Risk & Return Analysis

1845 words - 8 pages

Risk & Return Analysis:
Analyzing an equally weighted portfolio of investments in Amazon, Inc., Yahoo! Inc., and Direct TV stock compared to the S&P 500

Introduction:

Every day, millions of investors spend countless hours following the stock market in the hopes of striking it rich. Making the right moves at the right moments is crucial when one looks to make large returns in the market. While luck affords many investors the opportunity to make lucrative returns in the stock market, this reward does not come without risk. In order to balance their returns and the amount of risk that they are exposed to, many investors create an investment portfolio as a means to mitigate risks in ...view middle of the document...

The logic behind considering this to be a riskless investment is because if necessary interest payments are not made, the United States would be in default on their debt, a move that would be detrimental to both the U.S. and Foreign economies.

For the purposes of this analysis, the 10-year T-bill rates were used to define the Market Risk-Free rate. At December 1, 2014, the U.S. Department of the Treasury reported the 10-year T-bill interest rate to be 2.22%. As such, this rate will be used in all calculations where the risk-free rate (rRF) is utilized.

Beta (β):

A stock’s beta factor represents the amount of risk that the stock contributes to the market portfolio. By rule, the market has a beta of 1. A stock with a beta coefficient greater than one indicates that the stock moves in the same general direction as the market, but to a greater degree. Conversely, a stock with a beta coefficient less than one (but greater than zero) indicates that the stock moves in the same general direction as the market, but to a lesser degree. It is possible for a stock to have a beta coefficient less than zero (indicating stock movement is opposite in relation to the market), however it is difficult to sustain this over an extended period of time as stocks tend to be impacted, by some degree, to the general movement of the market.

A stock’s beta coefficient can be calculated in an excel spreadsheet by calculating the monthly returns of both the stock and the market. The stock’s returns are plotted on the y-axis, while the market’s returns are plotted on the x-axis. By generating a regression line of the data points, the slope of the line will reflect the stock’s beta. The graphs below illustrate that all three stocks in the portfolio have beta coefficients near 1, indicating that each stock has a close correlation with the movement in the market. The stock that provides the most risk in relation to market would be Yahoo! Inc. with a beta of 1.12 as illustrated by the slope of the regression line.

Standard Deviation (σ):

Standard deviation provides a measure of the tightness of the probability distribution for a stock’s rate of return. The lower a stock’s standard deviation is, the tighter the probability distribution will be. Therefore, a stock with a lower standard deviation will be less risky than those with higher standard deviations. The chart below illustrates the standard deviation of the three individual stocks as well as the S&P 500.

Of the three stocks, Amazon.com, Inc. has the largest standard deviation, and therefore, has the greatest risk that the stock’s return will vary from the expected rate of return.

Variance (σ2):

Variance is the square of an investment’s standard deviation and represents the spread in the data points. A large variance indicates that there is a large spread between numbers and the mean, whereas a smaller variance relates to a smaller spread between the values. Both Amazon.com Inc. and...

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