ ​ ​ ​ ​

Module 6-5: Portfolios and

Diversification
This section moves from evaluating individual securities to evaluating portfolios. The
professor introduces one of the central ideas in finance: investors generally should not put all
of their money into one security because combining investments can substantially reduce
risk.

A portfolio is simply a collection of assets. The purpose of creating one is to gain the
benefits of diversification.

1. Why Diversification Works

The professor uses the example of investing in several companies rather than putting
everything into TD Bank.

Suppose TD employees go on strike. That could hurt TD's performance and reduce the
return on TD shares. But if the investor also owns RBC and Shopify, those investments
aren't necessarily affected by the TD strike. In fact, RBC might even benefit if TD customers
move their business to RBC.

As a result, losses in one investment can be partially offset by gains in another.

This is the basic idea behind diversification: when investments do not all respond to
events in the same way, combining them can reduce the variability of the portfolio's
overall return.

2. Unique Risk vs. Market Risk

The professor introduces an important distinction between two kinds of risk.

Unique Risk

Unique risk is risk associated specifically with an individual company. The professor also
calls it:

●​ Firm-specific risk
●​ Idiosyncratic risk

The TD Bank strike is an example. It affects TD specifically rather than every company in the
economy.
This type of risk can be reduced or potentially eliminated through diversification.

Market Risk

Market risk comes from factors affecting the economy or market as a whole.

Because these events affect many or all investments simultaneously, market risk cannot be
diversified away.

The professor describes standard deviation as measuring the total risk of an investment,
with total risk consisting of both unique risk and market risk.

Diversification reduces the unique-risk portion, not the market-risk portion.

This distinction will become increasingly important later in the module.

3. Returning to the Auto and Gold Stocks

The professor returns to the stocks from 6-4:

Investmen Expected Return Standard Deviation

t

Auto stock 5.0% 10.6%

Gold stock 1.0% 16.4%

Viewed individually, the gold stock looks like a poor investment. It has:

●​ a lower expected return than the auto stock; and

●​ higher risk than the auto stock.

As the professor puts it, no rational investor looking only at the individual securities would
choose gold over auto.

But that doesn't necessarily mean gold has no value inside a portfolio.

This is the important shift in thinking in 6-5:

A security that looks unattractive by itself may still be valuable because of how it
interacts with the other securities in a portfolio.

4. Creating the Portfolio

The professor constructs a portfolio containing:

●​ 75% auto stock

●​ 25% gold stock

If the investor has $10,000, that means:

●​ $7,500 invested in auto

●​ $2,500 invested in gold

The percentage invested in each asset is called its portfolio weight.

5. Expected Return of the Portfolio

The expected return of a portfolio is the weighted average of the expected returns of the
individual investments.

For this portfolio:

So the portfolio's expected return is 4%.

Notice what happened: the portfolio return falls between the returns of the two individual
securities.

●​ Auto = 5%
●​ Portfolio = 4%
●​ Gold = 1%

That makes intuitive sense because 75% of the portfolio is invested in the higher-return auto
stock.
6. Portfolio Risk Is NOT Simply a
Weighted Average
This is probably the most important point in this section.

Expected portfolio return is calculated as a weighted average.

But portfolio standard deviation cannot simply be calculated as the weighted average of
the individual standard deviations.

If we incorrectly did that:

But the actual portfolio standard deviation in this example is only about 3.9%.

That enormous difference is the diversification benefit.

Why?

Because the auto and gold stocks respond differently to the same economic conditions.
Their movements partially offset one another.

The professor notes that later we will be able to calculate this using covariance or
correlation, but those concepts haven't been introduced yet. For now, he calculates the
portfolio return under each economic scenario and then calculates standard deviation from
those portfolio returns.

7. Calculate the Portfolio Return in Each

Economic State
We calculate what the entire portfolio would return under each economic scenario.
So our new probability distribution is:

Economic Probability Auto Gold Portfolio

State

Recession 1/3 −8% +20% −1.0%

Normal 1/3 +5% +3% +4.5%

Boom 1/3 +18% −20% +8.5%

Now the diversification benefit becomes much easier to see.

The auto stock ranges from −8% to +18%.

The gold stock ranges from −20% to +20%.

But the portfolio only ranges from −1% to +8.5%.

Combining the two has dramatically narrowed the range of possible outcomes.

8. Calculating Expected Return Using the

Scenarios
Now that we know the portfolio's return under each scenario, we can also calculate expected
return the same way we did for an individual stock:
We get exactly the same answer as before.

So there are two ways to calculate expected portfolio return:

●​ Take the weighted average of the individual securities' expected returns.

●​ Calculate the portfolio return in each economic state and then take the
probability-weighted average.

Both produce 4%.

For expected return, the first method is obviously much easier.

However, we need the second method here because we need the individual scenario returns
to calculate the portfolio's standard deviation.

9. Calculating Portfolio Standard

Deviation
Now we follow exactly the same process used in 6-3 and 6-4.

We know:

●​ Expected portfolio return = 4%

●​ Recession return = −1%
●​ Normal return = 4.5%
●​ Boom return = 8.5%
●​ Each outcome has probability 1/3
So the portfolio has an expected return of 4% and a standard deviation of only 3.89%.

10. The Diversification Result

Now compare all three:

Investment Expected Return Standard Deviation

Auto 5.0% 10.6%

Gold 1.0% 16.4%

75% Auto / 25% Gold Portfolio 4.0% 3.89%

This is the striking result of 6-5.

The portfolio's expected return of 4% is exactly what we would expect from the weighted
average.

But its risk is lower than either individual security:

●​ Auto risk = 10.6%

●​ Gold risk = 16.4%
●​ Portfolio risk = 3.89%

The professor identifies this dramatic reduction in standard deviation as the benefit of
diversification.

11. Why This Happens

The intuition is already visible even though the professor hasn't formally introduced
correlation yet.

The two stocks tend to perform differently under the same economic conditions:

●​ In a recession, auto does badly while gold does well.

●​ In a boom, auto does well while gold does badly.
●​ Under normal conditions, both produce relatively modest positive returns.

So the fluctuations partially cancel each other out.

This is why diversification isn't simply about owning more stocks. The diversification benefit
comes from combining assets whose returns do not move together in exactly the same
way.

That sets up the next part of the module, where the professor will formally explain this
relationship using covariance and correlation.

6-5 Key Takeaways

●​ A portfolio is a collection of assets.
●​ Diversification reduces risk by combining investments that respond differently to
events.
●​ Unique risk, also called firm-specific or idiosyncratic risk, can be diversified away.
●​ Market risk cannot be diversified away.
●​ Standard deviation represents the investment's total risk, which contains both
unique and market risk.
●​ Expected portfolio return is the weighted average of the individual securities'
expected returns.
●​ Portfolio risk is not simply the weighted average of the individual securities' standard
deviations.
●​ The 75% auto / 25% gold portfolio has an expected return of 4% and standard
deviation of only 3.89%.
●​ The portfolio therefore has less risk than either individual security, demonstrating
the benefit of diversification.
●​ The next question is why the two securities offset each other so effectively,
which leads into covariance and correlation.
6-6 Correlation and Covariance
​ ​ ​ ​ ​ ​ ​

Module 6-6: Correlation, Covariance &

Portfolio Risk
In 6-5, we saw something striking: combining the auto stock and gold stock reduced the
portfolio's standard deviation to only 3.89%, even though the individual stocks had standard
deviations of 10.6% and 16.4%.

Section 6-6 explains why.

The reason is that the two stocks do not move together. When one tends to perform poorly,
the other tends to perform well. That relationship between their movements is what creates
the diversification benefit.

1. Correlation and Diversification

The professor introduces correlation coefficient as a measure of the extent to which two
securities move together.

For diversification purposes, we generally want securities that do not move closely
together.

If two stocks tend to rise and fall together, combining them provides relatively little
diversification.

If they tend to move in opposite directions, losses in one can be offset by gains in the other,
substantially reducing the variability of the portfolio.

This is exactly what happened with the auto and gold stocks.

2. Correlation Coefficient
The correlation coefficient measures the strength and direction of the relationship
between the returns of two securities.

It always falls between −1 and +1.

Correlation Relationship Diversification

Benefit
 +1 Perfect positive correlation Lowest

Between 0 and Positive correlation Some

+1

0 Uncorrelated Greater

Between −1 and Negative correlation Greater still

0

−1 Perfect negative Maximum

correlation

The key principle is:

As correlation moves from +1 toward −1, the diversification benefit increases.

So, from a diversification perspective, a lower correlation coefficient is generally better.

+1: Perfect Positive Correlation

The securities move perfectly together.

When one rises, the other rises proportionately; when one falls, the other falls
proportionately.

This provides the least diversification benefit.

0: No Correlation

There is no consistent relationship between the movements of the securities.

Importantly, zero correlation still provides diversification benefits. The securities do not
need to move in opposite directions for diversification to work.

−1: Perfect Negative Correlation

The securities move perfectly in opposite directions.

This produces the greatest potential diversification benefit because movements in one
security can offset movements in the other.

The professor notes that perfect +1 or −1 relationships are unlikely in practice.

3. Covariance
Before calculating correlation, the professor introduces covariance.

Covariance also tells us how two securities move relative to one another:

●​ Positive covariance → they tend to move in the same direction.

●​ Negative covariance → they tend to move in opposite directions.

The calculation is similar to the variance calculation from 6-3 and 6-4, with one important
difference.

When calculating variance, we square the deviation of one security's return from its
expected return.

When calculating covariance, we instead multiply the deviation of Security A by the

deviation of Security B for each possible outcome. We then probability-weight those
products and add them together.

4. Calculating Covariance: Auto and

Gold
We already know:

●​ Expected return on auto = 5%

●​ Expected return on gold = 1%
●​ Each economic state has a probability of 1/3

The professor calculates covariance across the three economic states.

Recession

Auto return = −8%​

Gold return = 20%

Normal Economy

Auto return = 5%​

Gold return = 3%

Boom

Auto return = 18%​

Gold return = −20%

Adding these together gives:

The negative covariance confirms what we already observed: auto and gold tend to move
in opposite directions.
5. Covariance vs. Correlation
Covariance tells us the direction of the relationship, but its numerical value is difficult to
interpret by itself.

For example, the professor's covariance of −173 clearly tells us the relationship is negative,
but how strong is −173?

Unlike correlation, covariance is not bounded between −1 and +1. Its magnitude depends
on the scale of the variables.

Correlation solves that problem by standardizing covariance using the standard deviations of
the two securities.

6. Calculating the Correlation Coefficient

For the auto and gold stocks:

●​ Covariance = −173
●​ Auto standard deviation = 10.6%
●​ Gold standard deviation = 16.4%

The correlation coefficient is calculated as:

So the correlation between the auto and gold stocks is approximately −0.997, which is
extremely close to perfect negative correlation.

This explains why the diversification benefit in 6-5 was so dramatic.

The two securities move almost perfectly in opposite directions.

7. Why −0.997 Matters
Recall the results from 6-5:

Investment Expected Return Standard Deviation

Auto 5.0% 10.6%

Gold 1.0% 16.4%

75% Auto / 25% Gold Portfolio 4.0% 3.89%

The portfolio has much less risk than either stock individually because their correlation is
approximately −0.997.

If the correlation were instead +0.5, the professor explains that diversification would still
reduce risk, but not nearly as dramatically.

The closer the correlation gets to −1, the greater the potential diversification benefit.

8. A Faster Way to Calculate Portfolio

Risk
In 6-5, we calculated the portfolio return separately under recession, normal, and boom
conditions. We then used those possible portfolio returns to calculate variance and standard
deviation.

That works, but it's relatively cumbersome.

Once we know the correlation coefficient, the professor introduces a direct formula for the
standard deviation of a two-security portfolio:
This formula captures both:

1.​ the individual risk of each security; and

2.​ how the two securities move relative to one another.

9. Applying the Portfolio Risk Formula

For the auto/gold portfolio:

●​ Auto weight = 0.75

●​ Gold weight = 0.25
●​ Auto standard deviation = 10.62%
●​ Gold standard deviation = 16.4%
●​ Correlation = −0.997
We get exactly the same portfolio standard deviation that we calculated using the longer
scenario method in 6-5.

10. If Covariance Is Given Instead

The professor also points out that a question may give you covariance instead of
correlation.

Because correlation is calculated from covariance, we can rewrite the portfolio variance
calculation using covariance directly:

So there are really two versions of the same portfolio-risk calculation:

If given correlation: use the formula containing (\rho).

If given covariance: use the formula containing covariance directly.

11. The Big Conceptual Connection

Sections 6-5 and 6-6 together make an important point.

When evaluating an individual security, we measured its total risk using standard deviation.

But once we create a portfolio, the individual standard deviations are not enough.
We also need to know:

How do the securities move relative to one another?

That's why correlation matters.

A risky security can actually reduce the overall risk of a portfolio if its returns move
differently enough from the other securities.

This explains why the professor's "lousy" gold stock can still be useful.

By itself:

●​ Gold has lower expected return.

●​ Gold has higher risk.
●​ It looks inferior to auto.

But within the portfolio, its almost perfectly negative correlation with auto causes it to offset
much of auto's variability.

So the gold stock isn't attractive because of its individual risk-return characteristics. It's
attractive because of its diversification contribution to the portfolio.

6-6 Key Takeaways

●​ Diversification works because securities do not all move together.
●​ Covariance measures how the returns of two securities move relative to one
another.
●​ Negative covariance indicates that the securities tend to move in opposite directions.
●​ Correlation coefficient standardizes covariance and always falls between −1 and
+1.
●​ +1 means perfect positive correlation; 0 means no correlation; −1 means perfect
negative correlation.
●​ The closer correlation is to −1, the greater the diversification benefit.
●​ Even zero correlation provides diversification benefits.
●​ Auto and gold have a correlation of approximately −0.997, explaining the dramatic
reduction in portfolio risk.
●​ Once correlation or covariance is known, portfolio standard deviation can be
calculated directly rather than working through every economic scenario.
●​ A security that looks unattractive individually can still be valuable if it reduces the
risk of the overall portfolio.
6-8 - Market and Unique Risks
​ ​ ​ ​ ​ ​ ​

Module 6-8: Market Risk and Unique Risk

This final section brings the diversification discussion together by asking one central
question:

What type of risk can diversification eliminate, and what type of risk remains even
after a portfolio is well diversified?

The professor distinguishes between unique risk and market risk.

1. Unique Risk
Unique risk is risk associated specifically with an individual company.

The professor also uses several other terms for the same concept:

●​ Firm-specific risk
●​ Idiosyncratic risk
●​ Diversifiable risk
●​ Non-systematic risk

These all refer to risks that affect a particular company rather than the economy as a whole.

Example: Employee Strike

Suppose you invest only in TD Bank and TD employees go on strike.

Because all of your money is invested in TD, the strike could substantially reduce your
investment return.

But suppose your portfolio also contains:

●​ RBC
●​ Bank of Montreal
●​ Shopify
●​ Bell Canada

Those companies may not be affected by the TD strike. Some could even benefit from TD's
difficulties.

As a result, the negative effect of the TD-specific event becomes less important to the
performance of the overall portfolio.

This is why unique risk can be diversified away.

2. Market Risk
Some risks affect the entire economy rather than one particular company.

The professor calls this market risk.

Other terms for market risk include:

●​ Systematic risk
●​ Non-diversifiable risk
●​ Economy-wide risk

Because these risks affect the overall economic system, simply adding more companies to a
portfolio does not eliminate them.

Examples from the lecture include:

●​ Changes in interest rates

●​ Changes in unemployment
●​ Exchange-rate movements
●​ Oil-price shocks
●​ Other macroeconomic conditions
●​ Government-policy changes

These events can affect many companies and industries simultaneously.

3. The Terminology to Keep Straight

This is something the professor specifically emphasizes because students sometimes
confuse the terminology.

Type of Other Names Can It Be Diversified

Risk Away?

Unique Firm-specific, idiosyncratic, non-systematic, Yes

Risk diversifiable

Market Systematic, economy-wide, non-diversifiable No

Risk

The easiest distinction to remember is:

Unique = specific to the company → diversifiable

Market = affects the whole system → non-diversifiable

4. What Happens as More Stocks Are
Added?

If you own only one stock, you are exposed to both:

●​ that company's unique risk; and

●​ general market risk.

As you add more securities from different companies and sectors, the unique-risk
component becomes smaller.

The reason is that individual company problems increasingly offset one another rather than
determining the performance of the entire portfolio.

Eventually, adding additional stocks provides very little further reduction in risk because most
of the unique risk has already been eliminated.

The professor refers to research suggesting that a portfolio of roughly 28 stocks from
different sectors can eliminate most firm-specific risk, while also noting that some
estimates use approximately 15 stocks.

The important concept is not the exact number. It is that diversification eventually reaches a
point of diminishing additional benefit.

5. Diversification Across Sectors Matters

The professor stresses that merely owning a large number of stocks is not enough.

If all 28 companies are technology companies, for example, the portfolio may still be heavily
exposed to risks affecting the technology sector.

A better diversified portfolio would contain securities from different sectors, such as:

●​ Banking
●​ Technology
●​ Utilities
●​ Telecommunications
●​ Airlines
●​ Other industries
Diversification is more effective when the companies are exposed to different sources of
firm-specific and industry-specific risk.

This connects directly to the correlation discussion in 6-6: diversification benefits are greater
when the securities do not move together closely.

6. The Diversification Curve

The professor describes the standard diversification graph.

When the portfolio contains only one security, total risk is relatively high.

As more securities are added:

●​ unique risk declines;

●​ total portfolio risk falls.

Eventually the curve begins to flatten.

At that point, most of the unique risk has been eliminated.

The risk that remains is market risk.

Adding more domestic securities cannot eliminate that remaining market-risk component.

So conceptually:

Total risk consists of unique risk plus market risk.

As diversification increases, unique risk approaches zero, leaving market risk as the
remaining source of portfolio risk.
7. Why Market Risk Cannot Be
Diversified Away Domestically
Suppose an investor owns:

●​ banks,
●​ technology firms,
●​ utilities,
●​ telecom companies,
●​ retailers,
●​ airlines,

all within Canada.

An individual company strike could be diversified away.

But suppose Canadian interest rates rise sharply.

That change can affect:

●​ borrowing costs,
●​ consumer spending,
●​ corporate investment,
●​ stock valuations,
●​ exchange rates,

across many sectors at once.

Owning more Canadian companies does not remove exposure to that economy-wide event.

That is why the professor calls market risk systematic risk: it affects the broader system.

8. International Diversification
The professor then introduces an interesting extension.

If an investor diversifies internationally — for example, investing across:

●​ Canada
●​ United States
●​ China
 ●​ Hong Kong
●​ United Kingdom
●​ Australia
●​ New Zealand

— some country-specific market risk may potentially be reduced if the different national
economies do not move together perfectly.

The diversification benefit depends again on correlation.

If the Canadian economy and another country's economy are imperfectly or negatively
correlated, international investments may provide additional diversification beyond what is
possible using Canadian securities alone.

The professor's main point, however, is that within a single domestic market, market risk
cannot be eliminated simply by adding more securities.

9. Examples: Unique vs. Market Risk

A useful way to classify events is to ask:

Does this primarily affect one company, or does it affect much of the economy?

Event Type of Risk Diversifiable

?

Employees at one company go on strike Unique Yes

A company's product fails Unique Yes

Company-specific management Unique Yes

problems

Interest rates increase Market No

Exchange rates change Market No

Economy-wide unemployment rises Market No

Major oil-price shock Market No

The professor uses the oil-price example to show why macroeconomic shocks can spread
widely. Higher fuel costs affect transportation, businesses, grocery distribution, consumers,
and many other parts of the economy.
10. Connecting Back to Correlation
The professor returns once more to the idea from 6-6.

Diversification works because securities do not move in perfect tandem.

If the correlations among investments are less than perfectly positive, combining them can
reduce portfolio standard deviation.

The lower the correlations between the securities, the greater the potential diversification
benefit.

This applies whether the investor is:

●​ an individual building an investment portfolio; or

●​ a company investing excess cash in marketable securities.

11. Bringing the Entire Module Together

Module 6 has now built a complete sequence.

First, investors require an expected return before investing.

That required return depends partly on the risk they are accepting.

Risk can be measured using variance and standard deviation.

When investments are combined into a portfolio, risk can fall because the securities do not
move perfectly together.

Covariance and correlation measure how those securities move relative to one another.

Diversification can then eliminate much of the unique risk associated with individual firms.

But market risk remains, because economy-wide events affect many investments at the
same time.

For a well-diversified portfolio, therefore, market risk becomes the risk that ultimately
matters.

6-8 Key Takeaways

●​ Unique risk is company-specific and can be diversified away.
●​ Unique risk is also called firm-specific, idiosyncratic, non-systematic, or
diversifiable risk.
●​ Market risk affects the broader economy and cannot be eliminated through ordinary
domestic diversification.
●​ Market risk is also called systematic, economy-wide, or non-diversifiable risk.
●​ Adding securities from different firms and sectors reduces unique risk.
●​ Eventually diversification reaches a point where adding more stocks provides little
additional reduction in risk.
●​ The professor discusses approximately 15–28 diversified stocks as the range
where most unique risk has been eliminated.
●​ Diversification across different sectors is more effective than simply owning many
companies from the same sector.
●​ Once unique risk has been diversified away, market risk remains.
●​ International diversification may reduce some country-specific risk when national
markets are not perfectly correlated.
●​ Diversification works because securities do not move in perfect tandem.