Test 2  Investments  Returns and Risks of Investing
I) ANALYSIS OF RETURNS
 Review past performance to make future predictions
A) TOTAL RETURN (from previous chapters)Annualized
Best return to use if you are trying to measure the total effect of returns over time given some stated beginning amount
NOTE:
Calculation of TR Return in $ and in % for TSX
From page 161 to see how the TR % of TSX is calculated:
Year 
Ending & Opening Prices 
Change in Value 
DIV 
TR 
TR% 
1987 
3160.053066.18 
93.87 
97.32 
191.19 







2007 
13833.0612,908.39 
924.67 
344.44 
1269.11 

B) Return Relative (RR)
 Total return +1
Example:
Purchased a share that cost $100. A year later the value is $90. During the year received a dividend of $5 per share. Calculate the Return Relative.
 Converts total return to positive
 Used for cumulative wealth index and geometric mean
Problem 62 page 178 (Demo problem) — excel handout will be used to highlight Arithmetic Mean and Geometric Mean
C) Arithmetic Mean
 Better measure of average performance over single periods (average)
 Used to estimate performance for the next year
Formula
 Sum of ( total return %^{1} + total return %^{2} + total return % ^{nth year})
Number of years measured
Arithmetic Mean = Annual Average Return
D) Geometric mean
 Arithmetic mean is acceptable to evaluate estimated performance of next period but can be misleading when analyzing several years
 Geometric Mean:
1) shows true average compound rate of growth or the rate at which the dollar grows, taking into account the variability of the returns
2) better measure of the change in wealth over more than a single period
3) always less than arithmetic mean because it allows for the compounding effect
Formula
Geometric Mean = (RR^{1}*RR^{2}*…RR^{3})^{1/n}  1
E) Cumulative Wealth index –Excel handout on TSX to be used to illustrate calculations
 Measures the cumulative effect of total returns (income & price change) over time
 Measures change in wealth over time
 Uses index values (TSX/NASDAQ, NYSE) to have a specified beginning value
Formula
CWI = Beginning index * return relative ^{1}* return relative ^{2} * etc.

F) International Returns (covered this in chapter 4) — We will use same method used in chapter 4.
TR C
G) Inflation adjusted returns
Total return (adjusted for inflation) = (1+total return)  1
(1+inflation rate)
Assume the following 



Nominal Return for a share 
6.02% 



Inflation Rate 

2.% 


Calculate: Real Rate of Return (1 + .0602) (1 = .02)
Real return = 1.039 – 1= 3.9%




 Real Return (adjusts for inflation) = 3.9%
 Nominal Return (does not adjust for inflation) = 6.02%
II) FACTORS THAT AFFECT INVESTMENT RISK
 Interest Rate Risk
 Changes in interest rates will affect investment value.
 Market Risk
 Political, economic, social events
 Inflation (Purchasing Power) Risk
 interest rates usually rise with inflation
 Business Risk
 Risk of doing business in a particular industry or environment
 Certain investments have higher risks
Examples:
Banks shares vs resource shares
Airline industry (costly security issues)
 Similar business types have similar risk although differences in management, costs, and location can affect risk levels
(a) Arrival of marshals in Ontario & target inn Canada
 Financial Risk
 Mix of debt and equity
 Big interest payments may lead to default and bankruptcy or forced sale (takeover)
 Liquidity Risk
 Not being able to liquidate an investment conveniently and at a reasonable price
 Stocks on NYSE, TSX, and TBills have lower liquidity risk
 Private companies and shares listed on OTC have higher liquidity risk
 Exchange Rate (Currency) risk
 Country or Event Risk
 Something happens that has an immediate and material impact on its financial condition
Plane crash, contaminated product side effects of medical drugs, accusations of fraud, ceo leaving the company, health of top individual in company
Types of Risk
 Systematic Risk (Market risk)
 Risks that are pervasive in nature (company cannot control this risk)
 When stock markets decline most stockswill decline,when stock market goes up, most stovks go up.
 Bank of Canada interests rates
 Inflation and how governments deal wth it
 NonSystematic RiskSpecific Security risk
 Risks that affect a specific security e.g. business or financial risk (Not a market risk)
 Investment vehicle type, quality of management, how investment is financed and customer base of the issuer