Copyright Leslie Lum Module 3 Risk and Return. Copyright Leslie Lum Learning Objectives Calculate total and annualized capital gain and loss Calculate.

Copyright Leslie Lum

Module 3Risk and Return


Learning Objectives• Calculate total and annualized capital gain and loss • Calculate yield• Calculate average annual gain• Calculate rate of return• Calculate real return• Explain why standard deviation measures risk• Calculate standard deviation • Explain how beta measures risk• Explain the risk characteristics of the major asset classes• Explain investment risk• Explain the relationship between risk and return• Evaluate return per risk using the Sharpe ratio• Calculate and evaluate risk and return for specific investments


True or False?

• Most investors know exactly how much they make

• The investment with the most return is the one to go after

• You can’t predict when investments will tank


Capital Gain

• Why do we invest?• To make money on our money.


Capital Gain


Try some

• You bought AT&T at $32.77 per share and sell at $59.32 per share. What is your total holding gain?

• You buy Microsoft at $42.41 per share and sell at $52.94 per share. What is your total holding gain?


Try one on the web

Smart Money Website

Buy GE at the end of the month January 2000 and sell GE at the end of

the month January 2003.

http://www.smartmoney.com/


What if you held one investment for three years and another for

one year?


Try some

• You buy Microsoft for $54.97 on the last day of July 1998 and sell on the last day of July 2000 for $69.81. Calculate your annualized gain.

• You buy Intel for $23.01 on the last day of September 1997 and sell on the last day of July 2000 for $66.73. Calculate your annualized gain.


It’s not always a gain--


The same stocks

• You buy AT&T for $40.65 per share at the end of November 1998 and sell in July 2000 for $30.94. Calculate your annualized gain or loss.

• You buy Microsoft for $116.75 per share at the end of December 1999 and sell in July 2000 for $69.81. Calculate your annualized gain or loss.


Return - Income or Yield


Let’s look at how stocks give yield

• Exxon Mobil (Ticker symbol XOM)• General Motors (Ticker symbol GM)• Johnson and Johnson (Ticker symbol

JNJ)• Practice more on your own. Being

able to calculate return is important.Use finance.yahoo.com


20/20 hindsight is great but what about the future?

• Stock returns will differ depending on when you bought or sold the stock.

• How can you know what a stock will do in the future when you buy?

• There’s no sure way but investors look at the average return over a period of time to predict what will happen in the future.

• The average takes away some of the ups and downs of stock prices.


McDonald's and 3M Annual Return

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1996 1997 1998 1999 2000

McDonald's

3M

Best Performer for Year


Calculating year-to-year returns

McDonald'syear endclose price

($)

DividendMcDonald's annualreturn

3M yearend closeprice ($)

Dividend3M's annual return

1995 22.42 0.132 58.56 1.881996 22.54 0.152 (22.54 - 22.42 +

0.152)22.42 = 1%75.23 1.92 (75.23 - 58.56 +

1.92)58.56 = 32%1997 23.72 0.161 (23.72 - 22.54 +

0.161)22.54 = 6%76.14 2.12 (76.14 - 75.23 +

2.12)75.23 = 4%1998 38.16 0.176 62% 67.73 2.2 -8%1999 40.05 0.198 5% 95.56 2.24 44%2000 34.00 0.215 -15% 119.87 2.32 28%

Close

DividendCloseClose

1999

200019992000 Yearly Rate of Return =


Calculate the average annual return

McDonald'sAnnual Return

3M'sAnnual Return

19951996 1% 32%1997 6% 4%1998 62% -8%1999 5% 44%2000 -15% 28%Total 59% 100%

Average annual return(Totalnumber of

returns or 5)

12% 20%


McDonald's and 3M Annual Return

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1996 1997 1998 1999 2000

McDonald's

3M

3M Average 20%

MCD Average 12%

MCD Range 77%

Minimum -15%Maximum 62%

3M Range 52%Minimum -8%Maximum 44%

Best Performer for Year


Calculate average annual return

KMB Dividends TJX Dividends MHK APC DividendsDec-01 59.81 1.12 40.04 0.22 55.01 57.43 0.225Dec-00 70.69 1.08 27.75 0.155 27.375 71.08 0.2Dec-99 65.438 1.04 20.438 0.135 26.375 34.125 0.2Dec-98 54.5 1 29 0.115 42.063 30.875 0.188Dec-97 49.313 0.96 17.188 0.531 21.938 30.344 0.152Dec-96 47.625 11.844 14.667 32.375


Real ReturnThe effect of inflation


Inflation Rate

-15%

-10%

-5%

0%

5%

10%

15%

20%

1931 1936 1941 1946 1951 1956 1961 1966 1971 1976 1981 1986 1991 1996 2001

Source: bea.gov


How does inflation affect your investment?


Which is the best return?

Year Nominal Return 1980 14% 1996 6% 1974 10%


After inflation, the 6% return is the best!!

Year Nominal Return Inflation Rate Real Return 1980 14% 12.5% 1.3% 1996 6% 3.3% 2.6% 1974 10% 12.3% -2%


Figure out what the best real return is

Inflation

1981 9%1982 4%1983 4%1984 4%1985 4%1986 1%1987 4%1988 4%1989 5%1990 6%1991 3%1992 3%1993 3%1994 3%1995 3%1996 3%1997 2%1998 2%1999 3%2000 3%

T-Bills in 1981 at 15%

Corporate Bonds in 1988 at 14%

Government Bonds in 1998 at 13%


Risk

• True or false?– Risk is bad– You can go

through your investment life without selecting risky investments

– You can’t manage risk


It’s July 2000 and you’re trying to decide between buying Costco or

Starbucks• Costco’s average monthly return

for the past 5 years is 3%• Starbuck’s average monthly

return for the past 5 years is 3%• Which do you choose?


Given two stocks with the same return, pick the stock

with less volatility

Starbucks CostcoAverage MonthlyReturn

3% 3%

Standard Deviation 15% 10%Maximum MonthlyReturn

32% 20%

Minimum MonthlyReturn

-38% -41%


Standard deviation is used to measure risk


Here is the formula(Optional)

N

)X(X deviation dardtanS

N

x X Average

2i

i

Number of values

Individual values


Let’s do it for Family B—(Optional)

Family B

1. Each shoe size(X) minus theaverage.

2. Square theresult.

12 12 – 8 = 4 165 5 – 8 = -3 9

11 11 – 8 = 3 94 4 – 8 = -4 16

3. Total 504. Divide this bythe number ofpeople (4). 12.55. Take the squareroot. 3.54


Family B has more variability


Which is the most volatile?Do calculations before looking at

answers.

KMB Dividends TJX Dividends MHK APC DividendsDec-01 59.81 1.12 40.04 0.22 55.01 57.43 0.225Dec-00 70.69 1.08 27.75 0.155 27.375 71.08 0.2Dec-99 65.438 1.04 20.438 0.135 26.375 34.125 0.2Dec-98 54.5 1 29 0.115 42.063 30.875 0.188Dec-97 49.313 0.96 17.188 0.531 21.938 30.344 0.152Dec-96 47.625 11.844 14.667 32.375


BetaBeta is another measure of risk.

Based on the concept that market risk or overall volatility of the market is not something an investor can control.

Beta measures movement of the stock in relation to the market.


High Beta Stock - Yahoo - Beta 3.6

y = 3.6119x + 0.0317

R2 = 0.3468

-40%

-20%

0%

20%

40%

60%

80%

100%

-20% -15% -10% -5% 0% 5% 10% 15% 20%

S&P 500 Monthly Returns 1996-2001

Ya

ho

o M

on

thly

Re

turn

s (

19

66

-20

01

)

Beta

36%

10%

Beta = Slope or Rise over Run

36% divided by 10%


y = 0.2609x + 0.0158

R2 = 0.0452

-15%

-10%

-5%

0%

5%

10%

15%

-20% -15% -10% -5% 0% 5% 10% 15%

S&P 500 Monthly Returns 1996-2001

An

he

us

er

Bu

sc

h M

on

thly

Re

turn

s 1

99

6-2

00

1

Low Beta Stock - Anheuser Busch - Beta = 0.26

Beta

Beta = Slope or Rise over Run

2.6% divided by 10%

10%2.6%


Do these betas match your hunches about the

stocks?

Amazon 2.96 General Motors 1.13 Philip Morris 0.35 Bank of America 1.27 WalMart 0.88


Estimate these betas and then go to the web for

betas (finance.yahoo.com)Company Ticker Symbol IndustryBritish Petroleum BP Energy company. You might know

its BP gas stations.Fox Entertainment FOX Purveyor of television and movies.Kroger KR Large supermarket chain.Network Appliances NTAP Technology (data storage) company.Amgen AMGN Biotechnology company.


Let’s put it all togetherMajor asset classes: Risk & Return

Annual Return on Cash (Treasury Bill Total Return 1971-2000)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Source: Global Financial Data, www.globalfindata.com

Average 6.7%Standard Deviation 2.7%

About 70% of returns fall within one standard deviation of the average


Annual Return on Bonds (Total Return Government Bonds 1971-2000)

-10%

0%

10%

20%

30%

40%

50%

19

71

19

72

19

73

19

74

19

75

19

76

19

77

19

78

19

79

19

80

19

81

19

82

19

83

19

84

19

85

19

86

19

87

19

88

19

89

19

90

19

91

19

92

19

93

19

94

19

95

19

96

19

97

19

98

19

99

20

00

Source: Global Financial Data

Average 9.9%

Standard Deviation 9.3%



Annual Return on Stocks(Total Return S&P 500 1971-2000)

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000


Average 14.5%

Standard Deviation

16.5%



Distribution of Annual Total Returns

0

2

4

6

8

10

12

14

16

18

20

Less than-25%

-25% to-20%

-20% to-15%

-15% to-10%

-10% to-5%

-5% to0%

0 to5%

5% to10%

10% to15%

15% to20%

20% to25%

25% to30%

T-Bills

Bonds

Stocks


StocksAverage Annual Return 14.5%Standard Deviation 16.5%

BondsAverage Return 9.9%Standard Deviation 9.3%

T-BillsAverage Return 6.7%Standard Deviation 2.7%


The more return you need, the more risk you take.The more risk you take, the more return you need.

Major Asset Classes (1971-2000)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

0% 2% 4% 6% 8% 10% 12% 14% 16%

Risk (Standard Deviation)

Return (Annual Return)

T-BillsAverage Return 6.7%


BondsAverage Return 9.9%


StocksAverage Annual Return 14.5%




Plot the risk return graph for these. Does the risk

return relationship hold? What is the best stock for

you?Citigroup Caterpillar Motorola Oracle Amgen

StandardDeviation

10% 10% 13% 20% 12%

AverageMonthlyReturn

3.2% 1.0% 0.6% 4.7% 3.4%


Plot the risk return graph

Return

(Average Return)

Risk

(Standard Deviation)


Try another risk return graph

AmericanAirlines

PhilipMorris

AOL BritishPetroleum

BUD

StandardDeviation

11% 10% 21% 7% 6%

AverageMonthlyReturn

0.2% 1.7% 6.3% 1.5% 2.0%


Return per Risk

• Investment 1 gives a 15% return with a 25% risk.

• Investment 2 gives a 12% return with an 18% risk.

• Which one is better?


Sharpe Ratio

• Creates a measure of return for every unit of risk

• Used to measure portfolios of investments

• The higher the ratio the more return you’re getting for every unit of risk


Which is better for return per risk?

ARK Small Cap Fund 0.48

Franklin Small Cap 0.01

Fidelity Small Cap 0.07

Bank of America 1.27

Fremont Small Cap 0.29


How should you deal with volatility?

Copyright Leslie Lum Module 3 Risk and Return. Copyright Leslie Lum Learning Objectives Calculate total and annualized capital gain and loss Calculate.

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