1. Chapter 4
Return and Risks

2. The Concept of Return Return Components of Return
The level of profit from an investment, or
The reward for investing
Components of Return
Current income: cash or near-cash that is received as a result of owning an investment
Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price
Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time

3. Why Return is Important
Allows comparison of actual or expected gains with the levels of gain needed
Allows us to “keep score” on how our investments are doing compared to our expectations
Historical Performance
Provides a basis for future expectations
Does not guarantee future performance
Expected Return
Return an investor thinks an investment will earn in the future
Determines what an investor is willing to pay for an investment or if they are willing to make an investment

4. Key Factors in Return Internal Forces External Forces
Type of investment
Risks of investment
External Forces
Political environment
Business environment
Economic environment
Inflation
Deflation

5. Historical Returns for Popular Security Investments (1926-2005)

6. The Time Value of Money and Returns
The sooner you receive a return on a given investment, the better
A dollar received today is worth more than a dollar received in the future
The sooner your money can begin earning interest, the faster it will grow

7. Determining a Satisfactory Investment
The one that the present value of benefits equals or exceeds the present value of its costs

8. Measuring Return Required Return
The rate of return an investor must earn on an investment to be fully compensated for its risk

9. Measuring Return (cont’d)
Real Rate of Return
The rate of return that could be earned in a perfect world where all outcomes are known and certain—where there was no risk
Historically, this amount has remained relatively stable at 0.5% to 2%
Expected Inflation Premium
The average rate of inflation expected in the future

10. Measuring Return (cont’d)
Risk-free Rate
The rate of return that can be earned on a risk-free investment
The sum of the real rate of return and the expected inflation premium
The most common “risk-free” investment is considered to be the 3-month U.S. Treasury Bill

11. Measuring Return (cont’d)
Risk Premium
Additional return an investor requires on an investment to compensate for higher risks based upon issue and issuer characteristics
Issue characteristics are the type, maturity and features
Issuer characteristics are industry and company factors

12. Holding Period Return (HPR)
Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle
Realized Return: current return actually received by an investor during the given return period
Paper Return: return that has been achieved but not yet realized (no sale has taken place)

13. Holding Period Return (HPR)
The total return earned from holding an investment for a specified holding period (usually 1 year or less)

14. Using HPR in Investment Decisions
Advantages of Holding Period Return
Easy to calculate
Easy to understand
Considers current income and growth
Disadvantages of Holding Period Return
Does not consider time value of money
Rate may be inaccurate if time period is longer than one year

15. Yield: Internal Rate of Return (IRR)
Internal Rate of Return: determines the compound annual rate of return earned on an investment held for longer than one year
Yield (IRR) Example: What is the yield (IRR) on an investment costing $1,000 today that you expect will be worth $1,400 at the end of a 5- year holding period?

16. Yield Calculation

17. Using IRR in Investment Decisions (cont’d)
Advantages of Internal Rate of Return
Uses the time value of money
Allows investments of different investment periods to be compared with each other
If the yield is equal to or greater than the required return, the investment is acceptable
Disadvantages of Internal Rate of Return
Calculation is complex

18. Yield (IRR) for a Stream of Income
Some investments, such as bonds, provide uneven streams of income over the investment period
Calculate yield (IRR) by calculating the PV of the different income amounts and adding together
Yield Calculation for an $1,1,00 Investment

19. Internal Rate of Return (IRR): Using an Excel Spreadsheet

20. Interest on Interest: The Critical Assumption
Using yield (IRR) to measure return assumes that all income earned over the investment horizon is reinvested at the same rate as the original investment.
Reinvestment Rate is the rate of return earned on interest or other income received from an investment over its investment horizon.
Fully compounded rate of return is the rate of return that includes interest earned on interest.

21. Finding Growth Rates Rate of Growth
The compound annual rate of change in the value of a stream of income
Used to see how quickly a stream of income, such as dividends, is growing

22. Finding Growth Rates
Growth Rate Example: Calculate the rate of growth on the dividend stream
Dividends Per Share

23. Finding Growth Rates: Using an Excel Spreadsheet

24. Sources of Risk
Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
Risk is the chance that the actual return from an investment may differ from what is expected

25. Sources of Risk (cont’d)
Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries.
Types of Investments Affected
International stocks or ADRs
International bonds
Examples of Currency Exchange Risk
U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment

26. Sources of Risk (cont’d)
Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.
Types of Investments Affected
Common stocks
Preferred stocks
Examples of Business Risk
Decline in company profits or market share
Bad management decisions

27. Sources of Risk (cont’d)
Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk.
Types of Investments Affected
Common stocks
Corporate bonds
Examples of Financial Risk
Company can’t get additional loans for growth or to fund operations
Company defaults on bonds

28. Sources of Risk (cont’d)
Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.
Types of Investments Affected
Bonds (fixed income)
Certificates of deposit
Examples of Purchasing Power Risk
Movie that was $9.00 last year is $10.50 this year

29. Sources of Risk (cont’d)
Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value.
Types of Investments Affected
Bonds (fixed income)
Preferred stocks
Examples of Interest Rate Risk
Market values of existing bonds decrease as market interest rates increase
Income from an investment is reinvested at a lower interest rate than the original rate

30. Sources of Risk (cont’d)
Liquidity Risk is the risk of NOT being able to liquidate an investment conveniently and at a reasonable price.
Types of Investments Affected
Some small company stocks
Real estate
Examples of Liquidity Risk
The price of a house has to be lowered for a quick sale

31. Sources of Risk (cont’d)
Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments.
Types of Investments Affected
Municipal bonds
Real estate
Examples of Tax Risk
Lower tax rates reduce the tax benefit of municipal bond interest
Limits on deductions from real estate losses

32. Sources of Risk (cont’d)
Market Risk is the risk of decline in investment returns because of market factors independent of the given investment.
Types of Investments Affected
All types of investments
Examples of Market Risk
Stock market decline on bad news
Political upheaval
Changes in economic conditions

33. Sources of Risk (cont’d)
Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.
Types of Investments Affected
All types of investments
Examples of Event Risk
Decrease in value of insurance company stock after a major hurricane
Decrease in value of real estate after a major earthquake

34. Measures of Risk: Single Asset
Standard deviation is a statistic used to measure the dispersion (variation) of returns around an asset’s average or expected return
Coefficient of variation is a statistic used to measure the relative dispersion of an asset’s returns; it is useful in comparing the risk of assets with differing average or expected returns
Higher values for both indicate higher risk

35. Risk-Return Tradeoffs for Various Investment Vehicles

36. Acceptable Levels of Risk Depend Upon the Individual Investor
Risk-indifferent describes an investor who does not require a change in return as compensation for greater risk
Risk-averse describes an investor who requires greater return in exchange for greater risk
Risk-seeking describes an investor who will accept a lower return in exchange for greater risk

37. Steps in the Decision Process: Combining Return and Risk
Estimate the expected return using present value methods and historical/projected return rates
Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns
Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk
Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept