FINA3030 –

Behavioral Finance
Week 1 – Foundation in Finance 1

Dr. Marty Pham

 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Risk and return

• Risk and return are two inseparable concepts in finance:
 Return is what you earn on an investment
 Risk captures how certain you are that you will receive
a particular return on your investment. Higher risk
means less certain.
 Risk and return can be OBSERVED and QUANTIFIED
 Risk and return work in a trade-off position: higher
risk – higher return and vice versa.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Risk and return

Discussion #1: Which share would you pick for your investment?

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Holding period returns (HPR)

• Most used definition of return.
• Capture the total return over some investment
period or holding period.
• Consist of two components:

Holding
Capital Investment
Period
appreciation income
Return

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Holding period returns (HPR)

Single-year HPR: Multiple-year HPR:
If the holding period lasts for one If the holding period lasts for several
year/month/day, the HPR should be years, months or days, the HPR should
computed using the formula below: be computed using the formula below:

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Average returns – Arithmetic

mean
• When an asset has returns for multiple holding periods, it is
necessary to aggregate those returns into one overall
return for ease of comparison and understanding.
• The simplest way to compute the average return is to take
the simple average (i.e., arithmetic or mean) of all holding
period returns:

• is referred to as the average holding period return

• The arithmetic mean return assumes that the amount
invested at the beginning of each period is the same
(similar to the concept of simple interest)

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 Average returns – Geometric mean
Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

• The geometric mean return assumes that the investment amount is

not reset at the beginning of each year and, in effect, accounts for
the compounding of returns.
• The geometric mean reflects a “buy-and-hold” strategy, whereas
the arithmetic reflects a constant dollar investment at the beginning
of each period.

√
𝑇
𝑇
𝑅 𝐺𝑖= √ ( 1+ 𝑅 𝑖1 ) ( 1+ 𝑅𝑖 2 ) …(1+ 𝑅 𝑖𝑇 )−1= ∏
𝑇
( 1+ 𝑅 𝑖𝑡 ) − 1
𝑡=1

• A geometric mean return provides a more accurate representation

of the growth in portfolio value over a given time period.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Self-check examples
• Self-check #1: An investor purchased 100 shares of a stock
for $34.5 per share at the beginning of the quarter. If the
investor sold all the shares for $30.5 per share after receiving
a $51.55 dividend payment at the end of the quarter, what is
the HPR?
• Self-check #2: An analyst obtains the following annual rates
of return for an asset:
Year Return (%)
2018 14%
2019 -10%
2020 -2%

• What is the asset’s HPR over the three-year period? What is

the annual geometric mean return of this asset?
• Answers: 3-year HPR = 0.55%; Geometric mean = 0.18% 8
 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Expected return (E(R))

• E(R) represents the sum of products of possible outcomes
and probabilities that those outcomes will be realized.
• E(R) is an average of possible returns from an investment,
where each of these returns is weighted by the probability
that it will occur:

• Discussion #2: What if each of the possible outcomes is

equally likely (that is, p1 = p2 = p3 = … = pn = p = 1/n),
what would the E(R) become?

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Variance & Standard deviations

• The variance ():
1. squares the difference between each possible occurrence and
the mean (squaring the differences makes all the numbers
positive).
2. multiplies each difference by its associated probability before
summing them up:

3. take the square root of the variance to get the standard

deviation ().

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Variance & Standard deviations

• If all the possible outcomes are equally likely, then the
variance formula would be:

• However, in most cases, we are working with a finite

sample rather than the entire population of outcomes,
such as a sample of historical data. Thus, the formula
must be adjusted to (n – 1) degrees of freedom.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Self-check example
• Self-check #3: The last four years of returns for a stock are as follows:
Year 1 2 3 4
Return -4.3% 27.8% 12.1% 4.3%

• What are the variance and the standard deviation of the stock’s
returns?
• Answer: 0.0186 and 0.1364
• Self-check #4: The following table shows the one-year return
distribution of Startup Inc.:
Probability 40% 20% 20% 20%
Return -80% -85% -40% 1000%

• Calculate the expected return and the standard deviation of the return

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Variance & Standard deviations

The standard deviation (SD) tells us the probability that outcome will
fall a particular distance from the mean or within a particular range.
This allows us to directly compare the total risk associated with return
of different assets.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Variance & Standard deviations

Discussion #3: Which investment yields more disperse returns?
That is, which investment is riskier?

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Systematic vs. Unsystematic

risks
• The standard deviation (or volatility) of an asset’s return measures
its total risk or variation from the expected return. This total
variation can be explained by two components:
• Systematic (market) risk arises from market-level factors that
can affect the market as a whole and cannot be avoided. This
type of risk is non-diversifiable.
• Unsystematic (idiosyncratic) risk is local or limited to a
particular asset or industry that need not affect assets outside of
that asset class. Investors are capable of avoid this risk through
diversification.
• Only systematic risk is rewarded in asset markets.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Risk and diversification

• Diversification is a practice
of forming an investment
portfolio that consists of
two or more assets whose
values do not always move
in the same direction at the
same time.
• By doing this, investors can
reduce risk that they would
have otherwise faced if they
invested in a single asset.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Single-asset portfolios
• Returns for individual shares from one day to the next are
largely independent of each other and approximately
normally distributed.
• A first pass at comparing risk and return for individual
shares is coefficient of variation, CV:

• CV is a measure of risk associated with an investment for

each 1% of expected return  lower is better. It is also
referred to as risk-to-reward ratio.
• One key disadvantage of CV is that the ratio can be very
sensitive to minimal changes in small return values and
approach ±∞ when E(R) gets smaller. 17
 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Multiple-asset portfolio
• Expected return of portfolio made up of two assets:

where w denotes the weight of each asset in the portfolio.

• Expected return of portfolio made up of multiple assets:

• Self-check #5: Let's say you have a portfolio with two

assets: 60% invested in US stocks and 40% invested in
international bonds. The expected return of US stocks is
10% per year, and the expected return of international
bonds is 5% per year. Calculate the expected return of
this portfolio?
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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Multiple-asset portfolio
• Level of risk for portfolio of two assets is less than average of risks
associated with individual assets.
• Need to account returns for different assets in portfolio that partially
offset each other.
 This is done by adding another term, referred to as the
covariance of the returns of two assets - Cov().

 Covariance is a measure of how returns on two assets co-vary,

or move together:

where j represents possible return outcomes.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Multiple-asset portfolio
• To ease interpretation of covariance, we divide it by the product
of the standard deviations of returns for the two assets.

• ρ is referred to as the correlation coefficient between the

returns of two assets. This coefficient is bounded in the value
range from -1 to +1.
 ρ = 1: returns of the two assets are perfectly positively
correlated.
 ρ = -1: returns of the two assets are perfectly negatively
correlated.
 ρ = 0: returns of the two assets are uncorrelated.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Multiple-asset portfolio
• Discussion #4: Making appropriate adjustments to the
formula of the standard deviation of the portfolio return
when:
a. ρ = 1
b. ρ < 1
c. ρ = -1
• What is your conclusion about the effect of
diversification?

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Limitations of diversification
• Decrease in a portfolio’s standard deviation keeps
diminishing as more assets are added. Therefore, even
with a very large number of assets , portfolio standard
deviation will never be equal to zero.
• Investors can diversify away risk unique to individual
assets (unsystematic) but cannot diversify away risk
common to all assets (systematic).
• Most risk-reduction benefits from diversification can be
achieved in a 15-20 asset portfolio.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Limitations of diversification

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Measuring systematic (market)

risk
• Cannot use standard deviation as measure of risk since
it is a measure of total risk.
• Systematic risk (or market risk) of an individual asset is
just a measure of the relationship between returns on
individual asset and returns on market.
• Returns on a share and the general market can be
quantified by finding the slope (beta or β) of the line of
best fit between returns of a share and general market.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Beta
• β is a measure of how sensitive an asset’s return is to
the market as a whole.
• β tells us the percentage change in the asset returns
that we can expect for each 1% change in the overall
market.
 β = 1, then the asset has same systematic risk as
the market. In other words, the asset per se
represents the market portfolio.
 β > 1, then the asset has more systematic risk than
the market.
 β < 1, then the asset has less systematic risk than
the market.
 β = 0, then the asset is considered risk-free asset.
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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Beta
• Self-check #5: As the financial manager of UniCo, in the
coming year, you expect the company’s share to have a
standard deviation of 41% and a beta of 0.6. The shares
of your main competitor SysCo’s, is expected to have a
standard deviation of 30% and a beta of 1.2.
1. Which share carries more total risk and which has more
systematic risk?
2. Assuming that the investors in your company’s shares
are well diversified, which stock will they prefer? For
which stock will they require a higher return?

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Computing beta
• β is calculated by dividing the covariance between the
asset's returns and the market's returns by the variance of
the market's returns.

• Alternatively, β is the product of the asset’s correlation with

the market and the ratio of the standard deviation of the
returns.
• β could also be estimated using the slope coefficient from a
fitted regression model of an asset’s returns on the market
returns.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Compensation for bearing

systematic risk
Difference between required returns on government securities and
required returns for risky investments represents compensation
investors require for taking risk:
E(Ri) = Rrf + (Units of Systematic Riski x Compensation per Unit of
Risk)
Given that beta (β), is the appropriate measure for the number of
units of systematic risk:
E(Ri) = Rrf + (βi x Compensation per Unit of Risk)
The compensation per unit of risk is also referred to as the market
risk premium, which is equal to:
Market risk premium = E(Rm) – Rrf
E(Ri) = Rrf + βi [E(Rm) – Rrf]
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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Capital Asset Pricing Model

(CAPM)
• Security Market Line (SML) is described by the following
equation:
• E(Ri) = Rrf + βi(E(Rm) – Rrf)
• SML illustrates what CAPM predicts the expected total
return should vary with beta.

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 Measures of Return | Measure of Risk | Types of Risk and Diversification | CAPM

Capital Asset Pricing Model

(CAPM)
• Expected return for a portfolio:
E(Rn Asset Portfolio) = Rrf + βn Asset Portfolio(E[Rm] – Rrf)
• Beta of a portfolio is:

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Efficient market hypothesis
(EMH)
• If markets are efficient, investors and financial
managers can believe securities are priced at or near
true value.
• Overall efficiency of a capital market depends on its
operational and informational efficiency.
 Operational efficiency focuses on bringing buyers
and sellers together at lowest possible cost.
 Informational efficiency focuses on how quickly
market prices can adjust to new information about a
security as it becomes available. Competition
among investors is an important driver of
informational efficiency.
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Efficient market hypothesis
(EMH)
• Market efficiency can be explained at three form levels:

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Efficient market hypothesis
(EMH)
• Strong form market efficiency: the price of a security in a market
reflects all available information; public as well as private, inside
information.
• Semi-strong market efficiency: Implies that only public information
available to all investors is reflected in security’s market price.
• Investors with access to inside or private information will be able to earn
abnormal returns.
• New information is immediately reflected in security’s market price.
• Weak-form market efficiency: All historical information is reflected in
current prices.
• It would not be possible to earn abnormally high returns by looking for
patterns in security prices, but it would be possible to do so by trading
on public or private information. 33
Efficient market hypothesis
(EMH)
• Discussion #2: How does market efficiency manifest in
developed markets like Vietnam?

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