CHAPTER 5:

RISK AND
RETURN
Roseline Mannuela, S.E., M.S.M., CFP®
RISK & RETURN FUNDAMENTALS
• In most important business decisions there are two key financial considerations →
Risk & Return.
• Analysts use different methods to quantify risk, depending on whether
they are looking at a single asset or a portfolio → a collection or group of assets.
• Risk → A measure of the uncertainty surrounding the return that an investment will earn or the
variability of returns associated with a given asset.
• Investments whose returns are more uncertain are generally riskier. Example:
A $1,000 government bond that guarantees its holder $5 interest after 30 days has no risk because
there is no variability associated with the return.
A $1,000 investment in a firm’s common stock is very risky because the value of that stock may
move up or down substantially over the same 30 days.
RISK & RETURN FUNDAMENTALS
• If we are going to assess risk on the basis of variability of return, we need to be certain we
know what return is and how to measure it.
• Total rate of return → The total gain or loss experienced on an investment over a given
period of time.
• Mathematically, an investment’s total return is the sum of any cash distributions (for
example, dividends or interest payments) plus the change in the investment’s value, divided
by the beginning-of-period value.
REQUIRED RATE OF RETURN
RISK PREFERENCES
Different people react to risk in different ways.

RISK RISK RISK

AVERSE NEUTRAL SEEKING

The attitude toward risk in The attitude toward risk in

The attitude toward risk in
which investors require an which investors prefer
which investors choose the
increased return as investments with greater risk
investment with the higher
compensation for an increase even if they have lower
return regardless of its risk
in risk expected returns.
INVESTMENT RIST RANKING
Investment Instrument Risk Level Return Potential Examples
Bank Savings Very Low Low Regular savings, checking accounts
Less Risky Time Deposits Low Slightly higher than savings 1-month, 3-month, 12-month deposits
ORI (Retail Government Bonds),
Government Bonds (SBN) Low to Medium Higher than deposits, relatively stable
Sukuk Retail
Money Market Mutual Investment in deposits, short-term
Low More flexible than deposits, stable
Funds bonds
Higher than government bonds, depends
Corporate Bonds Medium Corporate debt securities
on issuer's health
Fixed Income Mutual Higher than money market funds, with Investment in government &
Medium
Funds some fluctuations corporate bonds
Combination of stocks, bonds, and
Balanced Mutual Funds Medium to High Higher returns, but more volatile
money market
Equity Mutual Funds High High potential returns, but fluctuates Majority investment in stocks

Company shares listed on the stock

Individual Stocks High Can yield high profits, but very volatile
exchange (e.g., BBCA, TLKM, BBRI)

Cryptocurrency Very High Extremely high potential, highly volatile Bitcoin, Ethereum, Dogecoin
Most Risky
Forex (Foreign Exchange) Very High High potential profits, extreme fluctuations Trading USD/IDR, EUR/USD
Derivatives (Options, Stock options, oil/gas futures
Extreme Huge profit potential, highly speculative
Futures, CFD) contracts
RISK AND RETURN CONCEPT
High risk → High Return / High Gain

Important Assumptions:
✓Every individual is rational and does not like risk (risk averse)
✓High risk high return
✓Individuals will choose a low risk investment, if the rate of return is the
same for all the option of the investments.
RISK ASSESSMENT - SCENARIO
ANALYSIS
• The more uncertain you are about how an investment will perform → The riskier that investment seems.
• Scenario analysis provides a simple way to quantify that intuition, and probability distributions offer an even
more sophisticated way to analyze the risk of an investment.
• Scenario Analysis → An approach for assessing risk that uses several possible alternative outcomes (scenarios)
to obtain a sense of the variability among returns.
• One common method involves considering pessimistic (worst), most likely (expected), and optimistic (best)
outcomes and the returns associated with them for a given asset.
• Range → A measure of an asset’s risk, which is found by subtracting the return associated with the pessimistic
(worst) outcome from the return associated with the optimistic (best) outcome → The greater the range, the
more variability / risk the asset is said to have.
SCENARIO ANALYSIS - EXAMPLE
RISK ASSESSMENT - PROBABILITY
DISTRIBUTIONS
• Probability → The chance that a given outcome will occur.
• Probability Distribution → A model that relates probabilities to the associated
outcomes.
• Bar Chart → The simplest type of probability distribution; shows only a limited
number of outcomes and associated probabilities for a given event.
• Continuous Probability Distribution → A probability distribution showing all the
possible outcomes and associated probabilities for a given event .
RISK ASSESSMENT - PROBABILITY
DISTRIBUTIONS

Although both assets

have the same
average return, the
range of return is
much greater, or
more dispersed, for
asset B than for
asset A: 16% vs
4%
RISK ASSESSMENT - PROBABILITY
DISTRIBUTIONS

Note that although the two

assets have the same average
return (15%), the distribution
of returns for asset D
has much greater dispersion
than the distribution for asset
C → Asset D
is more risky than asset C
RISK MEASUREMENT – STANDARD
DEVIATION
Standard Deviation (σr) :
Measures the dispersion of an investment’s return around the expected
return.
If the probability of occurrence of an If the probability of occurrence of an
outcome is considered equal: outcome is considered different:
RISK MEASUREMENT – EXPECTED
RETURN
• To be able to find the value of the standard deviation, it is necessary to find the
expected value first.
• Expected Return (𝑟)ҧ → The average return that an investment is expected to produce
over time.
The formulas for finding the expected return are:
Probability of the occurrence of different The probability of occurrence of an
results: outcome is assumed to be the same:
𝑛 σ𝑛𝑖=1 𝑟𝑖
𝑟=෍ 𝑟𝑖 . 𝑃𝑟𝑖 𝑟=
𝑖=1 𝑛
RISK & RETURN - EXAMPLE
RISK & RETURN – SINGLE ASSET
RISK & RETURN – SINGLE ASSET

Asset B

Kesimpulan:
Risiko Aset A (1,41%) < Aset B (5,66 %)
COEFFICIENT OF VARIATION (CV)
• Coefficient Variation → A measure of relative dispersion that is useful in comparing
the risks of assets with differing expected returns.
• A higher coefficient of variation means that an investment has more volatility relative
to its expected return. Because investors prefer higher returns and less risk, one might
intuitively expect investors to gravitate towards investments with a low coefficient of
variation.
The smaller the CV
X Y
value, the more efficient
𝑟ҧ 12%* 20%* the asset is because it
provides higher returns
σ 9% 10% with lower risk.

CV 0,75 0,5
RISK & TIME

Time Period Uncertainty Risk

DIVERSIFICATION & PORTFOLIO
• A collection of assets is called a Portfolio
• Diversification is the spread of wealth
RISK OF A PORTFOLIO
• Diversification is enhanced depending upon the extent to which the returns on assets “move” together.
• This movement is typically measured by a statistic known as “correlation”.
• Correlation → A statistical measure of the relationship between any two series of numbers → Positive & Negative
• Correlation Coefficient → A measure of the degree of correlation between two series.
• Perfectly positively correlated → Describes two positively correlated series that have a correlation coefficient of +1
• Perfectly negatively correlated → Describes two negatively correlated series that have a correlation coefficient of -1
RISK OF A PORTFOLIO
Correlation, Return, and Risk for Various Two-Asset
Portfolio Combinations
PORTFOLIO RETURN
Efficient Portfolio → A portfolio that maximizes return for a given level of risk.
ASSET PORTFOLIO
Expected return
Perhitungan return Expected return
Tahun
portofolio portofolio
Aset X Aset Y

2000 8 20 (0.5 x 8%) + (0.5 x 20%) 14 %

2001 10 20 (0.5 x 10%) + (0.5 x 20%) 15 %

2002 12 17 (0.5 x 12%) + (0.5 x 17%) 14,5 %

2003 14 17 (0.5 x 14%) + (0.5 x 17%) 15,5 %

(0.5 x 16%) + (0.5 x 12%)

2004 16 12 14 %
ASSET PORTFOLIO
14% + 15% + 14,5% + 15,5% + 14%
𝑅𝑝 =
5
73%
𝑅𝑝 = = 14,6%
5

(14% − 14,6%)2 + (15% − 14,6%)2 + (14,5% − 14,6%)2 + (15,5% − 14,6%)2 + (14% − 14,6%)2
𝜎𝑟𝑝 =
5−1

1,7
𝜎𝑟𝑝 = = 0,65%
4
RISK AND RETURN: THE CAPITAL ASSET
PRICING MODEL (CAPM)
A theoretical model that explains the relationship between risk and expected
return on risky assets.
This model helps investors understand how the market values the risk and return of an
asset.

1 Diversif iable Risk 2 Non-Diversif iable Risk

Risk that can be eliminated or Risk that cannot be eliminated
reduced through portfolio through diversification, such as
diversification, such as business market risk, interest rate risk,
risk and liquidity risk. and inflation risk.
RISK AND RETURN: THE CAPITAL ASSET
PRICING MODEL (CAPM)
THE MODEL: CAPM
Beta Coef f icient (β)
• The sensitivity or volatility of an asset or stock relative to the overall market
• Indicates how much the price of that asset moves relative to the movement of the market.

The value of β :
✓ β = 1 → The asset has the same volatility as the market. If the market goes up by 10%, this asset will
also go up by 10%.
✓ β > 1 → The asset is more volatile than the market. If the market goes up by 10%, this asset may go up
by more than 10%. This means the asset has higher risk but also higher potential returns.
✓ β < 1 → The asset is less volatile than the market. If the market goes up by 10%, this asset may only go
up by 5%, indicating lower risk.
✓ β < 0 → The asset moves in the opposite direction of the market. If the market goes up, the asset's
price may go down, and vice versa.
THE MODEL: CAPM

Example:
Given that Rm = 11%, Rf =
7%, βj =1.5
What is the value of Rj?

Answer:
Rj = Rf + [(Rm – Rf ) βj]
Rj = 7% + [(11% - 7 %) 1.5]
Rj = 13%
THE GRAPH: THE SECURITY MARKET
LINE (SML)

Security Market Line (SML) :

The depiction of the capital asset pricing
model (CAPM) as a graph that reflects the
required return in the marketplace for
each level of non diversifiable risk (beta).
SINGLE ASSET RISK
(Ri- (Ri-ER(A))2 x (Ri-ER(B))2
Pr A B ER(A) ER(B) (Ri-ER(B))2
ER(A))2 Pr x Pr

0.10 18% 15%

0.40 15% 12%

0.15 28% 33%
0.35 36% 32%

Jumlah σ2
σ
Koef. Var

Hitunglah nilai varians, standar deviasi, dan koef isien varians

dari kedua asset diatas!
Menurut anda, aset manakah yang sebaiknya dipilih
SINGLE ASSET RISK

Pr A B ER(A) ER(B) (Ri-ER(A))² (Ri-ER(B))² (Ri-ER(A))² x Pr (Ri-ER(B))² x Pr

0.1 18 15 1.8 1.5 43.56 55.50 4.36 5.55
0.4 15 12 6 4.8 92.16 109.20 36.86 43.68
0.15 28 33 4.2 4.95 11.56 111.30 1.73 16.70
0.35 36 32 12.6 11.2 129.96 91.20 45.49 31.92
Jumlah 24.6 22.45 σ² 88.44 97.85
σ 9.40 9.89
Risiko aset A 9.40% Koef. Var 0.38 0.44
Risiko aset B 9.89%
Lebih baik memilih aset A karena risikonya lebih kecil.
THANK YOU!