Ruchi26,

This is a discussion post

Please answer this question...

.............................................

The word doc is the question and the pdf. is the data... its not a big assignment...

Chapter 8 Risk and Rates of Return 269 THE HISTORICAL TRADE-OFF BETWEEN RISK AND RETURN this box summarizes the historThetable accompanying and return for different classes risk iCaltrade-offbetween through 2013. As the table 1926 of investmentsfrom produced the highest average that shows,those assets standard highest deviations and the returnsalso had the For example, returns. small-company widestranges of stocks had the highest average annual return, 16.9%, 32.3%, was but the standard deviation of their returns, had the bills also the highest. By contrast, U.s. Treasury had the also lowest standard deviation, 3.1%, but they guarno is lowest average return, 3.5%. Although there stanand returns antee that history will repeat itself, the as a used often dard deviations observed in the past are starting point for estimating future returns. Selected Realized Returns, 19262013 Average Return Standard Deviation Small-company stocks 16.9% 323% Large-company stocks 12.1 202 63 5.9 35 8.4 Long-term corporate bonds Long-term government bonds U.S. Treasury bills 98 3.1 p. 40. source:Based on Ibbotson Stocks, Bonds, Bills, and Inflation: 2014 Classic Yearbook (Chicago: Morningstar, Inc., 2014), The difference in returns, 13% 80/0 5%, would be a risk return to rise to 130/0.13 premium (RP), which represents the additional compensation investors require for bearing Martin's higher risk. RiskPremiumCRP) Thedifferencebetween theexpectedrateof return asset and This example demonstrates a very important principle: In a market dominated on a givenrisky asset. that on a less risky by risk-averseinvestors, riskier securities compared to less risky securities must have higherexpectedreturns as estimated by the marginal investor. If this situation does not exist,buyingand selling will occur until it doesexist. Later in the chapter we will considerthe question of how much higher the returns on risky securities must be, afterwe see how diversification affects the way risk should be measured. does investment risk mean? fiet an illustrativeprobability distributiontable for an investment with probabildifferent conditions, returns under those conditions, and the expected return. VVblchof the two stocks graphed in Figure 8.3 is less risky? Why? Explain why you agree or disagree with this statement: Most investors are risk-averse. How does risk aversion affect rates of return? An investment has a 50% chance of producing a 20% return, a 25% chance of producing an 8% return,and a 25% chance of producing a 12%return.What is its expected return?(9%) Given your risk tolerance, and your need to diversify, explain how the Selected Realized Returns (1926- 2013) page 269 and the Effects of Portfolio Risk for Average Stocks will impact your future investment decisions and why c 73 74 75 76 77 78 79 80 81 Year 1 2012 2013 2014 2015 Average Deviation Return 2 Average 30.0% -10.0% -19.0% 40.0% 10.3% (3) 19.8% 82 83 84 E F Squared Deviation -20.3% -29.3% 298% Sum of Squared Devs (SSDevs): SSDevs/(N 1 ) = SSDevs/3: Standard deviation= Square rootof SSDevs/3. = Excel Function: = (4) 0.0390 0.0410 0.0856 0.0885 02541 0 0847 29 novo 29 novo deviation of returns could be found as shown in Table 83.10Because often repeated in the future, the historical past is often used as an estimateresults are riskil A key question that arises when historical data is used to forecast of future how far back in time we should go. the future is Unfortunately, there is no simple answer. longer historical time series has the benefit Using a of giving more information, but some of that information may be misleading if you believe that the level of risk in the future is likely to be very different from the level of risk in the past. All financial calculators (and Excel)have easy-to-use functions for finding based on historical data. 12 Simply enter the rates of return and press the key marked S (or Sx) to obtain the standard deviation. However, neither calculators nor Excel have a built-in formula for finding where probabilistic data are involved. In those cases, you must go through the process outlined in Table 8.2. 8-2D MEASURUY OF VARIA ALONE RISK: THE COEFFICIENT If a choice has to be tween two investments that have the same expected returns but different st' r,anl deviations, most people would choose the one with the lower standard and therefore the lower risk. Similarly, given a choicebetween two investments with the same risk (standard deviation)but different expected relurns, investors would generally prefer the investment with the higher expected return. To most people, this is common sensereturn 10 The four years of historical data are considered to be a "sample" of the full (but unknown) set of data, and the procedure used to find the standard deviation is different from the one used for probabilistic data. Here is the equation for sample data, and it is the basis for Table 8.3: Estimated o = 8.2a is the average annual period t, and Herert ("r bar t") denotes the past realized rate of return in return earned over the last N years. our example) may also be used as an estimate of 11Theaverage return for the past period (10.3%in return varies widely depending on average historical future returns, but this is problematic because the would get a different average went from 2012 to 2014, we the period examined. In our example, if we more years of data, but that brings into stabilizes with from the 10.3%.The average historical return relevant today. question whether data from many years ago are still instructionson calculating your calculatormanual for our tutorials on the text's website or d deviations. I've always been a proponent of proper diversification by sector. I currently do not apply statistical analysis to my investments but I would be open to some changes if they proved to add enlightenment to my current choices. I actually like to allocate a portion on my portfolio to emerging companies that have the potential for exponential growth. Nothing wrong in investing in high dividend yield firms like DOW but I just like to look at some potential gems once in a while. With that said, I would be open to using a portfolio planning tool like QPP. There is a tendency to hop on stocks that are in growth spurts and strictly rely on past performance. This to me has proven to be ineffective (been there done that). The incorporation of statistics would help to do a review on my current holdings and figure out measures like RTM (Reversion to the Mean), used for predicting outperforming stocks and when they will eventually underperform. Other statistic like MAE (Mean Average Error) can also be used to come up with the difference between the projected performance and the actual performance of portfolios. The "bottom line" is education is priceless. References: Considine, Geoff, June 18, 2007 "Projecting Portfolio Risk and Return" retrieved from https://seekingalpha.com/article/38568projectingportfolioriskandreturn?page=2