Investment Risk

1. Investment Risk Eric Higgins Department of Finance, KSU

2. Investing • Investing • Definition of an investment: The current commitment of dollars for a period of time in order to get future payments • Put in money today to get more in the future

3. Investing • Risk -- Risk is the possibility that you won’t get back what you expect • The problem with ignoring risk: • Things sound too good • Don’t consider the downside

4. Investment • What are some investment options? • Bank Account • Bonds • Stocks • Real Estate • Art • Private Investment

5. How Risky are Investments • Rank the following investments in terms of risk … • An FDIC insured bank account • An investment in the debt of Microsoft • A 10-year government bond • A friend wants you to invest in his idea to open a new barbershop • A share of IBM stock • Buying a house

6. How Risky are Investments • Risk ranking… • An FDIC insured bank account • A 10-year government bond • An investment in the debt of Microsoft • Buying a house • A share of IBM stock • A friend wants you to invest in his idea to open a new barbershop • http://www.finrafoundation.org/resources/education/modules/ • http://www.callan.com/research/periodic/

8. Investing • Lesson: • Higher risk, higher return • Put money in a bank savings account, get 2% return guaranteed • Put money in the stock market, get 11% with the chance that you may lose money

9. Compound Interest • The principle of compounding means that you earn interest on interest • Three things to consider • Invest early • Invest often • Have patience

10. Risk • How risky are you? • You have the following choice for your salary in the first year that you graduate: • $50,000 for certain • A coin-flip where you get either $100,000 or $0

11. Probability • What is more likely? • Two people in this room have the same birthday • Somebody in this room has a birthday on October 31 • Two people having the same birthday is actually much more likely • You have to understand the role of probability in making investment decisions • Relates to risk

12. Expected Returns • Expected returns are based on the probabilities of possible outcomes • In this context, “expected” means average if the process is repeated many times • The “expected” return does not even have to be a possible return

13. Required Returns and Risk • Suppose we have two assets, A and B, that are both expected to return 15% and have a price of $100. (thus, both stocks will return $15) • Suppose that stock A is riskier than stock B. • What would happen? • What if the price of A fell to $75 and B rose to $150?

14. Required vs. Expected Returns • Expected returns are what an investment will earn • Required returns are what an investment should earn • The two may differ, creating investment opportunities

15. Example: Expected Returns • Suppose you have predicted the following returns for stocks C and T in three possible states of nature. What are the expected returns? • State Probability C T • Boom 0.3 0.15 0.25 • Normal 0.5 0.10 0.20 • Recession ??? 0.02 0.01 • RC = .3(.15) + .5(.10) + .2(.02) = .099 = 9.99% • RT = .3(.25) + .5(.20) + .2(.01) = .177 = 17.7%

16. Variance and Standard Deviation • Variance and standard deviation still measure the volatility of returns • Using unequal probabilities for the entire range of possibilities • Weighted average of squared deviations

17. Example: Variance and Standard Deviation • Consider the previous example. What are the variance and standard deviation for each stock? • Stock C • 2 = .3(.15-.099)2 + .5(.1-.099)2 + .2(.02-.099)2 = .002029 •  = .045 • Stock T • 2 = .3(.25-.177)2 + .5(.2-.177)2 + .2(.01-.177)2 = .007441 •  = .0863

18. Another Example • Consider the following information: • State Probability ABC, Inc. • Boom .25 .15 • Normal .50 .08 • Slowdown .15 .04 • Recession .10 -.03 • What is the expected return? • What is the variance? • What is the standard deviation?

19. Portfolios • A portfolio is a collection of assets • An asset’s risk and return is important in how it affects the risk and return of the portfolio • The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

20. Example: Portfolio Weights • Suppose you have $15,000 to invest and you have purchased securities in the following amounts. What are your portfolio weights in each security? • $2000 of DCLK • $3000 of KO • $4000 of INTC • $6000 of KEI • DCLK: 2/15 = .133 • KO: 3/15 = .2 • INTC: 4/15 = .267 • KEI: 6/15 = .4

21. Portfolio Expected Returns • The expected return of a portfolio is the weighted average of the expected returns for each asset in the portfolio • You can also find the expected return by finding the portfolio return in each possible state and computing the expected value as we did with individual securities

22. Example: Expected Portfolio Returns • Consider the portfolio weights computed previously. If the individual stocks have the following expected returns, what is the expected return for the portfolio? • DCLK: 19.65% • KO: 8.96% • INTC: 9.67% • KEI: 8.13% • E(RP) = .133(19.65) + .2(8.96) + .167(9.67) + .4(8.13) = 9.27%

23. Perfect Negative Correlation Stock W Stock M Portfolio WM . . . . 25 25 25 . . . . . . . 15 15 15 0 0 0 . . . . -10 -10 -10

24. 25 25 15 15 0 0 -10 -10 Perfect Positive Correlation Stock M’ Portfolio MM’ Stock M 25 15 0 -10

25. The Principle of Diversification • Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns • This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another • However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

26. Figure 13.1

27. Savings Game • Start with $1,000 • You need to pick a risk category • High risk earns 2X the market return, Medium risk earns the market return, Low risk earns ½ the market return. • Market returns will be determined randomly. • Each “round” represents 5 years. We will play four rounds. • You can change your risk category after every round • Goal is to end up with the most money at the end of the game.

28. Savings Game • In addition to ending up with the most money you have to have: • $500 at the end of round 2 to put a down payment on a car • If you don’t meet the goal, you lose $1,000 on your ending total.

29. Round 1 • We will randomly choose a card from a deck of cards. • Red means loss, black means gain • Amount of gain/loss equal to the amount on the card, face cards all 10% gain/loss

30. Round 2 • If the market went up in Round 1, it is likely that the market will go down in Round 2. • If the market went down in Round 1, it is likely that the market will go up in Round 2. • I will now remove one suit (red or black) from the deck of cards and we will draw again. • Remember • You need $500 at the end of Round 2 • The probability of the market going up/down has changed. It is not random any more.

31. Round 3 • Risk aversion…choice of certain vs. uncertain payoff • You can either go up 5% • Risk doesn’t matter here. If you choose this you get 5%. • I will flip a coin, heads the market goes up 10% tails the market goes down 5%. • Risk matters if you take the gamble. High risk gets 2X market, medium risk gets market, low risk gets ½ market

32. Round 4 • Roll the Dice • I will roll two dice… • 5, 6, 7, 8, 9 the market goes up 10% • 2, 3, 4, 10, 11, 12 the market goes down 5% • Think about the odds, what is most likely to happen? • Choose your risk level carefully this is the last round

34. External Resources • http://www.financialliteracyfocus.org/edu.html • http://www.mymoney.gov/myresources.html • http://www.jumpstart.org/jump$tart-clearinghouse.html • http://www.weseed.com/ • http://www.smartmoney.com/?link=SM_logo_home