Risk – Return Concepts
As a investor, selecting investment on
the basis of return is not enough.
Investors not only like return but also
dislike risk, so, what is required is
Clear understanding of what risk & return
What creates them, and
How can they be measured
Risk
Risk – The chance that an investment's actual
return will be different than expected.
This includes the possibility of losing some or
all of the original investment. Here the investor
is aware of the possible consequences of the
decision.
Uncertainty – here the outcome is not known to
the investor.
Risk comprises all elements of variability of
return and uncertainty of outcome.
Return
The gain or loss of a security in a particular
period.
Consists of the income and the capital gains
The greater the amount of risk that an
investor is willing to take on, the greater the
potential return.
The reason for this is that investors need to be
compensated for taking on additional risk.
Return- Continue….
Expected Return
Expected or estimated return and may or
may not occur
Realized Return
In the past allow an investor to estimate the
future expected returns.
Risk / Return Trade off
The risk/return tradeoff is the balance between
the desire for the lowest possible risk and the
highest possible return.
Risk is usually measured by calculating the
standard deviation of the historical returns or
average returns of a specific investment.
A higher standard deviation means a higher
risk and higher possible return. [There are no
guarantees]
Risk & Return Tradeoff
Risk-free rate & Risk Premium
Risk-free rate of return – Government
Securities are risk free because their
chance of default is next to nothing.
A corporate bond, provides a higher rate
of return, because the risk of investing in
a corporate bond is higher.
We call this additional return the risk
premium.
Risk Tolerance & Risk Discount
The degree of uncertainty that an investor can
handle in regards to a negative change in the
value of their portfolio is called risk
tolerance. An investor's risk tolerance varies
according to age, income requirements,
financial goals, etc.
The risk discount is the exact opposite of the
risk premium. Those who choose to take a risk
discount versus a risk premium are people who
are very risk averse.
Factors that cause Risk
Wrong decision of what to invest in
Wrong timing of investments
Nature of the instruments invested
{Bonds/Bank deposits}
Creditworthiness of the issuer {Govt. / Pvt.}
Maturity period or length of the investment
Amount of investment
Security availability
Terms of lending { interest pymt period,
redemption.}
Nature of the industry or business
Classification of Risks
Systematic Risks Unsystematic risks
•External to firm / industry •Internal to firm / industry
•Uncontrollable •Controllable
•Affects investor •May not affect investor
•Caused by economic, •Caused by strikes, irregular
sociological, political and legal management policies and
considerations consumer preferences
•Covers Market risk, Interest •Covers Business risk and
rate risk and Purchasing power Financial risk
risk •Results from company and
•Results from market influences industry influences.
Systematic Risk
The risk inherent to the entire market or entire
market segment.
Also known as "un-diversifiable risk" or "market
risk."
Interest rates, recession etc. represent sources
of systematic risk because they affect the entire
market and cannot be avoided through
diversification. It affects a broad range of
securities. Systematic risk can be mitigated only
by being hedged.
Even a portfolio of well-diversified assets cannot
escape all risk
Unsystematic Risk
Risk that affects a very small number of
assets. Sometimes referred to as
specific risk. For example, news that is
specific to a small number of stocks,
such as a sudden strike by the
employees of a company is considered
to be an unsystematic risk.
Systematic Risk – a. Market Risk
Arises out of changes in demand and supply in
market, business recession, depression and changes
in investor attitudes and expectations.
Results from investor’s reaction to tangible and
intangible events
Initial Decline / Fear of loss /
Emotional possibility of
Rise in
instability profit
prices
Reaction to gain Reaction to loss
Active buying Excessive selling
Higher prices Lower prices
Reducing Market risk
Market risk is uncontrollable
Brings down prices of all stocks.
Diversification can reduce but not
eliminate market risk
Can also be reduced by holding growth
stocks and proper timing of purchase of
stocks and wise combination of stocks in
the portfolio.
b. Interest Rate Risk
The return on an investment depends on
the interest rate promised and the
changes in market rates of interest..
Changes in interest rate affects investors
of fixed income securities directly and
leads to changes in equity prices.
Monetary and credit policies affect
interest rates and these are
uncontrollable factors.
Reducing Interest Rate Risk
Diversifying in various kinds of
securities
Buying securities of different maturity
dates.
Purchasing government securities –
which are risk free, assured return, and
has tax benefits.
c. Purchasing Power Risk
Also known as inflation risk.
Arises out of change in the prices of goods
and services.
Returns expected by investors will change due
to change in real value of returns.
Influences prices bonds and stocks
Can be reduced by estimation and investment
in securities that provide a rate of return higher
than inflation rate.
d. Exchange rate risk
Affects international investors
Uncertainty/variability in returns on
securities caused by currency
fluctuation.
Affects international mutual funds,
ADRs, foreign stocks and bonds.
Unsystematic Risk
It is specific or peculiar to an industry or
enterprise
Caused by factors internal to the issuer
of securities or companies and are
controllable.
Causes - Labour strike, consumer
preferences, management policie.
a. Business Risk
Relates to variability of business, sales,
income , profits etc..
Sometimes caused by external factors such as
govt. policies, competition, unforeseen market
conditions
Internal factors such as fall in production,
inadequate supply of raw materials/ electricity..
Leads to fall in revenue and profits
The degree of variation in operating income
would measure business risk.
Reducing business risk
Can be corrected by certain changes in
company policies..
A firm with high fixed costs has a larger
business risk
Can be reduced by keeping fixed costs
low
Diversifying into wide range of products
Cutting costs of production
b. Financial Risk
This relates to the method of financing
adopted by the company.
High leverage that leads to larger debt
servicing problem or short-term liquidity
problem due to bad debts, dec in C/A
and inc in C/L
Fluctuates earnings, profits & dividends.
Proper financial planning can control this
risk
C. Credit / Default risk
Risk due to failure to pay financial
obligations of principal / interest.
Higher with corporate bonds than govt.
bonds.
d. Liquidity risk
Associated with non availability of
buyers and sellers in particular
secondary market for securities.
