Lecture 7 - Risk, Return and Diversification

Question 1

What are the two forms return can come in?

Answer 1

A dividend or interest payment or a capital gain or capital loss.

Question 2

What does nominal return measure?

Answer 2

How much more money you will have at the end of the year if you invest today.

Question 3

What does real rate of return measure?

Answer 3

How much more you will be able to buy with your money at the end of the year.

Question 4

What is a market index?

Answer 4

Measure of the investment performance of the overall market - summarises the return on different classes of securities.

Question 5

What is the Dow Jones Industrial Average?

Answer 5

The Dow tracks the performance of a portfolio that holds one share in each of 30 large firms.

Question 6

Why is The Dow far from the best measure of performance for the stock market?

Answer 6

With only 30 large stocks, it is not representative of the performance of stocks generally. Secondly, investors do not usually hold an equal number of shares in each company.

Question 7

What is the Standard & Poor’s Composite Index?

Answer 7

The S&P 500 includes the stocks of 500 major companies and is, therefore, a more comprehensive index than The Dow. Also it measures the performance of a portfolio that holds shares in each firm in proportion to the number of shares that have been issued to investors. Thus, the S&P 500 shows the average performance of investors in the 500 firms.

Question 8

Why are Treasury bills a safe investment?

Answer 8

As they are issued by the US government, you can be confident to get your money back. Their short term maturity means that their prices are relatively stable.

Question 9

Long term Treasury bonds are also certain to be repaid when they mature, but the prices of these bonds fluctuate as…

Answer 9

Interest rates vary.

Question 10

When interest rates fall, the values of long term bonds rise; when rates rise…

Answer 10

The value of bonds fall.

Question 11

Why are common stocks a risky investment?

Answer 11

There is no promise that you will get your money back. As a part owner of the corporation, you receive what is left over after the bonds and any other debts that have been repaid.

Question 12

Long term government bonds give slightly higher returns than Treasury bills. This difference is called the…

Answer 12

Maturity premium. This is the extra annual return from investing in long versus short term Treasury securities.

Question 13

The compensation for taking on the risk of common stock ownership is known as the…

Answer 13

Market risk premium. This is the expected return in excess of risk free return as compensation for risk.

Question 14

Average returns on high risk assets have been higher than those on…

Answer 14

Low risk assets.

Question 15

Annual rates of return for common stocks fluctuate so much that…

Answer 15

Averages taken over short periods are extremely unreliable.

Question 16

What is the opportunity cost of capital?

Answer 16

The return that the firm’s shareholders are giving up by investing in the project rather than in comparable risk alternatives.

Question 17

If a project is risky, and most are, then the firm needs to at least match the return that…

Answer 17

Shareholders could expect to earn if they invested in other securities.

Question 18

The expected return on an investment provides…

Answer 18

Compensation to investors both for waiting (the time value of money) and for worrying (the risk of the particular asset).

Question 19

The opportunity cost of capital fo safe projects must be…

Answer 19

The rate of return offered by safe Treasury bills.

Question 20

The opportunity cost for ‘average risk’ projects must be…

Answer 20

The expected return on the market portfolio.

Question 21

What is variance?

Answer 21

Average value of squared deviations from mean. A measure of volatility.

Question 22

What is standard deviation?

Answer 22

Square root of variance. A measure of volatility.

Question 23

Treasury bills tend to be the least…

Answer 23

Variable security.

Question 24

Common stocks tend to be the most…

Answer 24

Variable.

Question 25

What is diversification?

Answer 25

Strategy designed to reduce risk by spreading the portfolio across many investments.

Question 26

Diversification reduces…

Answer 26

Variability.

Question 27

Why does portfolio diversification work?

Answer 27

Prices of different stocks do not move exactly together. Stock price changes are less than perfectly correlated. Diversification works best when returns are negatively correlated. When one business does well, the other does badly. In practice, stocks that are negatively related are very rare.

Question 28

What is the investment opportunity frontier?

Answer 28

Plot of the combinations of expected return versus standard deviation for various portfolio weights. It dramatically illustrates the benefit of diversification.

Question 29

The incremental risk of a stock depends on whether…

Answer 29

Its returns tend to vary with or against the returns of the other assets in the portfolio. It does not just depend on a stock’s volatility. If returns do not move closely with those of the rest of the portfolio, the stock generally will reduce the volatility of portfolio returns.

Question 30

Correlations are highest between pairs of industries that are…

Answer 30

Very sensitive to the business cycle.

Question 31

Investors care about the expected return and risk of their portfolio of assets. The risk of the overall portfolio can be measured by the volatility of returns, that is, the…

Answer 31

Variance or standard deviation.

Question 32

The standard deviation of the returns of an individual security measures…

Answer 32

How risky the security would be if held in isolation. However, an investor who holds a portfolio of securities is interested only in how each security affects the risk of the entire portfolio. The contribution of a security to the risk of the portfolio depends on how the security’s returns vary with the investor’s other holdings. Thus, a security that is risky if held in isolation may, nevertheless, serve to reduce the variability of the portfolio if its returns do not move in lockstep with the rest of the portfolio.

Question 33

The reduction in portfolio risk…

Answer 33

From diversification depends on the correlations between stocks in the portfolio. Portfolios of stocks all taken from one industry, for example, would not benefit much from diversification because the returns would be highly correlated. A portfolio diversified across different industries would benefit more because correlations would be lower.

Question 34

What is specific risk?

Answer 34

Risk factors affecting only that firm. Also called diversifiable risk. This risk can be eliminated by diversification.

Question 35

The risk that you cannot avoid regardless of how much you diversify is generally known as…

Answer 35

Market risk or systematic risk. Market risk is economy wide (macroeconomic) sources of risk that affect the overall stock market.

Question 36

Why does specific risk arise?

Answer 36

Many of the perils that surround an individual company are peculiar to that company and perhaps its direct competitors.

Question 37

What does market risk stem from?

Answer 37

Economy wide perils that threaten all businesses. Market risk explains why stocks have a tendency to move together, so even well diversified portfolios are exposed to market movements.

Question 38

For a reasonably well diversified portfolio…, only market risk matters.

Answer 38

Only market risk matters.

Question 39

What are the messages of risk?

Answer 39

• Some risks look big and dangerous but really are diversifiable.
• Market risks and macro risks. Factors such as changes in interest rates, industrial production, inflation, foreign exchange rates and energy costs affects most firms’ earnings and stock prices. When the relevant macro risks turn generally favourable, stock prices rise and investors do well; when the same variables go the other way, investors suffer. Airlines - As business travel falls during a recession, and individuals postpone vacations and other discretionary travel, the airline is subject to the swings of the business cycle. On the positive side, airline profits really take off when business is booming and personal incomes are rising. On the other hand, food companies - companies selling staples, such as breakfast cereal, flour, and dog food, find that demand for their products is relatively stable in good times and bad. Investors holding diversified portfolios are mostly concerned with macroeconomic risks. They do not worry about microeconomic risks peculiar to a particular company or investment project. Micro risks wash out in diversified portfolios. Company managers may worry about micro and macro risks, but only the former affect diversified investors and the cost of capital.
• Risk can be measured. The movements of the stock market sum up the net effects of all relevant macroeconomic uncertainties.