In this chapter, we start from the basic premise that investors like returns and dislike
risk. Therefore, people will invest in risky assets only if they expect to receive higher
returns. We define precisely what the term riskmeans as it relates to investments. We
examine procedures managers use to measure risk, and we discuss the relationship be-
tween risk and return. In Chapters 4 and 5, we extend these relationships to show how
risk and return interact to determine security prices. Managers must understand these
concepts and think about them as they plan the actions that will shape their firms’ fu-
tures.
As you will see, risk can be measured in different ways, and different conclusions
about an asset’s risk can be reached depending on the measure used. Risk analysis can
be confusing, but it will help if you remember the following:- All financial assets are expected to produce cash flows,and the risk of an asset is
judged in terms of the risk of its cash flows. - The risk of an asset can be considered in two ways: (1) on a stand-alone basis,where
the asset’s cash flows are analyzed by themselves, or (2) in a portfolio context,where
the cash flows from a number of assets are combined and then the consolidated
cash flows are analyzed.^1 There is an important difference between stand-alone and
portfolio risk, and an asset that has a great deal of risk if held by itself may be much
less risky if it is held as part of a larger portfolio. - In a portfolio context, an asset’s risk can be divided into two components: (a) diver-
sifiable risk,which can be diversified away and thus is of little concern to diversified
investors, and (b) market risk,which reflects the risk of a general stock market de-
cline and which cannot be eliminated by diversification, doesconcern investors.
Only market risk is relevant—diversifiable risk is irrelevantto rational investors be-
cause it can be eliminated. - An asset with a high degree of relevant (market) risk must provide a relatively high
expected rate of return to attract investors. Investors in general are averse to risk,so
they will not buy risky assets unless those assets have high expected returns. - In this chapter, we focus on financial assetssuch as stocks and bonds, but the con-
cepts discussed here also apply to physical assetssuch as computers, trucks, or even
whole plants.
Investment Returns
With most investments, an individual or business spends money today with the expec-
tation of earning even more money in the future. The concept of returnprovides in-
vestors with a convenient way of expressing the financial performance of an invest-
ment. To illustrate, suppose you buy 10 shares of a stock for $1,000. The stock pays no
dividends, but at the end of one year, you sell the stock for $1,100. What is the return
on your $1,000 investment?
One way of expressing an investment return is in dollar terms.The dollar return is
simply the total dollars received from the investment less the amount invested:
Dollar return Amount received Amount invested
$1,100 $1,000
$100.102 CHAPTER 3 Risk and Return(^1) A portfoliois a collection of investment securities. If you owned some General Motors stock, some Exxon
Mobil stock, and some IBM stock, you would be holding a three-stock portfolio. Because diversification
lowers risk, most stocks are held in portfolios.
The textbook’s web site
contains an Excelfile that
will guide you through the
chapter’s calculations. The
file for this chapter is Ch 03
Tool Kit.xls, and we encour-
age you to open the file and
follow along as you read the
chapter.