Chapter 8 Risk and Rates of Return StandAlone

Chapter 8 Risk and Rates of Return Stand-Alone Risk Portfolio Risk and Return: CAPM/SML 8 -1 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Stock Market Level, 2000 -2016, 2000=100 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Apple, Inc. and S&P 500 Monthly Adjusted Price 2000 -2016, 2000=100 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Apple & S&P 500 Monthly Returns, 2000 -2016 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Variance of Apple vs Variance of S&P 500 • • Standard deviation of Apple capital gain in decade shown is 12. 8% a month (not annualized) (arithmetic mean 3. 47% a month, geometric mean 2. 65% a month) – 1. 0347^123=65, 1. 0265^123=25 Standard deviation of S&P 500 return in decade shown is 4. 7% (arithmetic mean capital gain mean 0. 01%, geometric mean -0. 16% a month, meaning we’ve lost money) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

What is risk? 8 -6 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Investment Returns The rate of return on an investment can be calculated as follows: • Investors like returns & dislike risk – Prefer investment with high expected return & low risk For example if $1, 000 is invested and $1, 100 is returned after one year, the rate of return for this investment is: ($1, 100 – $1, 000)/$1, 000 = 10%. 8 -7 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

What is investment risk? • • Two types of investment risk: 1. Stand-alone risk 2. Portfolio risk o o Diversifiable risk: can be eliminated by proper diversification Market risk component: cannot be eliminated Investment risk is related to the probability of earning a low or negative actual return. o The greater the chance of lower than expected, or negative • returns, the riskier the investment. The expected rate of return need to be high enough to compensate the investor for its perceived risk 8 -8 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Probability Distributions • • A listing of all possible outcomes, and the probability of each occurrence. Can be shown graphically. Firm X Firm Y -70 0 15 100 Rate of Return (%) Expected Rate of Return 8 -9 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Selected Realized Returns, 1926 -2010 Source: Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2011 Classic Yearbook (Chicago: Morningstar, Inc. , 2011), p. 32. 8 -10 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Hypothetical Investment Alternatives Economy Recession Prob. T-Bills HT Coll 0. 1 5. 5% -27. 0% USR MP 6. 0% -17. 0% Below avg 0. 2 5. 5% -7. 0% 13. 0% -14. 0% -3. 0% Average 0. 4 5. 5% 15. 0% 0. 0% 3. 0% 10. 0% Above avg 0. 2 5. 5% 30. 0% -11. 0% 41. 0% 25. 0% Boom 0. 1 5. 5% 45. 0% -21. 0% 26. 0% 38. 0% 8 -11 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Do T-bills promise a completely risk-free return? Why is the T-bill return independent of the economy? • • T-bills will return the promised 5. 5%, regardless of the economy No, T-bills do not provide a completely risk-free return, as they are still exposed to inflation. • Although, very little unexpected inflation is likely • • to occur over such a short period of time. T-bills are also risky in terms of reinvestment risk. T-bills are risk-free in the default sense of the word. 8 -12 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating the Expected Return 8 -13 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Summary of Expected Returns High Tech Market US Rubber T-bills Collections Expected Return 12. 4% 10. 5% 9. 8% 5. 5% 1. 0% High Tech has the highest expected return, and appears to be the best investment alternative, but is it really? Have we failed to account for risk? 8 -14 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Standard Deviation • • A measure of how far the actual is likely to deviate from the expected return The smaller the STD DEV, The tighter the probability distribution the smaller the risk is. The lower the risk 8 -15 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Standard Deviation for Each Investment σHT = 20% σColl = 13. 2% σM = 15. 2% σUSR = 18. 8% 8 -16 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparing Standard Deviations Prob. T-bills USR HT 0 5. 5 9. 8 12. 4 Rate of Return (%) 8 -17 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comments on Std Dev as a Measure of Risk • Standard deviation (σi) measures total, • The larger σi is, the lower the probability that actual returns will be close to expected returns. • • • Stand-alone, risk. Larger σi is associated with a wider probability distribution of returns. If probability distribution is normal: The actual return between 1 STD DEV of expected return 68. 26% of time 8 -18 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparing Risk & Return Security T-bills High Tech Collections* US Rubber* Market Expected Return, 5. 5% 12. 4 1. 0 9. 8 10. 5 Risk, s 0. 0% 20. 0 13. 2 18. 8 15. 2 8 -19 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Coefficient of Variation (CV) • • A standardized measure of dispersion about the expected value, that shows the risk per unit of return Capture the effect of both risk and return • Better measure for evaluating risk in situation which investments have substantially different expected return 8 -20 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Illustrating the CV as a Measure of Relative Risk Prob. A B 0 Rate of Return (%) σA = σB , but A is riskier because of a larger probability of losses In other words, the same amount of risk (as measured by σ) for smaller returns 8 -21 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Risk Rankings by Coefficient of Variation CV T-bills 0. 0 High Tech Collections US Rubber Market • • 1. 6 13. 2 1. 9 1. 4 Collections has the highest degree of risk per unit of return. High Tech, despite having the highest standard deviation of returns, has a relatively average CV 8 -22 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -23 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Investor Attitude Towards Risk • • Risk aversion: assumes investors dislike risk & require higher rates of return to encourage them to hold riskier securities Risk premium: the difference between the return on a risky asset & a riskless asset, which serves as compensation for investors to hold riskier securities The willingness to take risk varies over time No investment should under take unless the expected rate of return is high enough to compensate for the perceived risk 8 -24 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Portfolio Construction: Risk & Return • • • A portfolio’s expected return is a weighted average of the returns of the portfolio’s component assets Risk decline as the number of assets increases • • Diversification can reduce risk but cannot eliminated it Impossible for completely riskless stock portfolio Standard deviation is a little more tricky • • • Requires that a new probability distribution for the portfolio returns be constructed. Not weighted average of the STD DEV of the individual • Smaller & depend on both STD DEV & correlation Diversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks 8 -25 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Portfolio Expected Return 8 -26 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

An Alternative Method for Determining Portfolio Expected Return Economy Recession Below avg Average Above avg Boom Prob 0. 1 0. 2 0. 4 0. 2 0. 1 HT -27. 0% -7. 0% 15. 0% 30. 0% 45. 0% Coll 27. 0% 13. 0% 0. 0% -11. 0% -21. 0% Port 0. 0% 3. 0% 7. 5% 9. 5% 12. 0% 8 -27 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Portfolio Standard Deviation and CV 8 -28 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comments on Portfolio Risk Measures • σp = 3. 4% is lower than the weighted average of High Tech & Collections’ σ (16. 6%). • • • is much lower than the σi of either stock o (σHT = 20. 0%; σColl = 13. 2%). • Not the weighted average of individual stocks’ STD Dev The portfolio provides the average return of component stocks, but lower than the average risk On average, Portfolio Risk decline as the number of assets increase Why? Negative correlation between stocks 8 -29 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

General Comments about Risk • • σ 35% for an average stock. • • Combining stocks in a portfolio generally lowers risk. Most stocks are positively (though not perfectly) correlated with the market (i. e. , ρ between 0 and 1). Rational investor choose to hold portfolio not a stock • Diversification is only good when assets or stocks are not perfectly correlated 8 -30 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Remmber : Correlation • Correlation : The tendency of two variable to move together • Correlation coefficient (ρ ): a measure of the degree of relationship between two variable 8 -31 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Returns Distribution for Two Perfectly Negatively Correlated Stocks (ρ = -1. 0) 8 -32 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Returns Distribution for Two Perfectly Positively Correlated Stocks (ρ = 1. 0) Stock M’ Stock M Portfolio MM’ 25 25 25 15 15 15 0 0 0 -10 -10 8 -33 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Partial Correlation, ρ = +0. 35 8 -34 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Creating a Portfolio: Beginning with One Stock & Adding Randomly Selected Stocks to Portfolio • • • σp decreases as stocks are added, because they would not be perfectly correlated with the existing portfolio. Expected return of the portfolio would remain relatively constant. Eventually the diversification benefits of adding more stocks dissipates (after about 40 stocks), and for large stock portfolios, σp tends to converge to 20%. 8 -35 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Illustrating Diversification Effects of a Stock Portfolio 8 -36 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Breaking Down Sources of Risk Stand-alone risk = Market risk + Diversifiable risk • • Market risk: portion of a security’s stand-alone risk that cannot be eliminated through diversification. • Measured by beta. Diversifiable risk: portion of a security’s stand-alone risk that can be eliminated through proper diversification 8 -37 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Failure to Diversify If an investor chooses to hold a one-stock portfolio (doesn’t diversify), would the investor be compensated for the extra risk they bear? o NO! Stand-alone risk is not important to a well diversified investor o Rational, risk-averse investors are concerned with σp, which is based upon market risk. o There can be only one price (the market return) for a given security. o No compensation should be earned for holding unnecessary, diversifiable risk. 8 -38 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -39 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Capital Asset Pricing Model (CAPM) • • Model linking risk & required returns. CAPM suggests that there is a Security Market Line (SML) that states that a stock’s required return equals the risk-free return plus a risk premium that reflects the stock’s risk after diversification. ri = r. RF + (r. M – r. RF)bi Primary conclusion: The relevant riskiness of a stock is its contribution to the riskiness of a well-diversified portfolio Market portfolio is a portfolio of all stock – High administration fees and commissions would be more than offset the benefit for individual investor – Index fund 8 -40 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Beta • • Measures a stock’s market risk, & shows a stock’s volatility relative to the market. Indicates how risky a stock is if the stock is held in a well-diversified portfolio. Theoretically the correct measure of any stock’s risk • The most relevant measure of stock’s risk Market risk premium: a measure of additional return over the risk-free rate needed to compensate investor for assuming an average amount of risk • It is the slope of SML & reflect the degree of risk in the economy 8 -41 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comments on Beta 1. If beta = 1. 0, the security is just as risky as the average stock. 2. If beta > 1. 0, the security is riskier than average. 3. If beta < 1. 0, the security is less risky than average. 4. Beta=0, riskless security • • Most stocks have betas in the range of 0. 5 to 1. 5. Changing the stocks in a portfolio can change its riskiness 8 -42 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Betas • • Well-diversified investors are primarily concerned with how a stock is expected to move relative to the market in the future. Without a crystal ball to predict the future, analysts are forced to rely on historical data. A typical approach to estimate beta is to run a regression of the security’s past returns against the past returns of the market. The slope of the regression line is defined as the beta coefficient for the security. 8 -43 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Can the beta of a security be negative? • • • Yes, if the correlation between Stock i & the market is negative (i. e. , ρi, m < 0). If the correlation is negative, the regression line would slope downward, and the beta would be negative. However, a negative beta is highly unlikely 8 -44 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Illustrating the Calculation of Beta _ ri . 20 15 . Year 1 2 3 10 r. M 15% -5 12 ri 18% -10 16 5 -5 0 . -5 -10 5 10 15 20 r. M Regression line: ^ ^ ri = -2. 59 + 1. 44 r. M 8 -45 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Beta Coefficients for High Tech, Collections & T-Bills HT: b = 1. 32 ri 40 20 T-bills: b = 0 -20 0 20 40 r. M Coll: b = -0. 87 -20 8 -46 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Comparing Expected Returns and Beta Coefficients Security High Tech Market US Rubber T-Bills Collections Expected Return 12. 4% 10. 5 9. 8 5. 5 1. 0 Beta 1. 32 1. 00 0. 88 0. 00 -0. 87 Riskier securities have higher expected returns, so the rank order is OK. 8 -47 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Portfolio Beta 8 -48 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -49 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -50 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

The Security Market Line (SML): Calculating Required Rates of Return SML: ri = r. RF + (r. M – r. RF)bi ri = r. RF + (RPM)bi • Assume the yield curve is flat and that r. RF = 5. 5% and RPM = r. M r. RF = 10. 5% 5. 5% = 5. 0%. 8 -51 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

What is the market risk premium? • • • Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk Its size depends on: 1. The perceived risk of the stock market 2. Investors’ degree of risk aversion Varies from year to year, but most estimates suggest that it ranges between 4% & 8% per year 8 -52 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Required Rates of Return 8 -53 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Expected vs. Required Returns High Tech Market US Rubber T-bills Collections r 12. 4% 12. 1% 10. 5 9. 8 9. 9 5. 5 1. 0 1. 15 Undervalued Fairly valued Overvalued 8 -54 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Illustrating the Security Market Line SML: ri = 5. 5% + (5. 0%)bi ri (%) SML . . . HT r. M = 10. 5 -1 . r. RF = 5. 5 Coll 0 . T-bills USR 1 2 Risk, bi 8 -55 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

An Example: Equally-Weighted Two-Stock Portfolio • Create a portfolio with 50% invested in High Tech and 50% invested in Collections. • The beta of a portfolio is the weighted average of each of the stock’s betas. b. P = w. HTb. HT + w. Collb. Coll b. P = 0. 5(1. 32) + 0. 5(-0. 87) b. P = 0. 225 8 -56 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Calculating Portfolio Required Returns • • The required return of a portfolio is the weighted average of each of the stock’s required returns. r. P = w. HTr. HT + w. Collr. Coll r. P = 0. 5(12. 10%) + 0. 5(1. 15%) r. P = 6. 625% Or, using the portfolio’s beta, CAPM can be used to solve for expected return. r. P = r. RF + (RPM)b. P r. P = 5. 5% + (5. 0%)(0. 225) r. P = 6. 625% 8 -57 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -58 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -59 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Is it possible to construct a portfolio of realworld stocks that has a required rate if return equal to the risk-free rate? 8 -60 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Factors That Change the SML • What if investors raise inflation expectations by 3%, what would happen to the SML? ri (%) SML 2 SML 1 ΔI = 3% 13. 5 10. 5 8. 5 5. 5 Risk, bi 0 0. 5 1. 0 1. 5 8 -61 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Factors That Change the SML • What if investors’ risk aversion increased, causing the market risk premium to increase by 3%, what would happen to the SML? ri (%) SML 2 ΔRPM = 3% SML 1 13. 5 10. 5 5. 5 Risk, bi 0 0. 5 1. 0 1. 5 8 -62 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Factors That Change the SML • • • As risk aversion increase, so do the this premium & slope of SML A firm influence its market risk by changing composition of assets or/and use of debt The greater the average investor aversion of risk: 1. The steeper the slop of the line 2. The greater the risk premium for all stocks 3. The higher the required rate of returns 8 -63 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Factors That Change the SML 8 -64 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Factors That Change the SML 8 -65 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Example 8 -66 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Verifying the CAPM Empirically • • The CAPM has not been verified completely. • Some argue that there additional risk factors, other than the market risk premium, that must be considered. Statistical tests have problems that make verification almost impossible. 8 -67 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

More Thoughts on the CAPM • • Investors seem to be concerned with both market risk & total risk. Therefore, the SML may not produce a correct estimate of ri. ri = r. RF + (r. M – r. RF)bi + ? ? ? • • CAPM/SML concepts are based upon expectations, but betas are calculated using historical data. A company’s historical data may not reflect investors’ expectations about future riskiness. 8 -68 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

Some Concluding Thoughts • There is a trade-off between risk and return • • • Diversification is crucial Real returns are what matters, not nominal returns. The risk of an investment depends investment horizon o Stocks are very risky on the short-term but their risk is reduced if you hold them over the long-run While historical data can be helpful, there is no guarantee that the past will repeat itself Studies have raised concerns about the validity of CAPM • • o Needs to take higher risk To achieve a higher expected return 8 -69 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.

The (in a Sense Fallacious) Risk/Return Pyramid © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part.