Risk and Return

# Risk and Return - Risk and Return This lecture develops the...

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Risk and Return This lecture develops the relationship between risk and return and presents methods for measuring risk. We also discuss the concept of investment diversification and portfolio risk analysis. I. Many important concepts are utilized when risky securities or investments are evaluated. A. Risk refers to the possibility that actual cash flows (returns) will be different than forecasted cash flows (returns). An investment is said to be risk-free if the dollar returns from the initial investment are known, in advance, with certainty. The best example of this is a 30-day U.S. Treasury Bill since the risk of default is almost nil. B. Risk may be more precisely defined by using some probability concepts. The probability that a particular outcome will occur is defined as the percentage chance of its occurrence. A probability distribution consists of the probabilities of every possible outcome. Probability distributions may be objectively or subjectively determined. and the probabilities must equal 100% C. The expected return E(R) is a weighted average of the individual forecasted returns: D. The standard deviation σ (Greek letter sigma ) is an absolute measure of risk. This statistical measure is defined as the square root of the weighted average of the squared deviations of individual observations from the expected value. First, let's show you how to calculate an investment's return: What is a Rate of Return? A rate of return is similar to calculating a percentage change, but in a rate of return you are calculating the percent change in the value of some kind of investment. Unlike just a percentage change, the phrase “rate of return” always assumes an annualized number. What that means is that the number has to be expressed in an equivalent number that would assume that the investment had been held for exactly a year; even though most times the actual time an investment has been held is different from a year. 1

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Calculating a Rate of Return How do we do calculate a rate of return? Well, we have a generic formula that we can adjust for exactly the amount of time and investment has been held for (which is also known as “the length of the investment"). So if you buy a stock on January 5 and sell it on January 20; the length of the investment is 15 days, which is January 20- January 5. Note that you do not include the date of purchase in this time period, but you do include the date of sale. There are two steps in calculating a rate of return: The first step is to calculate what is known as the "return on investment". This return on investment must be expressed as a decimal and is calculated as: ( Ending Price- Beginning Price) = Return on Beginning Price Investment The second step is to take the return on investment and annualize it so that is expressed in terms of one year. This is the generic formula that is used for annualized rates of return: [(1 + return on investment expressed as a decimal) n – 1] * 100% = Annualized Rate of Return
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## This note was uploaded on 12/08/2010 for the course FIN 4163N taught by Professor Spencer during the Spring '10 term at Dowling.

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Risk and Return - Risk and Return This lecture develops the...

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