Risk & Return

Risk& - RISK RETURN Stony Brook College of Business BUS 330 V Giardini 1 INVESTOR PSYCHOLOGY RATIONAL SELF-INTEREST CONCERN OVER HOW A

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1 Stony Brook College of Business BUS 330 V. Giardini
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2 INVESTOR PSYCHOLOGY INVESTOR PSYCHOLOGY RATIONAL SELF-INTEREST CONCERN OVER HOW A DECISION WILL AFFECT A PERSON’S WELL BEING RISK AVERSION PREFERENCE FOR LESS RISK TIME PREFERENCE OF MONEY PREFERENCE FOR EARLIER RATHER THAN LATER CASH FLOWS
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3 EXPECTED RETURN ON INVESTMENT Return = K = [(P 1 - P 0 ) + D 1 ] / P 0
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4 EXPECTED CASH FLOWS = EXPECTED VALUE = = M j j j i R p R 1 Where: R j = the j th cash flow M = the number of possible cash flows p j = the likelihood that the j th outcome will occur
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5 VARIANCE & STANDARD DEVIATION AS MEASURES OF RISK RISK DEFINED: VARIABILITY OF RISK DEFINED: VARIABILITY OF RETURNS RETURNS
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VARIANCE VARIANCE Think of variance as variability in successive annual returns The bigger the variance, the more different successive returns are likely to be P(k X ) Small Variance (low risk) Large Variance (high risk) k X k X Expected Return Return Probability Distributions with Large and Small Variances
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Standard Deviation of a Probability Standard Deviation of a Probability Distribution Distribution ( 29 2 / 1 1 2 - = = M j i j j i R R p σ
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Risk-Return Trade-Off Risk-Return Trade-Off Risk-Return 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00% 14.00% 16.00% 18.00% 20.00% 0.00% 10.00% 20.00% 30.00% 40.00% Standard Deviation Average Return Small-Company Stocks T-Bills Corporate Bonds T-Bonds Large-Company Stocks
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9 PORTFOLIOS PORTFOLIOS Investors generally hold the stocks of several companies. An investor's total stock holding is a portfolio. Risk and Return for a Portfolio The return on a portfolio is the average return of the stocks in it, weighted by the dollars invested in each stock. The portfolio's return has a probability distribution with a mean and variance. These are the portfolio's expected return and risk. The expected return is the weighted average of the stock's expected returns. The variance depends on the stock's variances, but in a complex way.
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Risk Premiums in a Portfolio Context Risk Premiums in a Portfolio Context Risk that can be diversified away does not command a risk premium. The market demands a return premium that’s related to an asset’s contribution to the risk of a diversified portfolio. Diversification works because stock prices don’t move in lock step. Portfolio risk depends on both the risk of the individual assets and how their returns relate to one another.
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11 Return, k A C C A P k p k B B Time Risk In and Out of a Portfolio A adds risk to the portfolio (perfectly positively correlated with market) B reduces the portfolio's risk (perfectly negatively correlated with market) BUT outside the portfolio A and B are equally risky
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This note was uploaded on 02/15/2012 for the course GERM 200 taught by Professor Kuhmar during the Spring '10 term at SUNY Albany.

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Risk& - RISK RETURN Stony Brook College of Business BUS 330 V Giardini 1 INVESTOR PSYCHOLOGY RATIONAL SELF-INTEREST CONCERN OVER HOW A

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