Page 76 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Unit 2: Risk and Return

On the lower end of the scale, the risk-free rate of return is represented by the return on Treasury Notes
Bills of government securities, because their chance of default is next to nil. If the risk-free rate
is currently 8 to 10 %, this means, with virtually no risk, we can earn 8 to 10 % per year on our
money.
The common question arises: who wants to earn 6% when index funds average 12% per year
over the long run? The answer to this is that even the entire market (represented by the index
fund) carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25%
the next year, and so on. An investor still faces substantially greater risk and volatility to receive
an overall return that is higher than a predictable government security. We call this additional
return the risk premium, which in this case is 8% (12% - 8%).

Task What do you think determines the risk level?
1. goals
2. income
3. personal situation

4. any other factor.
Give reasons to support your argument.

2.4 Portfolio and Security Returns

A portfolio is a collection of securities. Since it is rarely desirable to invest the entire funds of an
individual or an institution in a single security, it is essential that every security be viewed in a
portfolio context. Thus, it seems logical that the expected return of a portfolio should depend on
the expected return of each of the security contained in the portfolio. It also seems logical that
the amounts invested in each security should be important. Indeed, this is the case. The example
of a portfolio with three securities shown in Table A illustrates this point.
The expected holding period value - relative for the portfolio is clearly shown:

23,100
= 1.155
20,000
Giving an expected holding period return of 15.50%.
1. Security and Portfolio Values

No. of Current Price Current Expected End-of Expected End-of
Security Shares Per Share Value Period Share Value Period Share Value
( ) ( ) ( ) ( ) ( )
1 2 3 4 5 6
XYZ 100 15.00 1,500 18.00 1,800
ABC 150 20.00 3,000 22.00 3,300
RST 200 40.00 8,000 45.00 9,000
KNF 250 25.00 6,250 30.00 7,500
DET 100 12.50 1,250 15.00 1,500
20.000 23.100

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