The demand for rental equipment was affected by the fact that many companies didn't have enough work to keep their machines running during the recession.
The economy began to show signs of life in the spring of 2009, and by August of that year, the stock price had more than doubled from its low point.
You should be able to tell that it borrowed a lot of money to finance its operations after studying this chapter.
When the broader market shifted, the stock of URI moved sharply.
Mr. Ihle's recommendation was a good one.
The value of the stock of the University of Rhode Island increased from the end of August of 2009, to the end of August of 2014, by over 1,200%.
The 500 index, a widely used indicator of the stock market, rose by less than stellar 95 percent.
The tradeoff between risk and return is explored in this chapter, and we will see that a stock's beta is used to measure risk.
Explain the capital asset pricing model.
Take a look at the traditional and modern approaches to portfolio management.
Portfolios of investments are more beneficial to investors than single investments.
Without sacrificing returns, investors who hold portfolios can reduce risk.
The volatilities of the assets in the portfolio may be less than the volatility of the portfolio.
Different investors have different objectives.
Portfolio objectives involve tradeoffs between risk and return, as well as between potential price appreciation and income.
How investors evaluate tradeoffs will depend on their tax brackets, current income needs and ability to bear risk.
It's not easy to identify efficient portfolios.
The best combinations of risk and return are usually searched for by investors.
The first step in forming a portfolio is to analyze the characteristics of the securities that are in the portfolio.
The returns that each asset might be expected to earn and the uncer tainty surrounding that expected return are two of the most important characteristics to examine.
We will look at historical data to see what returns stocks have earned in the past and how much has changed in the past.
The weighted average of returns on the assets that make up the portfolio is used to calculate the portfolio return.
The weight that each asset gets in the portfolio is indicated by M06_SMAR3988_13_GE_C05.indd.
The sum of the portfolio weights must be 100%.
The sum must be equal to 1.0 when you add up the fractions.
The table shows the annual returns on International Business Machines Corp. and Celgene Corp.
IBM earned an average annual return of 9.0%, which is close to the average annual return on the U.S. stock market over the past century.
The average annual return for Celgene was 40.7%.
The annual rate of return is determined by the end-of-year closing prices.
The end-of-year closing prices are obtained from Yahoo Finance.
We want to calculate the return on a portfolio of investments.
Determining how much each stock to hold is the first step in the calculation.
We have to decide what weight each stock should get in the portfolio.
Let's assume that we want to invest most of our money in IBM.
We know that over this period, Celgene earned higher returns than IBM, so we might expect that a portfolio containing both stocks would earn a higher return than IBM's.
You might think that the portfolio's return would be closer to IBM's than to Celgene's, because most of the portfolio is invested in IBM.
The portfolio's return is shown in the columns 3 and 4.
The average annual return on this portfolio was 13.4%, which is higher than the return on IBM and lower than the return on Celgene.
If an investor invested a little in Celgene, they could earn a higher return than if they held IBM stock in isolation.
Measure the risk of the stocks in the portfolio.
Standard deviation of returns is a measure of invest ment's risk.
The standard deviation of returns on IBM and Celgene stock is calculated using the formula we introduced earlier.
If you prefer, you can use an excel spreadsheet to do the calculations instead of using the formulas in Table 5.1.
The stan dard deviation of IBM's returns is 23.6%, and the standard deviation of Celgene's stock returns is 53.7%.
There is evidence of the tradeoff between risk and return.
IBM's stock earned a lower return than that of Celgene's stock.
You might think that a portfolio containing both stocks would have a standard deviation that is higher than IBM's, but lower than Celgene's.
That's not what happens.
The standard deviation formula is used to calculate the IBM-Celgene portfolio's standard deviation.
The portfolio has a standard deviation of 18.4%.
This is good news for investors.
An investor who only held IBM shares would have had to endure a 23.6% standard deviation in order to achieve an average return of 9.0%.
An investor could have increased his or her return to 13.4% and reduced the standard by using the proceeds from IMPoRtAnt ConCEPtUAl tools to buy a few Celgene shares.
The investor could have had more return and less risk at the same time.
An alterna tive portfolio exists that has a better return-to-risk tradeoff than an investor who only owns IBM shares.
The power of diver sification.
The key factor in making this possible is a low correlation between IBM and Celgene returns.
Diversification involves the inclusion of a number of different investments in a port folio, and it is an important aspect of creating an efficient portfolio.
The statistical concept of correlation is at the center of the appeal of diversification.
It's important to understand how correlation and diversification affect a portfolio's risk.
If we record the number of hours of sunshine and the average daily temperature, we would expect them to show positive correlation.
The days with more sunshine tend to be hotter.
If we record the number of hours of sunshine and the amount of rain, we would expect the correlation to be negative because the amount of rain is lower on days with lots of sunshine.
We wouldn't expect a correlation between the number of hours of sunshine on a particular day and the change in the value of the U.S. dollar against other world currencies on the same day.
There is no correlation between sunshine and world currency markets.
The following spreadsheet shows the correlation coefficients between IBM and Celgene stock returns.
The correlation coefficients between IBM and Celgene were -0.43 during the 2005-2014 period.
There was a tendency for the two stocks to move in opposite directions.
In other words, years in which IBM's return was better than average tended to be years in which Celgene's return was worse than average.
Most stocks are affected in the same way by macroeconomic forces, so a negative correlation between two stocks is unusual.
Most stocks will show at least some positive correlation with each other because they tend to move in the same direction as the economy.
It is not surprising that the correlation between IBM and Celgene is not strong.
The companies compete in entirely different industries, have different customers and suppliers, and operate within very different regulatory constraints; however, the relatively large magnitude of their negative correlation raises concerns and should cause us to question the validity of basing investment decisions on this correlation measure.
Maybe the sample period we are using to estimate the correlation is too short or not representative of the investment performance of these two stocks.
There were three strong market-wide events during the 2005 to 2014 period, including a financial crisis, a Great Recession, and an economic recovery.
The correlation between most pairs of stocks, even when they are drawn from different industries, is due to the sharp macroeco nomic fluctuations that drive most securities' returns up and down at the same time.
Ten yearly observations is a small sample size, and it may be too small to accurately capture a measure of correlation between IBM and Celgene.
Increasing the period of time over which the cor relation is being measured is one way to address this concern.
The correlation between two investments will fall between the two extremes.
Two IMPoRtAnt ConCEPtUAl tools investments are M and P and M and N. In the real world, it is very rare to find two investments that are perfectly correlated, but you could think of M and P as representing two companies that operate in the same industry, or even two mutual funds that invest in the same types of stocks.
The returns on investments M and N are exactly opposite.
The correlation between asset returns varies from high to low, but can be illustrative.
The exception is negative correlation.
The lower the correlation between assets, the greater the risk reduction that investors can achieve by combining those assets in a portfolio.
The lower the correlation between assets, the lower the risk.
The average return and standard deviation of returns are shown in the table.
The percentage of the portfolio invested in IBM and Celgene is shown in columns 1 and 2, while the average return and standard deviation are shown in columns 3 and 4.
The portfolio return goes up as you move from the top of the table to the bottom.
As you move from the top to the bottom, the percentage invested in Celgene increases and the average return is higher than IBM's.
The general conclusion from column 3 is that when a portfolio contains two stocks, one with a higher average return than the other, the portfolio's return rises the more you invest in the stock with the higher return.
The standard deviation of returns for different portfolios of IBM is shown in column 4.
Again, we see a surprising result.
There is a standard deviation of 23.6% for a portfolio entirely invested in IBM.
It would seem that increasing the investment in Celgene would increase the standard deviation of the portfolio because the stock is more volatile than IBM stock.
Up to a point, the opposite is true.
As the percentage invested increases, the standard deviation falls.
Increasing the amount invested in Celgene does increase the standard deviation of the portfolio.
The general conclusion from column 4 is that when a portfolio contains two stocks, one with a higher standard deviation than the other, the portfolio's standard deviation may rise or fall the more you invest in the stock with the higher standard deviation.
There are two lessons emerging from Table 5.2.
Each portfolio is listed in Table 5.2.
The standard deviation initially falls as the portfolio composition changes from 100% IBM to a mix of IBM and Celgene.
There is a backward-bending arcs in portfolios of IBM and Celgene.
The investor could earn a higher return with a lower standard deviation if he or she held at least some stock in Celgene.
If you want to earn the highest possible returns, you have to accept a higher standard deviation.
The table shows the projected returns from X, Y, and Z over the next five years.