MEASURES OF RETURN AND RISK

This selection process requires that you estimate and evaluate the expected risk-return trade-offs for the alternative investments available. Therefore, you must understand how to mea-sure the rate of return and the risk involved in an investment accurately. To meet this need, in this section we examine ways to quantify return and risk. The presentation will consider how to mea-sure both historical and expected rates of return and risk.  We consider historical measures of return and risk because this book and other publications provide numerous examples of historical average rates of return and risk measures for various assets, and understanding these presentations is important. In addition, these historical results are often used by investors when attempting to estimate the expected rates of return and risk for an asset class.  The first measure is the historical rate of return on an individual investment over the time period the investment is held (that is, its holding period). Next, we consider how to measure the average historical rate of return for an individual investment over a number of time periods. The third subsection considers the average rate of return for a portfolio of investments.  Given the measures of historical rates of return, we will present the traditional measures of risk for a historical time series of returns (that is, the variance and standard deviation).Following the presentation of measures of historical rates of return and risk, we turn to esti-mating the expected rate of return for an investment. Obviously, such an estimate contains a great deal of uncertainty, and we present measures of this uncertainty or risk.