An Overview of Investment
Process-II
Historical Rates of Return
A Portfolio of Investments
• Portfolio HPY:
• The mean historical rate of return (HPY) for a portfolio of investments
is measured as the weighted average of the HPYs for the individual
investments in the portfolio, or the overall percent change in the value
of the original portfolio.
• The weights used in computing the averages are the relative beginning
market values for each investment, this is referred to as dollar-
weighted or value-weighted mean rate of return.
Example: Computation of Holding Period
Yield for a Portfolio
Investment No.of Beginning Beginning Ending Ending HP HPY Market Weighted
shares Price Market Price Market R Weights HPY
Value Value
A 100,000 $ 10 $ 1,000,000 $ 12 $ 1,200,000 1.20 0.2/20% 0.05 0.01
B 200,000 20 4,000,000 21 4,200,000 1.05 0.05 0.20 0.01
C 500,000 30 15,000,000 33 16,500,000 1.10 0.10 0.75 0.075
Total 20,000,000 21,900,000 0.095/9.5
%
Example: Computation of Holding Period
Yield for a Portfolio
• OR
• HPR =
• HPR =
• HPR = 1.095
• HPY = 1.095 – 1
• HPY = 0.095/9.5% = Average Rate of Return of Portfolio
Expected Rate of Return
• The rate of return expected to be realized from an investment and it is
the weighted average of the probability distribution of possible returns.
• If expected returns are higher than required returns, then investor will
go for the investment and vice versa.
• An investor determines how certain the expected rate of return on an
investment is by analyzing the estimates of possible returns.
• To do this, the investor assigns probability values to all possible returns.
• These probability values range from zero, which indicates no chance of
return, to one, which indicates complete certainty that the investment
will provide the specified rate of return.
Expected Rate of Return
• These probabilities are subjective estimates based on the historical
performance of the investment or similar investments modified by the
investor’s expectations for the future.
• Possible returns are best estimates of brokers and market participants
who have more information of the market than us/others.
• Expected Return = ∑
• E( ) = ) ) + ) )+………………….. ) )
• E( ) = ∑ ) )
Expected Rate of Return
• Example:
Economic Conditions Probability Rate of Return
Strong economy, no 0.15 0.20
inflation
Weak economy, above- 0.15 -0.20
average inflation
No major change in 0.70 0.10
economy
• E( ) = ∑ ) )
• E( ) =
• E( ) = 0.07/ 7%
Measures of Risk
Measures of Historical Risk
• Total Risk:
• Total risk = systematic risk + unsystematic risk
• Systematic Risk (Market Risk):
• The risk that remains in a portfolio after diversification has eliminated all company-
specific risk. It can not be diversified as it arises from economy wide factors such as
GDP growth, inflation, interest rate etc.
• Unsystematic Risk (Unique Risk):
• It is diversifiable by combining multiple securities in a portfolio while considering their
inter-relationship.
• The measure of total risk is standard deviation)
• Graphical relationship of portfolio risk with no. of securities in the context of risk
diversification is on the next slide.
Measures of Historical Risk
Period Stock Market Return of Stock ( - For Downside
Prices ) Risk
MPS
30-06-2018 Rs.100 - - - -
30-09-2018 105 105/100 – 1=0.05 0.02 0.0004 -
31-12-2018 111 0.06 0.03 0.0009 -
31-03-2019 108 -0.03 -0.06 0.0036 0.0036
30-06-2019 112 0.04 0.01 0.0001 -
0.12 0.005 0.0036
Measures of Historical Risk
• Total Risk Contd.
• Return of stock ( ):
• =
• = (Assuming no dividend)
• = -1
• = Σ /n
• = 0.12/4
• = 0.03
Measures of Historical Risk
• Total Risk Contd.
• =Σ/n
• = 0.005/4 = 0.00125
• Standard deviation = =
• =
• = 0.035 / 3.5%
• Return can be deviated by 3.5% upward or downward from mean i.e.
3%.
Measures of Historical Risk
• Downside Risk:
• This risk is attributable to Sortino. He argued that people are only concerned
with the downside aspect of the risk.
• Total risk is deviation from mean, deviation may be upside or it may be
downside.
• There is no upside risk as per Sortino, as it is beneficial for us, the other
situation i.e. downside risk is important for us.
• In downside risk, we take less than mean/ average values i.e. negative values.
• The measure of downside risk is semi-variance.
• Semi-variance = 0.0036/1 = 0.0036
Measures of Historical Risk
• Relative Risk:
• If conditions for two or more investment alternatives are not similar-
i.e. if there are major differences in the expected rates of return- it is
necessary to use a measure of relative variability to indicate risk per
unit of expected return.
• A widely used relative measure of risk is the coefficient of variation
(CV).
• CV =
• CV = or
Measures of Historical Risk
• CV =
• CV =
• CV = 1.17/ 1.2
• For 1 % return, 1.2 % risk will have to be taken.
• CV is used, which security is more or less risky in two securities.
• Example:
Description Investment A Investment B
Expected Return 0.07 0.12
Standard Deviation 0.05 0.07
• Which investment is more risky from the above two investments?
Measures of Historical Risk
• Systematic Risk:
• The measure of systematic (market) risk is beta, which was derived by
William Sharpe.
• Beta is a measure of volatility.
• The beta of a stock or portfolio is a number which describes the
correlated volatility of an asset in relation to the volatility of the
benchmark, with which that asset is being compared to.
• Covariance – Concept and its Importance:
• Covariance means co-movement, how the two series move together.
• e.g; Price and Demand, Price and Supply, FDI and Growth etc.
Measures of Historical Risk
• Systematic Risk Contd.
• Covariance reflects the degree to which the returns of two securities vary or
change together.
• A positive covariance means that the return of two securities move in the
same direction.
• Whereas a negative covariance means that the return of the two securities
move in the opposite direction.
• Using this relationship in price movements, a portfolio may be constructed to
yield maximum return for a given level of combined price fluctuation or in
other words, risk.
• Beta/ = /
