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Finance (21)
FIN 302 (21)
Lecture 17

FIN 302 Lecture 17: Session 17

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FIN 302
Denis Sosyura

SESSION 17: RETURN, RISK, AND DIVERSIFICATION - PART 1 - Asset Returns - What can we learn from historical returns? - Portfolio risk STOCK RETURN AND DIVIDEND-ADJUSTED PRICES - Yahoo Finance reports adjusted closing prices for all stocks, and these adjusted closing prices already include dividends paid - This facilitates incorporation of dividends in computing stock returns - Returns can be computed directly from div-adjusted prices: - - P_1, div-adjusted - dividend-adjusted stock price, end of period - P_0, div-adjusted - dividend-adjusted stock price, beginning of period RETURN OF A PORTFOLIO OF STOCKS Return of a Stock Portfolio - a weighted average of individual stock returns, where the weight of each stock is the percentage of portfolio value invested in that security at the beginning of period - - W_n - weight of stock n in the portfolio at the beginning of the period - R_n - percentage return of stock n during the time period WHAT CAN WE LEARN FROM HISTORICAL RETURNS? - Mutual funds advertise their historical return as an indicator of managerial ability (over 43% of all ads refer to past performance) - Can we benefit from seeking funds with high recent returns? - Among the funds with top performance over the trailing 12 months (funds in the top 25% based on returns), over 55% will end up below-median performance next year - Stocks that have historically well usually will not produce as well in the following year (do not pick them when you are a novice trader) - The larger the corporation, the harder it is to turn a profit from their firm PORTFOLIO RISK - The concept of risk in finance refers to the possibility of incurring losses as a result of negative returns on a financial asset - The likelihood of losses and the level of risk increase with the variability in security’s returns - One of the common measures of absolute risk of a financial asset is the standard deviation (∂) or variance (∂^2) of its returns: - Variance = (standard deviation)^2 - Standard deviation is the main measure of risk in Finance STANDARD DEVIATION OF A PORTFOLIO OF TWO ASSETS ● W - weights of the assets ○ The greater the weight of the security, the greater the contribution of risk to the portfolio ● Sigma - the squares of the standard deviations (variation) ● Roe - correlation ESTIMATING STANDARD DEVIATION FROM MONTHLY DATA - Standard deviation is usually expressed on an annual basis. However, in practice, it is often estimated from monthly data to allow for sufficient observations Estimating annual standard deviation of
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