Chapter-2
Risk and Return
Concepts and techniques
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Understanding the Fundamental
Relationships
• Balanced scale with coins (risk vs. return)
Proverb: "Don't put all your eggs in one basket.“
• Introduction to Risk and Return
• Return: Reward for owning an investment (income +
capital gains).
• Risk: Uncertainty of achieving expected returns.
• Higher potential returns usually come with higher risk.
Example:
• Low-risk: Government bonds (3% return).
• High-risk: Startup stock (20% return or total loss).
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Measuring Historical Returns
• Holding Period Return (HPR):
HPR = (Ending Value / Beginning Value)
Example: $200 → $220 in 1 year:
HPR = 220/200 = 1.10 (10% return).
• Annualized Return: Adjust for multi-year investments.
Example: $250 → $350 in 2 years:
Initial Value: $250
• End Value: $350
• Years: 2
• CAGR: (350/250)^1/2−1=18.32
• This means the investment grew at an average rate of 18.32% per year,
demonstrating how steady compounding ("slow and steady") leads to
significant growth.
• Proverb: "Slow and steady wins the race." (Geometric mean favors
consistency.)
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Cont’d…
• Expected Return Calculation
• Probability-weighted average of possible
outcomes.
Formula:
E(R) = Σ (Probability × Return)
Example:
– Scenario 1: 30% chance of 5% return.
– Scenario 2: 70% chance of 15% return.
E(R) = (0.3×5%) + (0.7×15%) = 12%.
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Types of Investment Risks
• Business Risk: Volatility in sales/operations (e.g., tech
startups).
• Financial Risk: Debt burden (e.g., highly leveraged
companies).
• Liquidity Risk: Can’t sell quickly (e.g., real estate vs.
stocks).
• Exchange Rate Risk: Currency fluctuations (e.g.,
foreign stocks).
• Country Risk: Political instability (e.g., emerging
markets).
• Image: Risk pyramid (low to high risk assets).
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Measuring Risk
Variance & Standard Deviation
• Variance (σ²): Measures dispersion of returns.
Formula: σ² = Σ [Probability × (Return - E(R))²].
• Standard Deviation (σ): Square root of variance.
Example: Investment with σ = 20% is riskier
than σ = 10%.
"The higher the climb, the harder the fall."
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Cont’d….
• Coefficient of Variation (CV)
• Relative risk per unit of return: CV = σ / E(R).
Example:
– Investment A: E(R) = 10%, σ = 5% → CV = 0.5.
– Investment B: E(R) = 20%, σ = 15% → CV = 0.75.
A is less risky per unit of return.
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Risk Aversion
• Investors prefer lower risk for the same return.
• Risk premium: Extra return demanded for
taking risk.
Example:
– Risk-free rate (T-bills) = 3%.
– Stock expected return = 10%.
– Risk premium = 7%.
Risk-return tradeoff curve.
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Systematic vs. Unsystematic Risk
• Systematic Risk: Market-wide (e.g., recessions).
Cannot be diversified.
• Unsystematic Risk: Asset-specific (e.g.,
company scandal). Diversifiable.
Proverb: "Diversification is the only free lunch in
finance."
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Measuring Systematic Risk
(Beta)
• Beta (β): Sensitivity to market movements.
– β = 1: Moves with market.
– β > 1: More volatile (e.g., tech stocks).
– β < 1: Less volatile (e.g., utilities).
Example: A stock with β = 1.5 rises 15% if market
rises 10%.
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Portfolio Risk and Return
• Portfolio Return: Weighted average of individual
returns.
• Portfolio Risk: Depends on correlation between
assets.
Example: Mixing stocks and bonds reduces overall
risk.
Why Business fail?
• Overconfidence, timing errors, ignoring costs.
Proverb: "Fools rush in where angels fear to tread."
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Qualities of Successful Investors
• Patience, discipline, flexibility.
Proverb: "The market can stay irrational
longer than you can stay solvent.“
End!!!
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