Introduction to Corporate Finance

6: The Trade-Off Between Risk and Return

6-4 THE POWER OF DIVERSIFICATION

6-4a SYSTEMATIC AND UNSYSTEMATIC RISK

In this section, our objective is to take the lessons we’ve learned about risk and return for major asset classes

and apply those lessons to individual securities. As a starting point, examine Table 6.6, which shows the

average annual return and the standard deviation of annual returns from 1993–2010 for several well-known

shares. The average annual return and the average annual standard deviation for this group of shares appear

in the table’s next-to-last row. At the very bottom of the table, we show the average return and standard

deviation of an equally weighted portfolio of all ten of these shares. Several observations are in order.

TABlE 6.6 AVERAGE RETURNS AND STANDARD DEVIATIONS FOR 10 SHARES FROM 1993–2010

Compared to the figures reported for all ordinary shares in Table 6.4, these shares earned slightly higher returns, but their

standard deviations were also much higher.

Company Average annual return (%) Standard deviation of annual returns (%)

Archer Daniels Midland 10.5 24.8

American Airlines 7.1 47.0

Coca-Cola Company 10.6 21.3

Exxon Mobil Corp. 13.3 16.6

General Electric Co. 12.6 29.9

Intel Corporation 22.8 50.3

Merck & Co. 11.2 32.3

Procter & Gamble 12.8 17.3

Walmart Stores 9.7 27.7

Wendy’s International 10.3 46.7

Average for ten shares 12.1% 31.4%

Equally weighted portfolio 12.1% 19.1%

First, the average return for this group of shares is higher than the average return for all shares

since 1993, as shown in Table 6.4. This group’s average return is 12.1%. Perhaps one reason these

companies are so familiar is because they have performed relatively well in the recent past. Second,

and more important, most of these individual shares have a much higher standard deviation than was

reported in Table 6.4, where we showed that a portfolio of all ordinary shares had a standard deviation

of 19.9% from 1993–2010. Table 6.6 illustrates that eight of these 10 individual shares have a

standard deviation in excess of 20%. In fact, the average standard deviation across these 10 securities

is 31.4%. However, observe that the standard deviation of a portfolio containing all 10 shares is just

19.1% (comparable to the figure from Table 6.4). This raises an interesting question. If the average

share in Table 6.6 has a standard deviation of 31.4%, how can the standard deviation of a portfolio of

those shares be 19.1%?^11

11 The shares in Table 6.6 are less volatile than the average share. From 1993–2010, the standard deviation of the typical US stock was about

55%, yet we know from Table 6.4 that standard deviation of the entire market is far lower than that.

LO6.4