Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

6-4b RISK AND RETURN REVISITED

Remember that our goal in this section is to be able to say something useful about the relationship

between risk and return for individual assets. We already know that asset classes that pay higher returns

have higher standard deviations. Is the same true for securities within a particular asset class? Do

individual shares with higher standard deviations earn higher returns over time?

Figure 6.9 plots the average return and standard deviation for the 10 shares featured in Table 6.6.

Unlike the predictable, almost linear relationship between standard deviation and returns that we

observed for asset classes, no obvious pattern leaps out of this figure. If we compare the standard

deviations and average returns of Intel to those of Walmart, then the positive relation between these two

variables seems to hold. Clearly, Walmart shares were less volatile than Intel shares during this period,

and Walmart investors earned much lower returns. However, comparing Walmart to American Airlines,

Walmart shares were actually less volatile than were AMR shares, but shareholders of the airline earned

returns even lower than those achieved by Walmart.

In contrast to the positive relationship between average returns and standard deviations for asset

classes shown previously in Figure 6.6, this figure shows no such pattern for individual assets. There

is no obvious tendency for the shares that have earned the highest returns to be the most volatile. This

suggests that for an individual share, standard deviation may not be an appropriate measure of that

share’s risk because it is unrelated to the share’s returns.

Why does the relationship between risk and return observed for asset classes in Figure 6.6 seem

to break down when we focus on specific securities? The horizontal axis in Figure 6.9 offers a clue.

Remember that the standard deviation of a single investment’s return contains both systematic and

unsystematic components. If investors are wise enough to diversify, then the unsystematic component of risk

FIGURE 6.9 AVERAGE RETURN AND STANDARD DEVIATION FOR 10 SHARES, 1993–2010

The figure indicates that a positive relationship exists between the average returns offered by an asset class and the

standard deviation of returns for that class.

Average annual return (%)

Standard deviation (systematic + unsystematic risk)

0%

5%

10%

15%

20%

30%

25%

0.0% 10.0%

Exxon

P&G

Coke

ADM

GE

Walmart

Merck

Intel

Amer. AL

20.0% 30.0% 40.0% 50.0% 60.0%

Wendy’s