15.1 Risk and Return to an Individual Asset
3 min read•june 18, 2024
Measuring risk and return is crucial for evaluating investments. This topic covers how to calculate returns, analyze historical data, and understand different types of risk. It's all about figuring out if an investment's potential reward is worth the risk.
Investors use tools like , , and to assess performance. They also consider firm-specific risks and market-wide factors. Understanding these concepts helps create balanced portfolios and make informed investment decisions.
Measuring Risk and Return of an Individual Asset
Return calculation for single investments
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- quantifies the actual gain or loss on an investment over a defined period
- Factors in the change in asset value and any (dividends or interest payments)
- Formula:
- Example: An investor buys a stock for 2 dividend, and sells it for 110 - 2) /
- Expressed as a percentage or decimal for easy comparison across investments
- Provides a backward-looking assessment of an investment's performance
- estimates the anticipated future return based on historical data and market conditions
Analysis of historical returns data
- Average return represents the arithmetic mean of a series of past returns
- Calculated by adding up all the returns and dividing by the number of periods
- Formula:
- Example: Returns of 5%, 8%, -2%, and 6% over four years yield an average return of (5% + 8% - 2% + 6%) / 4 = 4.25%$
- indicates how much returns fluctuate around the average
- is a widely used volatility metric
- Calculated as the square root of the (average squared deviation from the mean)
- Formula:
- Higher standard deviation signifies more volatile and risky returns
- Analyzing historical data helps assess an asset's risk-return profile and informs investment decisions
- measures an asset's sensitivity to market movements
Firm-specific risk in asset valuation
- , or , stems from factors unique to a particular company
- Examples include management quality, competitive position, financial leverage, and product pipeline
- Can be mitigated through portfolio (holding a variety of assets)
- Contrasts with , which affects the entire market (interest rates, inflation)
- influences asset valuation and required returns
- Investors demand a for holding assets with higher firm-specific risk
- Assets with elevated firm-specific risk may trade at discounted prices relative to their expected cash flows
- The (CAPM) posits that investors should only be rewarded for bearing , not diversifiable firm-specific risk
Risk and Return Relationships
- describes investors' preference for lower risk given the same level of expected return
- suggests that higher potential returns are associated with higher levels of risk
- represents the set of optimal portfolios that offer the highest expected return for a given level of risk
- between assets affects overall portfolio risk and benefits
- Lower correlation between assets generally leads to better diversification
Key Terms to Review (42)
3M (MMM): 3M (MMM) is a diversified global corporation known for its innovative products across multiple industries including healthcare, consumer goods, and industrial applications. It is publicly traded on the NYSE under the ticker symbol MMM and is often analyzed for its performance in financial markets.
Apple, Inc.: Apple, Inc. is a multinational technology company known for its innovative products such as the iPhone, MacBook, and Apple Watch. It is also one of the largest publicly traded companies by market capitalization.
Arithmetic average return: Arithmetic average return is the sum of a series of returns divided by the number of observations in the series. It provides a simple average that indicates the typical return over a given period.
Average Return: Average return is a measure of the central tendency of a set of returns, calculated by summing the individual returns and dividing by the number of observations. It provides a general indication of the typical or expected return an investor can anticipate from an asset or investment over a given period of time.
Beta Coefficient: The beta coefficient, or simply beta, is a measure of the volatility or systematic risk of an individual asset or security in relation to the overall market. It quantifies the sensitivity of an asset's returns to changes in the broader market's returns.
Capital Asset Pricing Model: The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between the expected return of an asset and its risk. It provides a framework for understanding how the market values an asset based on its systematic risk, which is measured by the asset's beta. CAPM is a fundamental concept in finance that is widely used in investment analysis, portfolio management, and corporate finance decision-making.
Cash Distributions: Cash distributions refer to the payments made by a company to its shareholders, typically in the form of dividends or share repurchases. These distributions represent a return of a portion of the company's profits or accumulated earnings to its owners, the shareholders.
Correlation: Correlation is a statistical measure that describes the strength and direction of the linear relationship between two variables. It quantifies how changes in one variable are associated with changes in another variable.
CVS: CVS, or Coefficient of Variation of Standard Deviation, measures the relative risk of an asset by comparing the standard deviation to the mean return. It is used to assess the risk per unit of return for different investments.
CVS Health Corp. (CVS): CVS Health Corp. (CVS) is a diversified healthcare company that operates through several segments including pharmacy services, retail/LTC, health care benefits, and corporate. It is a significant player in the U.S. healthcare industry, influencing various aspects of patient care and service delivery.
DAL: Diversified Asset List (DAL) is a portfolio of investments spread across various asset classes to reduce risk. It aims to balance the potential return and risk by investing in different financial instruments, industries, and other categories.
Delta Airlines (DAL): Delta Airlines (DAL) is one of the major airlines in the United States, providing both domestic and international flights. It is a publicly traded company whose stock is listed on the New York Stock Exchange under the ticker symbol DAL.
Disney: Disney is a global entertainment conglomerate known for its film studios, theme parks, and media networks. In finance, Disney serves as an example of a blue-chip stock with a diversified portfolio, impacting risk and return considerations for investors.
Diversification: Diversification involves spreading investments across various financial assets to reduce risk. It aims to minimize the impact of any single asset's poor performance on an overall investment portfolio.
Diversification: Diversification is the practice of investing in a variety of assets to reduce the overall risk of a portfolio. It involves spreading investments across different asset classes, industries, and geographic regions to minimize the impact of any single investment's performance on the overall portfolio.
Efficient Frontier: The efficient frontier is a concept in finance that represents the set of optimal portfolios, where each portfolio offers the maximum expected return for a given level of risk or the minimum risk for a given level of expected return. It is a crucial tool for understanding and optimizing the risk-return tradeoff in investment decisions.
Expected Return: The expected return is the anticipated or average return an investor expects to receive on an investment or asset over a given period of time. It is a crucial concept in the context of understanding risk and return, as well as the application of the Capital Asset Pricing Model (CAPM) to evaluate the performance of investments.
ExxonMobil (XOM): ExxonMobil (XOM) is one of the world's largest publicly traded oil and gas companies. It is a major player in the energy sector, operating in exploration, production, refining, and marketing of petroleum products.
Facebook (FB): Facebook (FB) is a social media platform founded by Mark Zuckerberg in 2004, which has since become a major player in digital advertising. It is also a publicly traded company on the NASDAQ stock exchange under the ticker symbol 'FB'.
Firm-specific risk: Firm-specific risk is the risk associated with an individual company or asset, independent of market-wide factors. It can be mitigated through diversification in a portfolio.
Firm-Specific Risk: Firm-specific risk, also known as unsystematic risk, refers to the risk associated with a particular company or asset that is independent of overall market or industry performance. It is the risk that is unique to a specific firm and can be diversified away by investing in a portfolio of assets.
Geometric average return: Geometric average return is the average rate of return per year over a period of time, accounting for compounding. It provides a more accurate measure of an investment's performance compared to the arithmetic average return, especially over long periods with volatile returns.
Holding period percentage return: Holding period percentage return is the total return received from holding an asset or investment over a specified period, expressed as a percentage. It includes both capital gains and income, such as dividends or interest, earned during the holding period.
Lower-volatility investments: Lower-volatility investments are financial assets that exhibit smaller price fluctuations over time compared to higher-volatility investments. These assets are often considered safer and more stable, making them attractive for risk-averse investors.
LUV: LUV is the ticker symbol for Southwest Airlines Co., a major American airline. It is often analyzed as an individual asset to understand its risk and return characteristics in the market.
Market risk premium: The market risk premium is the additional return expected by investors for taking on the higher risk of investing in the stock market over a risk-free asset. It is a key component in determining the cost of equity using the Capital Asset Pricing Model (CAPM).
Peloton: Peloton is a technology company that offers internet-connected stationary bicycles and treadmills for indoor fitness. It provides live and on-demand classes through a subscription service, integrating data analytics to enhance user experience.
Realized return: Realized return is the actual gain or loss an investor experiences on an investment over a specific period. It includes income from interest or dividends plus any capital gains or losses realized during the holding period.
Realized Return: Realized return refers to the actual return an investor receives on an investment over a specific period of time. It represents the gains or losses that have been realized through the sale or disposition of an asset, as opposed to the potential or unrealized returns that may be reflected in the asset's current market value.
Risk Aversion: Risk aversion is a fundamental concept in finance and economics that describes an individual's or entity's preference for avoiding or minimizing potential losses, even if it means forgoing potential gains. It is a crucial factor in decision-making processes related to investments, portfolio management, and broader economic behaviors.
Risk Premium: The risk premium is the additional return that investors expect to receive as compensation for taking on the higher risk associated with a particular investment. It represents the extra yield that investors demand to hold riskier assets compared to safer, less volatile investments.
Risk-Return Tradeoff: The risk-return tradeoff is a fundamental concept in finance that describes the relationship between the level of risk associated with an investment and the potential return it can generate. It suggests that higher-risk investments typically offer the potential for higher returns, while lower-risk investments generally provide lower returns.
Southwest Airlines (LUV): Southwest Airlines (LUV) is a major U.S. airline known for its low-cost business model and point-to-point route structure. It is listed on the New York Stock Exchange under the ticker symbol LUV.
Standard deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion in a set of data values. It is used to assess the risk and volatility of an investment's returns in finance.
Standard Deviation: Standard deviation is a statistical measure that quantifies the amount of variation or dispersion of a set of data values around the mean or average. It provides a way to understand how spread out a group of numbers is from the central tendency.
Systematic risk: Systematic risk is the risk inherent to the entire market or a market segment. It cannot be eliminated through diversification and is influenced by factors such as economic changes, political events, and natural disasters.
Systematic Risk: Systematic risk, also known as market risk or undiversifiable risk, is the risk inherent to the entire market or market segment, which cannot be mitigated through diversification. It is the risk that affects all assets and cannot be eliminated by holding a diversified portfolio.
Target (TGT): Target (TGT) is a retail corporation that operates a chain of discount department stores. It is also a publicly traded company, with its stock listed on the New York Stock Exchange under the ticker symbol TGT.
Unsystematic Risk: Unsystematic risk, also known as diversifiable or idiosyncratic risk, refers to the risk that is specific to an individual asset or a small group of assets. It is the portion of an asset's total risk that is not related to overall market movements or systematic factors, and can be reduced or eliminated through diversification.
Variance: Variance is a statistical measure that quantifies the amount of variation or dispersion of a set of data values from the mean or expected value. It is a fundamental concept in finance that is closely related to the assessment of risk and return for individual assets and portfolios.
Volatility: Volatility refers to the degree of variation in the price or value of a financial asset, economic indicator, or market over time. It is a measure of the uncertainty or risk associated with the size of changes in a variable's value. Volatility is a crucial concept in finance, economics, and risk management, as it helps understand the stability and predictability of various financial and economic phenomena.
XOM: XOM is the stock ticker symbol for Exxon Mobil Corporation, a major American multinational oil and gas corporation. Investing in XOM involves analyzing its risk and return characteristics in the context of individual assets.