Returns earned over a given time period are called realized returns. Historical data on realized returns is often used to estimate future results. Analysts across companies use realized stock returns to estimate the risk of a stock. Consider the case of Happy Dog Soap Inc. (HDS): Five years of realized returns for HDS are given in the following table. Remember: 1. While HDS was started 40 years ago, its common stock has been publicly traded for the past 25 years. 2. The returns on its equity are calculated as arithmetic returns. 3. The historical returns for HDS for 2012 to 2015 are: 4. Statistical measures of standalone risk Remember, the expected value of a probability distribution is a statistical measure of the average (mean) value expected to occur during all possible circumstances. To compute an asset's expected return under a range of possible circumstances (or states of nature), multiply the anticipated return expected to result during each state of nature by its probability of occurrence. Consider the following case: James owns a two-stock portfolio that invests in Blue Llama Mining Company (BLM) and Hungry Whale Electronics (HWE). Threequarters of James's portfolio value consists of BLM's shares, and the balance consists of HWE's shares. Each stock's expected return for the next year will depend on forecasted market conditions. The expected returns from the stocks in different market conditions are detailed in the following table: Calculate expected returns for the individual stocks in James's portfolio as well as the expected rate of return of the entire portfolio over the three possible market conditions next year. - The expected rate of return on Blue Llama Mining's stock over the next year is - The expected rate of return on Hungry Whale Electronics's stock over the next - The expected rate of return on James's portfolio over the next year is The expected returns for James's portfolio were calculated based on three possibl time, and for each condition there will be a specific outcome. These probabilities a probability distribution graph. For example, the continuous probability distributions of rates of return on stocks for two different companies are shown on the following graph: For example, the continuous probability distributions of rates of return on stocks for two different companies are shown on the following graph: Based on the graph's information, which company's returns exhibit the greater risk? Company H Company G Risk is the potential for an investment to generate more than one return. A security that will produce only one known return is referred to as a riskfree asset, as there is no potential for deviation from the known expected outcome. Investments that have the chance of producing more than one possible outcome are called risky assets. Risk, or potential variability in an investment's possible returns, occurs when there is uncertainty about an investment's future outcome, such as the return expected to be generated by the investment and realized by an investor. As an investor and based on your understanding of risk, which of the following statements is true? You should invest in a stock if the expected rate of return from the stock is greater than the expected rate of return on an asset with a similar risk. You should invest in a stock if the expected rate of return on an asset with similar risk is higher than the expected rate of return from the stock. Read the following descriptions and identify the type of risk or term being described: You invest $100,000 in 40 stocks, 20 bonds, and a certificate of deposit (CD). What kind of risk will you primarily be exposed to? Portfolio risk Stand-alone risk Generally, investors would prefer to invest in assets that have: a lower-than-average expected rate of return given the perceived risk. a higher-than-average expected rate of return given the perceived risk. Professor Isadore (Izzy) Invest-a-Lot retired two years ago from Exceptional College, a small liberal arts college in Oklahoma after teaching corporate finance and investment theory for 35 years. Yesterday, Izzy appear on EC LIVE, a television show produced for the students, faculty and staff on the EU campus and the local communities. Betty Bigsmile is the host of EC LIVE, and one of Professor Izzy's former students. The following is a transcript of the interview. Unfortunately the software that transcribes the interview into written form failed to understand several words and phrases used in the interview. To complete the transcript and demonstrate your knowledge of the risks and returns of investing, please select the best answer from each dropdown menu. BETTY: Good morning, Professor Invest-a-Lot. I'd like to welcome you to EC LIVE, and thank you for coming in today to offer us insights into the basics of investing. I remember your course well, and while my grades didn't always reflect great success, I was always very interested in the material and the possibility of using the concepts and techniques when the opportunities arose. IZZY: Good morning, Betty, and please call me, Izzy. Thank you for the invitation to discuss one of the important fundamentals to sound investing: an appreciation of the relationship between the objective or outcome of your investment, that is its return, and the likelihood of receiving it, or the investment's BETTY: Let's begin with the way that risk can-or should be-analyzed. Izzy, what is investment risk, and how should it be evaluated? IZZY: An investment's risk, or the probability that it generates a return that is its expected return, can be considered from two perspectives: that of asset, or a single-asset portfolio, and that of a multiple-asset portfolio. The risk of a single asset is best measured by the of the asset's possible outcomes, while the risk of an asset in a multiple-asset portfolio is best measured by its BETTY: Now, I seem to recall that there are two major types of risk affecting a security: systematic and unsystematic risk. What is the difference between them, and is there a way to reduce your exposure to them? Systematic risk, also called or market risk, results from phenomena that affect the majority of firms and securities. Since the events or circumstances that give rise to market risk affect most firms, it possible to diversify away this type of risk. Unsystematic, or company-specific, risk, on the other hand, is , because it results from events and phenomena that are unique to a particular individual firm. Examples of these events or phenomena include, but are not limited to, earthquakes and tornados, labor unrest and strikes, and lawsuits or marketing campaigns. As these occurrences are , an investor's unsystematic risk can be diversified away by the number of securities held in the investor's portfolio. The reduced riskiness of the market portfolio is reinforced by noting that the standard deviation of the average single-stock portfolio is 35%, whereas the standard deviation of the market portfolio, which is assumed to contain approximately stocks, is 20%. Therefore, the addition of more and more randomly selected stocks to the portfolio its riskiness. BETTY: That makes sense. So what does this mean for the returns earned on an investment? IZZY: In short, it means that a rational investor can only expect to be compensated for his or her exposure to risk. He or she will not be compensated for the risk that could be eliminated by increasing the size of his or her portfolio. BETTY: So, the market will not compensate me for not doing what a rational investor could-and should-do. Is that right? IZZY: That is absolutely correct. The fact that you, as an investor, do not choose to act rationally be compensated. BETTY: Izzy, this is fascinating stuff. Unfortunately our time is up, but I'd like very much for you to come back next week to continue our discussion. Would that fit into your schedule? IZZY: Of course, and I'll look forward to it! However, before I leave, I'd like to ask you and the audience to take a pop quiz. It addresses the material discussed today and several related concepts. It is intended to reinforce some of the important risk-and-return-related concepts. Have fun, and I'll see you next week! 1. Which of the following statements is correct? Check all that apply. Systematic risk reflects the risk that remains after an investor has diversified his or her portfolio. Possible sources of diversifiable risk include inflation and commodity price changes, changes in currency exchange rates, and fluctuations in interest rates. The practice of diversification can effectively reduce an investor's systematic risk. 2. The phenomena and behaviors discussed above are based on the assumption that the majority of investors are risk averse. According to the concept of risk aversion, Check all that apply. Investors prefer certainty to uncertainty, and therefore will accept a lower return to avoid a potentially larger and more uncertain return. Risk-averse investors require a greater return for owning securities that exhibit greater risk. 3. The financial performance of an investment is best expressed as a: Dollar amount, since it reflects the timing of the investment's return. Dollar amount, since it clearly identifies the sum of money that can be spent by the owner of the investment. Percentage, since it scales, or standardizes, the return earned from the investment by the investment's size. Percentage, as it ignores the timing of the return, such as one year or ten years