1. CHAPTER 2 RISK, RETURN AND PORTFOLIO ALLOCATION SAMER AOUN 138035 RUSTAM PIRIZADE 109170 CHIA KENNETH TOH 145388

2. CONTENTS Measuring Risk and Return Risk and Holding Period Investor Returns from Market Peaks Standard Measures of Risk Varying Correlation between Stock and Bond Returns Efficient Frontiers Recommended Portfolio Allocations Inflation-Indexed Bonds

3. RISK AND RETURN  Building blocks of finance and portfolio management  Risk and return on stocks and bonds are not physical constants  It cannot be experimented  The past should be analyzed for a better future  Investors time horizon is extremely important

4. RISK AND HOLDING PERIOD  Basically, the worst-case scenario is very useful for investors, this way they can be more prepared for the outcome  Analyzes the max & min real holding period returns and consists of three periods  Between 1-5 years holding period, the worst performance in stocks is slightly worse than the worst performance of bonds and bills

5. For 10 year holding periods, worst performance has been better than bonds or bills For 20 year holding periods, stocks have never fallen below inflation

6. RISK AND HOLDING PERIOD

7. The relevance of the holding period is that of a portfolio of assets Stocks are riskier than bonds in one or two year periods As time period increases, the opposite occurs

8. HOLDING PERIOD COMPARISONS

9. As the time horizon increases, the percentage of the performance of stocks outperforming bills and bonds increases After 30 years of holding period, it becomes a 100% of the time Never in the past 175 years would a buyer of 30year government bonds outperform an investor of a diversified portfolio of common stocks

10. INVESTOR RETURNS FROM MARKET PEAKS The wealth accumulated in stocks is much larger than bonds and bills Investors in the stock market have no reason to abandon this market, no matter how high the market may seem As difficult as it seems to sell stocks at a peak, it is more difficult to buy at market bottoms because of fear

11. Average Total Real Returns after Major Twentieth-Century Market Peaks

12. STANDARD MEASURES OF RISK The standard deviation is one the basic measures of the risk The higher the standard deviation, the higher the risk Over 30 year periods, the standard deviation of portfolio of equities is less than three-fourths of bills or bonds

13. Risk for Average Real Return over Various Holding Periods

14.  If asset return is following a random walk, as holding period is increasing the standard deviation tends to decrease A random walk is explaining that future returns is independent than past returns As a holding period increases this hypothesis is disobeyed by fixed income assets

15. Varying Correlation between Stock and Bond Returns  Diversifying strength of asset is measured by correlation coefficient If bonds and stock have negative correlation, that means their price will move in opposite directions As the correlation coefficient between assets and portfolio return increases, the diversifying quality of assets decreases

16. Correlation Coefficient between Monthly Stock and Bond Returns

17. EFFICIENT FRONTIERS  Investors may alter the risk by mixing assets Modern portfolio theory describes how investors may alter the risk and return of a portfolio by changing the mix between assets Each combination of assets has its own risk and returns

18. Risk-Return Trade-Offs for Various Holding Periods, 1802 through December 2006

19. Recommended Portfolio Allocations Portfolio allocation depends on personal attitude In order to better share risk, the best allocation of portfolio should always contain a greater share of stocks It might seem puzzling that the holding period has never been considered in the portfolio construction

20. Portfolio Allocation: Percentage of Portfolio Recommended in Stocks Based on All Historical Data

21. INFLATION-INDEXED BONDS Before 1779 there were no USA bonds whose returns were guaranteed by inflation But after 1997 bonds change in prices were guaranteed by inflation For most long-term investors, inflation-indexed bonds should dominate nominal bonds in a portfolio

22. CONCLUSION History has shown that stocks are less risky in the long run There is still no definite answer regarding what the dollar will be worth two or three decades later We can be more certain of a purchasing power in a diversified portfolio of common stocks than 30 year U.S. government bond