Transcript Risk and Return - Bellevue College

Module 3
Risk and Return
Copyright Leslie Lum
Learning Objectives
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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
Copyright Leslie Lum
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
Copyright Leslie Lum
Capital Gain
• Why do we invest?
• To make money on our money.
Copyright Leslie Lum
Capital Gain
Copyright Leslie Lum
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?
Copyright Leslie Lum
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.
Copyright Leslie Lum
What if you held one investment for three
years and another for one year?
Copyright Leslie Lum
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.
Copyright Leslie Lum
It’s not always a gain--
Copyright Leslie Lum
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 $69.81. Calculate your annualized
gain or loss.
Copyright Leslie Lum
Return - Income or Yield
Copyright Leslie Lum
Let’s look at how stocks give yield
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Exxon Mobil (Ticker symbol XOM)
General Motors (Ticker symbol GM)
Johnson and Johnson (Ticker symbol JNJ)
Practice more on your own. Being able to
calculate return is important.
Use finance.yahoo.com
Copyright Leslie Lum
20/20 hindsight is great but what
about the future?
• Stock returns will differ depending on when you
bought or sold the stock.
• How can you know what a stock will do in the
future when you buy?
• There’s no sure way but investors look at the
average return over a period of time to predict what
will happen in the future.
• The average takes away some of the ups and downs
of stock prices.
Copyright Leslie Lum
McDonald's and 3M
Annual Return
70%
60%
50%
McDonald's
3M
40%
30%
20%
10%
0%
1996
-10%
1997
1998
Best Performer for Year
-20%
Copyright Leslie Lum
1999
2000
Calculating year-to-year returns
Yearly Rate of Return =
2000Close  1999Close  2000Dividend
1999Close
McDonald's Dividend McDonald's annual 3M year Dividend 3M's annual return
year end
return
end close
close price
price ($)
($)
1995
1996
22.42
22.54
0.132
0.152
1997
23.72
0.161
1998
1999
2000
38.16
40.05
34.00
0.176
0.198
0.215
(22.54
- 22.42 +

0.152) 22.42 = 1%

(23.72
- 22.54 +
0.161) 22.54 = 6%
62%
5%
-15%
58.56
75.23
76.14
67.73
95.56
119.87
Copyright Leslie Lum
1.88
1.92 
(75.23 - 58.56 +
1.92) 58.56 = 32%
2.12  (76.14 - 75.23 +
2.12) 75.23 = 4%
2.2
-8%
2.24
44%
2.32
28%
Calculate the average annual return
McDonald's
Annual Return
1995
1996
1997
1998
1999
2000
Total
Averageannual return
(Total number of
returns or 5)
3M's
Annual Return
1%
6%
62%
5%
-15%
59%
12%
Copyright Leslie Lum
32%
4%
-8%
44%
28%
100%
20%
McDonald's and 3M
Annual Return
70%
60%
50%
McDonald's
3M
MCD Range
77%
Minimum -15%
Maximum 62%
40%
30%
20%
10%
3M Range 52%
Minimum -8%
Maximum 44%
3M Average 20%
MCD Average 12%
0%
1996
-10%
1997
1998
Best Performer for Year
-20%
Copyright Leslie Lum
1999
2000
Calculate average annual return
Dec-01
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
KMB
Dividends
59.81
1.12
70.69
1.08
65.438
1.04
54.5
1
49.313
0.96
47.625
TJX
40.04
27.75
20.438
29
17.188
11.844
Dividends
0.22
0.155
0.135
0.115
0.531
Copyright Leslie Lum
MHK
55.01
27.375
26.375
42.063
21.938
14.667
APC
Dividends
57.43
0.225
71.08
0.2
34.125
0.2
30.875
0.188
30.344
0.152
32.375
Real Return
The effect of inflation
Copyright Leslie Lum
Inflation Rate
20%
15%
10%
5%
0%
1931
1936
1941
1946
1951
1956
1961
1966
1971
-5%
-10%
-15%
Source: bea.gov
Copyright Leslie Lum
1976
1981
1986
1991
1996
2001
How does inflation affect your
investment?
Copyright Leslie Lum
Which is the best return?
Year
1980
1996
1974
Nominal Return
14%
6%
10%
Copyright Leslie Lum
After inflation, the 6% return is
the best!!
Year
1980
1996
1974
Nominal Return
14%
6%
10%
Inflation Rate
12.5%
3.3%
12.3%
Copyright Leslie Lum
Real Return
1.3%
2.6%
-2%
Figure out what the best real return is
Inflation
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
9%
4%
4%
4%
4%
1%
4%
4%
5%
6%
3%
3%
3%
3%
3%
3%
2%
2%
3%
3%
T-Bills in 1981 at 15%
Corporate Bonds in 1988 at 14%
Government Bonds in 1998 at 13%
Copyright Leslie Lum
Risk
• True or false?
– Risk is bad
– You can go through
your investment life
without selecting risky
investments
– You can’t manage risk
Copyright Leslie Lum
It’s July 2000 and you’re trying to decide
between buying Costco or Starbucks
• 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?
Copyright Leslie Lum
Given two stocks with the same
return, pick the stock with less
volatility
Average Monthly
Return
Standard Deviation
Maximum Monthly
Return
Minimum Monthly
Return
Starbucks
3%
Costco
3%
15%
32%
10%
20%
-38%
-41%
Copyright Leslie Lum
Standard deviation is used to measure
risk
Copyright Leslie Lum
Here is the formula
(Optional)
Average X  
xi
N
Individual
values
S tandarddeviation  
2
(X

X
)
 i
Number of
values
Copyright Leslie Lum
N
Let’s do it for Family B—
(Optional)
1. Each shoe size
(X) minus the
Family B average.
12
12 – 8 = 4
5
5 – 8 = -3
11
11 – 8 = 3
4
4 – 8 = -4
2. Square the
result.
3. Total
4. Divide this by
the number of
people (4).
5. Take the square
root.
Copyright Leslie Lum
16
9
9
16
50
12.5
3.54
Family B has more variability
Copyright Leslie Lum
Which is the most volatile?
Do calculations before looking at answers.
Dec-01
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
KMB
Dividends
59.81
1.12
70.69
1.08
65.438
1.04
54.5
1
49.313
0.96
47.625
TJX
40.04
27.75
20.438
29
17.188
11.844
Dividends
0.22
0.155
0.135
0.115
0.531
MHK
55.01
27.375
26.375
42.063
21.938
14.667
Copyright Leslie Lum
APC
Dividends
57.43
0.225
71.08
0.2
34.125
0.2
30.875
0.188
30.344
0.152
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.
Copyright Leslie Lum
High Beta Stock - Yahoo - Beta 3.6
Yahoo Monthly Returns (1966-2001)
100%
80%
Beta
y = 3.6119x + 0.0317
R2 = 0.3468
Beta = Slope or
Rise over Run
36% divided by 10%
60%
40%
20%
36%
10%
0%
-20%
-15%
-10%
-5%
0%
5%
-20%
-40%
S&P 500 Monthly Returns 1996-2001
Copyright Leslie Lum
10%
15%
20%
Low Beta Stock - Anheuser Busch - Beta = 0.26
Anheuser Busch Monthly Returns 1996-2001
15%
Beta
10%
y = 0.2609x + 0.0158
2
R = 0.0452
5%
2.6%
10%
0%
-20%
-15%
-10%
-5%
0%
5%
10%
-5%
-10%
Beta = Slope or
Rise over Run
2.6% divided by 10%
-15%
S&P 500 Monthly Returns 1996-2001
Copyright Leslie Lum
15%
Do these betas match your
hunches about the stocks?
Amazon
General Motors
Philip Morris
Bank of America
WalMart
Copyright Leslie Lum
2.96
1.13
0.35
1.27
0.88
Estimate these betas and then go
to the web for betas
(finance.yahoo.com)
Company
British Petroleum
Fox Entertainment
Kroger
Network Appliances
Amgen
Ticker Symbol Industry
BP
Energy company. You might know
its BP gas stations.
FOX
Purveyor of television and movies.
KR
Large supermarket chain.
NTAP
Technology (data storage) company.
AMGN
Biotechnology company.
Copyright Leslie Lum
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%
Source: Global Financial Data, www.globalfindata.com
Copyright Leslie Lum
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
0%
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%
Average 9.9%
10%
-10%
Source: Global Financial Data
Copyright Leslie Lum
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
0%
Annual Return on Stocks
(Total Return S&P 500 1971-2000)
50%
40%
30%
Standard
Deviation
16.5%
20%
Average 14.5%
10%
-10%
-20%
About 70% of returns fall within one
standard deviation of the average
-30%
Source: Global Financial Data
Copyright Leslie Lum
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
0%
Distribution of Annual Total Returns
20
18
T-Bills
Average Return 6.7%
Standard Deviation 2.7%
T-Bills
Bonds
16
Stocks
Bonds
Average Return 9.9%
Standard Deviation
9.3%
14
12
10
Stocks
Average Annual Return
14.5%
Standard Deviation 16.5%
8
6
4
2
0
Less than
-25%
-25% to
-20%
-20% to
-15%
-15% to
-10%
-10% to
-5%
-5% to
0%
0 to
5%
Source: Global Financial Data
Copyright Leslie Lum
5% to
10%
10% to
15%
15% to
20%
20% to
25%
25% to
30%
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%
Standard Deviation 16.5%
14%
Return
12%
(Annual Return)
10%
Bonds
Average Return 9.9%
Standard Deviation 9.3%
8%
6%
4%
T-Bills
Average Return 6.7%
Standard Deviation 2.7%
2%
0%
0%
2%
4%
6%
8%
Risk
(Standard Deviation)
Copyright Leslie Lum
10%
12%
14%
16%
Copyright Leslie Lum
Plot the risk return graph for
these. Does the risk return
relationship hold? What is the best
stock for you?
Citigroup
Standard
Deviation
Average
Monthly
Return
Caterpillar
Motorola
Oracle
Amgen
10%
10%
13%
20%
12%
3.2%
1.0%
0.6%
4.7%
3.4%
Copyright Leslie Lum
Plot the risk return graph
Return
(Average
Return)
Risk
Copyright Leslie Lum
(Standard
Deviation)
Try another risk return graph
American
Airlines
Standard
Deviation
Average
Monthly
Return
Philip
Morris
AOL
British
Petroleum
BUD
11%
10%
21%
7%
6%
0.2%
1.7%
6.3%
1.5%
2.0%
Copyright Leslie Lum
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?
Copyright Leslie Lum
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 risk
Copyright Leslie Lum
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
Copyright Leslie Lum
How should you deal with volatility?
Copyright Leslie Lum