>> Recall from our first video in this series,
we learned about the five principles of finance.
One of the most important concepts in finance is risk and return,
which is the focus of our third principle of finance;
risk requires a reward.
So owning a stock is sometimes not for the faint of heart,
where in a single day,
you could earn as much as five percent on your investment or lose even more.
Therefore, many investors and business managers alike
have become much more cognizant of financial risk.
In this small video grouping dealing with risk and return,
you will understand the nature of risk
and how risk should relate to expected returns on investment.
Let's begin by looking at what some of the various returns are
and how they can be measured.
There are three types of returns we will look at;
holding period returns and
expected returns measured in both cash flow and rate of return.
The focus of this video will be on expected returns.
There are two ways to measure expected returns.
The first is in terms of cash flow,
meaning how much money did we earn as a return.
The second is in terms of a percentage,
meaning how much was our return as a percentage of our investment.
The expected cash flow is the weighted average of the possible cash flow outcomes.
The weighting is the probabilities of the occurrence of various states of the economy.
That definition is a little confusing.
So I think the easiest way to understand it is with an example.
The Hold Steady have $10,000 to invest.
The table on the slide shows the possible returns on the investment
during various states of the economy.
It also shows the probability of those returns.
Let me summarize the table for you.
There is a 20 percent chance of a recession.
If this happens, the most likely outcome is $1,000 return on investment.
There's a 30 percent chance of moderate economic growth.
If this happens, the most likely outcome is $1,200 return on investment.
Finally, there is a 50 percent chance of strong economic growth.
If this happens, the most likely outcome is a $1,400 return on investment.
In order to determine expected cash flow from the $10,000 investment,
we multiply the expected cash flow return
from each of the possible states of the economy by the probability that they will happen.
Then we total them to arrive at our expected cash flows.
So the expected cash flow in this example is shown on the table.
The possible recession data is $1,000 return
times 20 percent likelihood of the recession equals $200,
plus $1,200 return times 30 percent likelihood of moderate growth equals $360,
plus $1,400 return times 50 percent likelihood of strong growth equals $700.
We would total these and the expected cash flow is $1,260 from the $10,000 investment.
The last thing we're going to learn in this video is
how to calculate the expected rate of return,
which is the weighted average of the possible return percentages.
The weighting is the probability of the occurrences of the various states of the economy.
Using the same data as before,
there's a 20 percent chance of a recession.
If this happens, the most likely outcome is a 10 percent return on investment.
There's a 30 percent chance of moderate economic growth.
If this happens, the most likely outcome is a 12 percent return on investment.
Finally, there's a 50 percent chance of strong economic growth.
If this happens, the most likely outcome is a 14 percent return on investment.
In order to determine expected rate of return from the $10,000 investment,
we multiply the expected rate of return from each of the possible states of economy
by the probability that they happen,
and then we total them to arrive at the expected rate of return.
So the expected rate of return in this example is shown on the slide.
The possible recession data is 10 percent return
times 20 percent likelihood of a recession equals two percent,
plus 12 percent return
times 30 percent likelihood of a moderate growth equals 3.6 percent,
plus 14 percent return times 50 percent likelihood of strong growth equals 7 percent.
We total these and the expected rate of return is 12.6 percent on a $10,000 investment.