1. The Returns and Risks From Investing
Chapter 6
Charles P. Jones, Investments: Analysis and Management,
Twelfth Edition, John Wiley & Sons

2. Asset Valuation Function of both return and risk
At the center of security analysis
Historical risk-return relationships useful indicators
No guarantee future will be like the past
Also no reason to assume that relative relationships will be much different in the future than they are now
Especially useful in the long-run

3. Return Components Returns consist of two elements:
Yield
Periodic cash flows such as interest or dividends
Measures return relative to purchase or current price
Capital gain (loss)
The change in price of the asset
Total Return =Yield + Price Change
Investors sometimes focus only on yield

4. Measuring Returns
For comparing performance over time or across different securities
Total Return is a percentage relating all cash flows received during a given time period, denoted CFt + (PE - PB), to the start of period price, PB

5. Measuring Returns Total Return can be either positive or negative
When cumulating or compounding, negative returns are problem
A Return Relative solves the problem because it is always positive

6. Measuring Returns
To measure return in dollars and reflect compounding returns over a time period, given a specific initial investment, use Cumulative Wealth Index
Cumulative Wealth Index, CWIn, over n periods =

7. Measuring International Returns
International investments subject to exchange rate risk
When you buy a foreign asset, you must use the foreign currency, so you must first exchange home currency
If foreign currency depreciates, returns lower in domestic currency terms
Total Return in domestic currency =

8. Measures Describing a Return Series
TR, RR, and CWI are useful for a given, single time period
What about summarizing returns over several time periods?
Arithmetic mean, or simply mean,

9. Arithmetic Versus Geometric
Arithmetic mean does not measure the compound growth rate over time
Does not capture the realized change in wealth over multiple periods
Does capture typical return in a single period
Geometric mean reflects compound, cumulative returns over more than one period
Over multiple periods, the geometric mean shows the true average compound growth rate

10. Geometric Mean
Defined as the n-th root of the product of n return relatives minus one, or G =

11. Adjusting Returns for Inflation
Return measures are nominal, i.e., are not adjusted for inflation
Purchasing power of investment may change over time
Nominal return = real return + expected inflation rate
Consumer Price Index (CPI) is possible measure of inflation

12. Risk Risk and return are opposite sides of the same coin
Risk is the chance that the actual outcome from an investment will differ from the expected outcome
Investors willing to assume large risks may gain large returns, but they may also lose money

13. Interest Rate Risk Market Risk Inflation Risk Business Risk
Affects income return
Market Risk
Recession, war, etc.
Inflation Risk
Purchasing power variability
Business Risk
Financial Risk
Tied to debt financing
Liquidity Risk
Marketability of security in secondary market
Currency Risk
Exchange Rate Risk
Country Risk
Political stability
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14. Measuring Risk Risk arises from variability of outcomes
Variance and standard deviation measure variability
Standard Deviation is simply the square root of the variance

15. Returns for Major Asset Classes
200
Spread in Returns for Major Asset Classes,
-60
Inflation
Treasury bills
Corporate bonds
Treasury bonds
S&P 500
Small stocks

16. Risk Types Two general types:
Systematic (general) risk
Pervasive, affecting all securities, cannot be avoided
Interest rate or market or inflation risks
Nonsystematic (specific) risk
Unique characteristics specific to issuer
Total Risk = General Risk + Specific Risk

17. Risk Premiums
Premium is additional return earned or expected for additional risk
Calculated for any two asset classes
Equity risk premium is the difference between stock and risk-free returns
Stocks versus Treasury bills
Stocks versus Treasury bonds

18. Risk Premiums
Equity Risk Premium, ERP, =

19. The Risk-Return Record
From , geometric average annual return was 9.6% for S&P 500
Arithmetic mean was 11.4%
Standard deviation was 19.9%
Smaller common stocks show greater risks and returns than large common stocks in that period
T-bills showed lowest risk and return

20. Cumulative Wealth Indexes
Cumulative wealth index can be decomposed into
Dividend component: cumulative dividend yield (CDY)
Price change component: (CPC)
6-20 20

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