Flirting with Risk

Solution to Case 02

Risk and Return

Flirting With Risk

Questions:

1. Imagine you are Bill. How would you explain to Mary the relationship between risk and return of individual stocks?

I would explain to Mary that risk and return are positively related, i.e. if one expects to earn higher returns, then one has to be willing to invest in stocks whose price can vary significantly from year to year or in different economic conditions. For example, in the table below we see that treasury bills would have yielded 4% with almost no variability, while the index fund is expected to yield 10.1% with a standard deviation of 9.15%.

| | Expected Rate of Return |

|Scenario |Probability |Treasury Bill |Index Fund |Utility Company |High-Tech Company|Counter-Cyclical |

| | | | | | |Company |

|Recession |20% |4% |-2% |6% |-5% |20% |

|Near Recession |20% |4% |5% |7% |2% |16% |

|Normal |30% |4% |10% |9% |15% |12% |

|Near Boom |10% |4% |15% |11% |25% |-9% |

|Boom |20% |4% |25% |14% |45% |-20% |

|Expected Return | |4% |10.10%...