Week 5 Discussion

Risks and Rates of Return

The investor’s return is a measure of the increase in the expected future returns to the investment, in other words, the creation of wealth. It is the change in the value of the investment over the initial investment for a speci�c time interval, usually for one year. The use of a mean or average measure of return aids in determining the returns.

The dispersion around the expected return is one calculation used to measure risk. This concept is expressed by using a statistical measure called standard deviation (S), which is the square root of the variance. The variance, S squared, is the average deviation from the mean. The deviation is multiplied by itself (squared) to measure the magnitude of the deviation, whether it is positive or negative. The standard deviation is a unit measure of the dispersion about the average expected return, rather than the squared measure of the variance.

Usually, investors prefer high returns and low standard deviation or risk. In this way, you can summarize stock return data using the arithmetic mean and standard deviation measures as proxies for expected returns and risk.

Over long periods, investors can earn more on stock than bonds, but they must incur more risk in doing so. Investors must choose to maximize return while minimizing risk. Managers must choose �nancing that minimizes the cost of funds, while not creating so much risk that it threatens the �rm.