1. Introduction to risk, return, and the opportunity
cost of capital
So, don't ask me no questions And I won't tell you no lies So, don't ask me about my business And I won't tell you goodbye - Rossington, VanZant

2. Stock market indexes DOW JONES INDUSTRIAL AVERAGE (The Dow)
Value of a portfolio holding one share
in each of 30 large industrial firms.
STANDARD & POOR'S COMPOSITE INDEX (The S&P 500)
Value of a portfolio holding shares in 500
major firms. Holdings are proportional to
the number of shares in issue.

3. Stocks, Bonds, Bills, and Inflation
Ending Wealth
Average Return
$12,233
$2,587
$84.39
$20.53
Stocks, Bonds, Bills, and Inflation® A 80-year examination of past capital market returns provides historical insight into the performance characteristics of various asset classes. This graph illustrates the hypothetical growth of a $1 investment in four traditional asset classes, as well as inflation, over the time period December 31, 1925 through December 31, Large and small company stocks have provided the largest increase in wealth over the past 80 years. The fixed-income investments provided only a fraction of the growth provided by stocks. Judging from the ending wealth value, stocks would appear to be the investment of choice. However, these higher returns came with much greater volatility (risk) when compared to the fixed-income investments. Furthermore, small company stocks may be subject to a higher degree of market risk than large company stocks. Note: The data assumes reinvestment of all income and does not account for taxes or transaction costs. The average return represents a compound annual return. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest. Stocks are not guaranteed and have been more volatile than the other asset classes. Small company stocks are more volatile than large company stocks and are subject to significant price fluctuations, business risks, and are thinly traded. Underlying data is from the Stocks, Bonds, Bills, and Inflation (SBBI) Yearbook, by Roger G. Ibbotson and Rex Sinquefield updated annually. An investment cannot be made directly in an index. Past performance is no guarantee of future results. Source: Small Company Stocks—represented by the fifth capitalization quintile of stocks on the NYSE for and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S Small Company Portfolio thereafter; Large Company Stocks—Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general; Government Bonds—20-year U.S. Government Bond; Treasury Bills—30-day U.S. Treasury Bill; Inflation—Consumer Price Index.
$12.14
2009
1925
1935
1945
1955
1965
1975
1985
1995
Hypothetical value of $1 invested at year-end Assumes reinvestment of income and no transaction costs or taxes
This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2010. Copyright © 2010 Ibbotson Associates, Inc.

4. Volatility of Stock and Bond Returns
Stocks
Bonds
-40%
-30%
-20%
-10% 0%
10%
20%
30%
40%
50%
1926
1946
1966
1986
2006
50%
40%
30%
20%
10%
Monthly Returns 0%
Volatility of Stock and Bond Returns Stocks and bonds have experienced different levels of return over the past 80 years. Both stocks and bonds have experienced changes in return behavior over the past 80 years. Although stocks exhibited tremendous volatility before World War II, the market has been much less dramatic since that time. Conversely, bonds exhibited more stability in earlier periods, but have seen dramatic increases in volatility over the past 20 years. One relationship has remained constant: stocks have been more volatile than bonds on a month-to-month basis. Over the long term, however, stock investors have been rewarded for assuming this greater volatility. Due to a moderately low correlation between stock and bond returns (stocks and bonds have responded differently to economic events), a mix of these two asset classes can provide significant diversification benefits Note: The disparity between performance and volatility in the bond market for the periods prior to and after October 1979 can be attributed to the new operating procedures of the Federal Reserve. Prior to this date, the Federal Reserve used the federal funds rate as an operating target. Subsequently, the Federal Reserve de-emphasized this rate as an operation target and instead began to focus on the manipulation of the money supply (through nonborrowed reserves). As a result, the federal funds rate underwent much greater volatility, which brought about greater volatility in Treasury returns. Diversification does not eliminate the risk of experiencing investment losses. Government bonds are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest. Stocks are not guaranteed and have been more volatile than bonds. An investment cannot be made directly in an index. Past performance is no guarantee of future results. Source: Stocks—Standard & Poor’s 500®, which is an unmanaged group of securities and considered to be representative of the stock market in general; Bonds—20-year U.S. Government Bond.
-10%
-20%
-30%
-40%
1926
1946
1966
1986
2006
Monthly returns in percent from
This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2006. Copyright © 2006 Ibbotson Associates, Inc..

5. Rates of Return 1926-2009 Percentage Return Year
Source: Ibbotson Associates

6. Stocks, Bonds, Bills, and Inflation
Summary Statistics
Compound
Annual
Return
Arithmetic
Annual
Return
Risk
(Standard Deviation)
Distribution of
Annual Returns
Large
Company
Stocks
9.66%
11.8%
20.5%
Small
Company
Stocks *
11.7%
16.5%
33.0%
5.7%
6.1%
9.4%
Government Bonds
Stocks, Bonds, Bills, and Inflation: Summary Statistics This image summarizes, quantitatively, the risk/return trade-off inherent in investing; that is, the potential return of an asset generally increases with the asset’s risk.
The compound annual return shown in the first column reflects the annual rate of return achieved over the entire 80-year time period assuming the reinvestment of all income. It is the average rate of return which, when earned each year, equates the investment’s beginning value with its ending value. The figure in the second column represents a simple or arithmetic average of the individual annual returns over the past 80 years. Standard deviation, shown in the third column, is used to measure the risk of an investment. It shows the fluctuation of returns around the arithmetic annual return of the investment. The higher the standard deviation, the greater the variability of the investment returns. The “skyline” or distribution for each asset class graphically depicts the information contained in the summary statistics table. Riskier assets, such as stocks, have spread out “skylines,” reflecting the broad distribution of returns from very poor to very good. Less risky assets, such as bonds, have narrow “skylines” indicating a tight distribution of returns around the average. Note: The data assumes reinvestment of all income and does not account for taxes or transaction costs. Underlying data is from the Stocks, Bonds, Bills, and Inflation® (SBBI ®) Yearbook, by Roger G. Ibbotson and Rex Sinquefield, updated annually. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest. Stocks are not guaranteed and have been more volatile than the other asset classes.Small company stocks are more volatile than large company stocks and are subject to significant price fluctuations, business risks, and are thinly traded. An investment cannot be made directly in an index. Past performance is no guarantee of future results. Source: Small Company Stocks—represented by the fifth capitalization quintile of stocks on the NYSE for and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S Small Company Portfolio thereafter; Large Company Stocks—Standard & Poor’s 500®; Government Bonds—20-year U.S. Government Bond; Treasury Bills—30-day U.S. Treasury Bill; Inflation—Consumer Price Index.
3.7%
3.8%
3.1%
Treasury Bills
2.9%
3.1%
4.2%
Inflation
*The 1933 Small Company Stock total return was 142.9%.
This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2010. Copyright © 2010 Ibbotson Associates, Inc.

7. Large Company Stocks Histogram 1926-2009
Source: Ibbotson Associates 2010

8. Risk Premiums 1926-2009 Average Risk Portfolio Premium
Small-firm stocks %
Common stocks
(S&P 500)
Long-term govt
bonds
Treasury bills 0

9. Average Market Risk Premia (by country)
Risk premium, %
Country

10. Expected return on market portfolio (= expected return on average-risk US stock)
current expected
rm = interest market risk
rate (rf) premium
If expected risk premium = long-run average*
rm = interest rate (rf) %*
* Note: This can change a little bit from year to year.

11. Risk and Return Expected Return Variance and Standard Deviation (Risk)
Prefer more to less.
Variance and Standard Deviation (Risk)
Prefer less to more.

12. Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility.
Standard Deviation – square root of variance.

13. Calculating standard deviation of returns
Rate of from Squared
Year return average deviation
Total
Average rate of return = 83.4/5 = = 16.7
Variance = average of squared deviations = /5 =
Std deviation = square root of variance = = 13.34%

14. Calculating variance and standard deviation of Merck returns from past monthly data
from mean Squared
Month Return return deviation
% %
Total
Mean: /6 = 2.8%
Variance: /6 =
Std dev: Sq root of = 5.85% per month

15. Total risk (standard deviation) for common stocks, 1989 - 1994
Standard Standard
Stock deviation Stock deviation
AT&T % Exxon %
Biogen Ford Motor
Bristol-Myers Squibb General Electric
Coca Cola McDonald’s
Compaq Microsoft

16. Risk and Diversification
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments.
Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”

17. Diversification eliminates unique risk
Portfolio
standard
deviation
Unique risk
Market risk 5 10
Number of
securities

18. Reduction of Portfolio Risk
40%
35%
30%
25%
Risk
20%
15%
Reduction of Portfolio Risk
As the number of asset classes in a portfolio increases, the total risk or volatility of the portfolio decreases.
Diversification is the strategy of holding more than one asset class in a portfolio in order to reduce risk. This image depicts the relationship between portfolio volatility, measured by standard deviation, and the number of asset classes included in a portfolio.
You can limit the effect any individual security or asset class may have on the performance of your portfolio by investing in a combination of asset classes. As a result, declines in one or two assets may be offset by increases in others. Notice that as the number of randomly selected assets in the portfolio increases, the risk level decreases.
While it is impossible to completely avoid risk, diversifying your investments can reduce the overall volatility your portfolio experiences.
Note: Diversification does not eliminate the risk of experiencing investment losses. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns. The portfolios used in this image are created from equally weighted combinations of the following randomly selected asset classes:
Asset Classes Time Period
1. Small Company Stocks
2. Large Company Stocks
3. International Stocks
4. Long-Term Government Bonds
5. Business Real Estate
6. Long-Term Corporate Bonds
7. Treasury Bills
8. International Bonds
U.S. Government bonds and Treasury bills are guaranteed by the full faith and credit of the United States government as to the timely payment of principal and interest. Stocks are not guaranteed and have been more volatile than the other asset classes. Small company stocks are more volatile than large company stocks, are subject to significant price fluctuations and business risks, and are thinly traded. International securities involve special risks that investors should consider such as fluctuations in currency, foreign taxation, political instability, and differing securities regulations and accounting methods. An investment cannot be made directly in an index. Past performance is no guarantee of future results.
Source: Small Company Stocks—represented by the fifth capitalization quintile of stocks on the NYSE for and the performance of the Dimensional Fund Advisors, Inc. (DFA) U.S Small Company Portfolio thereafter; Large Company Stocks—Standard & Poor’s 500®, which is an unmanaged group of securities and is considered to be representative of the stock market in general; Long-Term Government Bonds—20-year U.S. Government Bond; Business Real Estate—Wilshire Real Estate Securities Index; Long-Term Corporate Bonds—Salomon Brothers Long-Term High-Grade Corporate Bond Index; Treasury Bills—30-day U.S. Treasury Bill; International Stocks—Morgan Stanley Capital International Europe, Australasia, and Far East (EAFE®) Index; International Bonds—Salomon Brothers Non-U.S. 1+ Year Government Bond Index.
10% 5% 0% 1 2 3 4 5 6 7 8
Number of Randomly Selected Assets in Portfolio
Risk is measured by standard deviation.
This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2000. Copyright © 2000 Ibbotson Associates, Inc.

19. Stock Diversification
Diversifiable Risk
Market Risk
Risk
Stock Diversification
Diversification is a major benefit of investing in mutual funds.
Company or individual security risk is the risk that a specific stock may fall in price due to non-market-related factors such as poor company management. It is the risk in excess of the overall stock market and is not always rewarded with higher returns. You assume greater company risk when you invest in a limited number of securities.
Including more securities in a portfolio can reduce the level of company-specific risk to which you are exposed. This is true of stocks as well as other types of asset classes. This image illustrates that an investor holding more than 100 stocks assumes little company risk.
Generally, it is impractical for most investors to buy hundreds of individual stocks. Mutual funds are able to reduce company risk because they have economies of scale. With millions of dollars in assets, mutual funds can afford to take positions in hundreds of stocks.
However, even mutual funds cannot diversify away market risk. Market risk is the risk that the entire market will experience a decline in price. Even if you hold every stock in the market and have very little company-specific risk, you will still be exposed to market risk.
Note: Diversification does not eliminate the risk of experiencing investment losses. The portfolios used in this study are equally weighted. Mutual funds may have management fees and other additional costs. Past performance is no guarantee of future results.
Source: Lawrence Fisher and James H. Lorie, “Some Studies of Variability of Returns on Investments in Common Stocks,” Journal of Business, April 1970; Edwin J. Elton and Martin J. Gruber, “Risk Reduction and Portfolio Size: An Analytical Solution,” Journal of Business, October 1977; and Meir Statman, “How Many Stocks Make a Diversified Portfolio?” Journal of Financial and Quantitative Analysis, September 1987. 1 2 4 6 8 16 30 50
100
1000
Number of Stocks in Portfolio
This is for illustrative purposes only and not indicative of any investment.
Past performance is no guarantee of future results. 3/1/2000. Copyright © 2000 Ibbotson Associates, Inc.

20. Where do Diversification Benefits Come from?
Concepts of Correlation and Covariance
Expected Return on portfolio
Standard Deviation of Portfolio Returns

21. Portfolio Risk and Return19

22. Portfolio Return Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The expected return on your portfolio is: 19

23. Portfolio Risk Example
Suppose you invest 60% of your portfolio in Wal-Mart and 40% in IBM. The expected dollar return on your Wal-Mart stock is 10% and on IBM is 15%. The standard deviation of their annualized daily returns are 19.8% and 29.7%, respectively. Assume a correlation coefficient of 1.0 and calculate the portfolio variance. 19

24. To calculate portfolio variance add up the boxes
The shaded boxes contain variance terms; the
remainder contain covariance terms. 1 2 3 4
STOCK 5 6 N 1 2 3 4 5 6 N
STOCK

25. Beta and Unique Risk
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.
How can we measure exposure to market risk?
Beta - Sensitivity of a stock’s return to the return on the market portfolio. Beta is a measure of sensitivity to market movements.

26. Beta Computation
Covariance with the market
Variance of the market

27. Beta

28. Market risk (beta) for common stocks 1994
Stock Beta Stock Beta
AT&T Exxon
Biogen Ford Motor Co
Bristol Myers Squibb General Electric
Coca Cola McDonald’s
Compaq Microsoft

29. Market risk (beta) for common stocks 2010*
Stock Beta Stock Beta
AT&T Exxon
Biogen Ford Motor Co
Bristol Myers Squibb General Electric
Coca Cola McDonald’s
Hewlett-Packard Microsoft
* Source: Finance.yahoo.com, which is based on 36 months of data and S&P500 as market index.

30. Firm Goals to Diversify?
Since diversification reduces risk, should
firms be concerned about diversification?
Investors may diversify more easily.
Value Additivity