Returns and risk: an application

In this step you will consider purchasing the stock of two companies: Mondelez International Inc., the American multinational food, drink and confectionary corporation; and Tesla Inc., the American company manufacturing electric cars and solar panels.

How would you characterise these two companies? For example, you might differentiate the

• markets they sell in
• prices of finished goods
• technology embodied in finished products
• technology and processes involved in production
• cost and availability of raw materials
• scale and location of operations
• workforce
• corporate structure and leadership styles.

Are there other factors you would consider when characterising these two companies? In overly simple terms, and depending on your perspective, you might characterise one company as relatively more ‘exciting’ and the other company as comparatively more ‘traditional’.

If we are considering investing in one or both of these two companies we might conduct a detailed analysis of the factors suggested above. And we could examine their financial reports, including the income statements and balance sheets. In addition, we could see how stock markets and investors value the two companies by examining their share prices. The daily price of Mondelez shares is shown below, from 2010 onwards.

Mondelez share price, daily

Source: finance.yahoo.com

The average annual return on Mondelez shares over this period is 12 per cent per year. (We have calculated the return from the daily change in the share price, ignoring any dividend payments.) The price of Tesla shares is shown in the following figure.

Tesla share price, daily

Source: finance.yahoo.com

Over the same period, the average annual return on Tesla shares was 33 per cent per year. If we took past performance as an indication of future performance, we might expect to earn a better return from holding Tesla shares than we would from holding Mondelez shares.

However, take a moment to examine the patterns of share prices for the two companies. The share price for Tesla shows more variation than the share price for Mondelez. This corresponds to larger positive returns, but also larger negative returns, for Tesla shares compared to Mondelez shares. In the next steps you will see how to examine this variation using the standard deviation of returns. For the moment we can say the standard deviation of returns for Mondelez is 19 per cent per annum, calculated from this historical data.

The annual standard deviation of Tesla returns is 51 per cent per annum, calculated from the historical data. How might this information influence your investment decision concerning Mondelez and Tesla shares?

In this step we have estimated the average return for each asset using historical data. In the next step you will see how the expected return relates to the probability distribution of returns. The probability distribution describes the possible returns for an asset, and the probability that they will occur. So, for example, the probability distribution for Mondelez returns would exhibit less extreme returns compared to Tesla, and with a smaller probability of occurring.

To capture the variability of returns we consider how the returns for an asset vary relative to the mean return for the asset. If more extreme returns are possible (both positive and negative), these will contribute to a higher standard deviation. However, if the extreme returns have a low probability of occurring, their contribution to the overall measure of variability will be small.

So the question is, do you want to invest in biscuits or driverless electric vehicles?