Personal Investment Management
ADMS 3531 Fall 2011 – Professor Dale Domian
Lecture 8 Part 1 – Return, Risk and the Security Market Line – Nov 8
Chapter 12 Outline
Announcements, surprises and expected returns.
Efficient frontier and capital asset line.
Risk: systematic and unsystematic.
Diversification, systematic risk and unsystematic risk.
Systematic risk and beta.
The security market.
More on beta.
A brief history of testing CAPM.
The FamaFrench threefactor model.
Return, Risk and the Security Market Line
Our goal in this chapter is to define risk more precisely, and discuss how to measure it.
In addition, we will quantify the relation between risk and return in financial markets.
Expected and Unexpected Return
The return on any stock traded in a financial market is composed of two parts.
o The normal, or expected, part of the return is the return that investors predict or
o The uncertain, or risky, part of the return comes from unexpected information
revealed during the year.
Announcement and News
Firms make periodic announcements about events that may significantly impact the
profits of the firm.
o Product development.
The impact of an announcement depends on how much of the announcement represents
new information. o When the situation is not as bad as previously thought, what seems to be bad news
is actually good news.
o When the situation is not as good as previously thought, what seems to be good
news is actually bad news.
News about the future is what really matters.
o Market participants factor predictions about the future into the expected part of
the stock return.
o Announcement = expected news + surprise news
Markowitz claims that investors find the minimum risk portfolios at every return level
and choose these portfolios over the others.
When investors minimize risk for every return level they obtain a parabola and the upper
part of the parabola is called the efficient frontier.
Capital Asset Line
In every economy, when investors combine the risk free asset with efficient frontier, they
obtain a line called the CAL (Capital Asset Line).
Markowitz states that, every rational investor will choose his or her optimal portfolio on
CAL according to his or her preferred risk level.
Systematic and Unsystematic Risk
Systematic risk is risk that influences a large number of assets. Also called market risk.
Unsystematic risk is risk that influences a single company or a small group of companies.
Also called unique risk or firmspecific risk.
Total risk = systematic risk + unsystematic risk
Diversification and Risk
In a large portfolio:
o Some stocks will go up in value because of positive companyspecific events,
o Others will go down in value because of negative companyspecific events.
Unsystematic risk is essentially eliminated by diversification, so a portfolio with many
assets has almost no unsystematic risk.
Unsystematic risk is also called diversifiable risk. Systematic risk is also called non
The Systematic Risk Principle What determines the size of the risk premium on a risky asset?
The systematic risk principle states:
o The reward for bearing risk depends only on the systematic risk of an investment.
So, no matter how much total risk an asset has, only the systematic portion is relevant in
determining the expected return (and the risk premium) on that asset.
Measuring Systematic Risk
To be compensated for risk, the risk has to be special.
o Unsystematic risk is not special.
o Systematic risk is special.
The beta coefficient measures the relative systematic risk of an asset.
o Assets with betas larger than 1.0 have more systematic risk than average.
o Assets with betas smaller than 1.0 have less systematic risk than average.
Because assets with larger betas have greater systematic risks, they will have greater
Note that not all betas are created equally.
The total risk of a portfolio has no simple relation to the total risk of the assets in the
o Recall the variance of a portfolio equation.
o For two assets, you need two variances and the covariance.
o For four assets, you need four variances, and six covariances.
In contrast, a portfolio Beta can be calculated just like the expected ret