1. Risk & Return (Part 2) Lecture 06

2. EFFECTIVE ANNUAL RETURN:  The return on an investment expressed on a per-year, or “annualized,” basis.  Till now we have discussed only returns of the overall investment. E.g. if the total percentage return on an investment is 35% and the investment was done for 6 months. Than it means that, this 35% return belong to the full life of investment i.e. 6 months.  Holding period: is the length of the time for which the investment was done.  For example: Suppose you bought 200 shares of Shah Companies, Inc. at a price of $48 per share. In three months, you sell your stock for $51. You didn’t receive any dividends. What is your return for the three months? What is your annualized return?

3. Solution:

4. Now Finding Effective Annual Return:

5. AVERAGE RETURN:  Whenever we are having returns for more than one year, than at this particular time in order to make investment decision, it will be vice to calculate the average of the different returns you have in historical data.  The change in the annual return figure actually leads us to do so.  We have many measures of central tendency; we will discuss only two of them.

6. 1. Arithmetic Return: YearReturns 1 10% 2 12% 3 15% 4 (6%) 5 8% 6 4%

8. 2. Geometric Average Return:  The formula for calculating geometric average return is,

9. Numerical: YearsReturns 1 10% 2 12% 3 3% 4 (9%)

11. BLUME’S FORMULA:  Sometime our concerns are to forecast the future.  There is a lot of confusion among analysts and financial planners. i.e. Which one method is to be used for good estimations?  The good news is that there is a simple way of combining the two averages, which is called Blume’s formula.  Presented by Marshal Blume’s. Journal of the American Statistical Association, September 1974. Where, T = Number of years for which you wish to find average possible return. N = Number of years for which historical return data is taken. R (T) = The forecasted average return for T period

12. Numerical based on Blume’s Formula:

14. THANKS