Summary-C4

1.How can one estimate the opportunity cost of capital for an “average-risk”

project?

Over the past 73 years the return on the Standard & Poor’s Composite Index of common

stocks has averaged almost 9.4 percent a year higher than the return on safe Treasury bills.

This is the risk premium that investors have received for taking on the risk of investing in

stocks. Long-term bonds have offered a higher return than Treasury bills but less than stocks.

If the risk premium in the past is a guide to the future, we can estimate the expected

return on the market today by adding that 9.4 percent expected risk premium to today’s

interest rate on Treasury bills. This would be the opportunity cost of capital for an averagerisk

project, that is, one with the same risk as a typical share of common stock.

2.How is the standard deviation of returns for individual common stocks or for a

stock portfolio calculated?

The spread of outcomes on different investments is commonly measured by the variance or

standard deviation of the possible outcomes. The variance is the average of the squared

deviations around the average outcome, and the standard deviation is the square root of the

variance. The standard deviation of the returns on a market portfolio of common stocks has

averaged about 20 percent a year.

3.Why does diversification reduce risk?

The standard deviation of returns is generally higher on individual stocks than it is on the

market. Because individual stocks do not move in exact lockstep, much of their risk can be

diversified away. By spreading your portfolio across many investments you smooth out the

risk of your overall position. The risk that can be eliminated through diversification is

known as unique risk.

4.What is the difference between unique risk, which can be diversified away, and

market risk, which cannot?

Even if you hold a well-diversified portfolio, you will not eliminate all risk. You will still be

exposed to macroeconomic changes that affect most stocks and the overall stock market.

These macro risks combine to create market risk—that is, the risk that the market as a

whole will slump.

Stocks are not all equally risky. But what do we mean by a “high-risk stock”? We don’t

mean a stock that is risky if held in isolation; we mean a stock that makes an above-average

contribution to the risk of a diversified portfolio. In other words, investors don’t need to

worry much about the risk that they can diversify away; they do need to worry about risk that

can’t be diversified. This depends on the stock’s sensitivity to macroeconomic conditions.