Risk and return are important factors of Financial Management that must be considered in making new investments. It is the desire of every investor to earn maximum return on his investment but for that he should bear some kind of risk.
The combination of danger & opportunity is considered as risk. If risk is described with the perspective of investment then it takes the form of uncertainty in outcomes of that investment. In other words the spread or variability that can occur in the expected future value or returns (cash flows) is considered as risk. For example if an investor purchases the share of particular company for market price of $100. Then it is not sure what will be the price of that share after one year and the investor is taking some kind of risk in the shape of uncertainty about the future outcome of his investment. So the riskiness of particular investment is also represented by the difference or variation in the possible outcomes.
Another reference of describing risk is related with the uncertainty of future cash flows generated by assets (physical or financial securities). Companies make forecasts on the basis of certain assumptions. These forecasts are not 100% accurate and the element of uncertainty is present in the possible outcomes. The cash flows that actually take place after five years are different from the forecasted ones which is the representation of risk.
Types of Risk
There are two main types of risk which are as follow
- Stand Alone Risk
- Portfolio Risk
Stand Alone Risk:
The risk associated with only single investment is regarded as stand alone risk.
The risk that is related with portfolio investment is called portfolio risk. In this case the entire risk of the portfolio is considered. Portfolio risk has further two classifications
- Diversifiable Risk
- Market Risk
It is also called Non-Systematic or Company Specific risk. It is linked with the random events happening in the company whose stocks are purchased by investor. These random events may be successful marketing campaign, losing a court case, winning of major contract or losing of charismatic CEO etc. Through diversification of investments, the diversifiable risk can be reduced. The good random events happening in one stock will offset the bad random events happening in another stock of the portfolio.
It is also called Systematic or Non –diversifiable or Beta risk. Market risk cannot be reduced through diversification of investments. It is linked with the Socio-political, Macroeconomic global events that influence the stock investments in every stock market in the country in a systematic manner e.g. Macro Market Interest Rates, Inflation, War and Recession.
Causes of Risk
Causes of risk can be general or company specific in nature. It may be because of poor management of the company or cash losses from financial operations. This is possible events but its causes may be inflation, company debt, politics, economy, war etc. The net analysis of risk is that it is a game of chance or fate.
Measurement of Risk
It is significant that different numbers should be attached to risk in order to rank different investments. Standard deviation or variance is used to measure risk. Another important fact is that risk is subjective factor although certain numbers are calculated from standard deviation. The reason behind this fact is that there are different kinds of risk that are calculated like
- Stand Alone risk
- Portfolio Risk
- Market Risk or Diversifiable Risk
- Earnings Risk or Stock Price Risk
Another important point is the consideration of the time horizon in measuring the risk like investment made in stock is for 1 year or for twenty years. With the change in the time period of investment, the level of risk also changes.
Fundamental Rules of Risk and Return
The rule of Risk and return is described in a concise manners as “NO pain – No gain”. Whenever there is presence of risk, there must also the presence of return. If an investor has certain amount that is safe then he will not invest that amount in risky project unless there is presence of some additional return against taking that risk. The investor likes to invest in that investment that can provide him additional return. So expectation of additional return by investor against bearing of additional risk is quite logical. But mostly the investors are risk averse.
Following are some of daily life example of Risk & Return
Diversification is understood better with the sentence that “don’t put all the eggs in one basket”. The investors make many investments in different industries, markets and countries to avoid the weaknesses of every single investment. This investment in different uncorrelated investments is referred to as diversification. Due to change in the interest rates, some investments in the portfolio may go down while others may go up.
In case of consideration of risk of certain investment, the different possible outcomes are pointed out by analyzing the expected return. When there is idea of variation of the possible outcomes of particular investment, then risk can be measured.
The overall Return on Stock = Dividend Yield + Capital Gain Yield
In simple sense, the return is proportional to capital gain which further is proportional to selling price. So selling price is forecasted as a measure of return. The risk enhances with the widening of the range of possible outcomes that occur.
Probability is used for measuring the chance that future event will occur actually.
Expected ROR <r> = pi x ri
Where pi shows the probability of event “i” occurring and ri shows the Rate of Return (ROR) if event “i” occurs. The probability provides weight age to the return. The most likely or Expected ROR is the sum of weight age of all the possible outcomes.
Suppose an investor is making decision to invest in the stocks of Company XYZ. He is not confident about the expected or future price of the stock after 1 year can become any of one of the three possible values (outcomes). Before calculation of expected or mean future price, the probability of each possible outcome needs to be ascertained.
Payoff Table for Investment in Stock
Expected ROR <r> of the Stock
Mean or Weighted Average rate of Return
Expected ROR <r> = pi x ri
Expected ROR <r> = p1 (r1) + p2 (r2) + p3 (r3)
Expected ROR <r> = 0.4 (10%) + 0.3 (40%) + 0.3 (-20%)
Expected ROR <r> = +4% + 12% – 6% = 10%
In the above diagram, Rate of Return is graphed on x-axis & probability is graphed on y-axis. All three outcomes are represented by bars. In this diagram, the value of expected rate of 10% shows the largest probability. By connecting the top of all three bars, a bell curve is formed. After calculating the expected rate of return, it is easy to calculate the risk. For calculation of risk, the formula of standard deviation is used.
Stand Alone Risk of Investment of Single Stock
When the range of the possible outcomes becomes wider, the risk resultantly becomes higher.
By using the following formula of standard deviation, risk is measured.
Risk = Stand Dev = ∑(ri – <ri>)2 x pi
It is clear that variance = Standard Deviation2
So, Stand. Dev = [∑(ri – <ri>)2 x pi]0.5
Stand. Dev = [(10-10)2 x 0.4 + (40-10)2 x 0.3 + (-20-10)2 x 0.3]0.5
Stand. Dev = [0 + 270 +270]0.5
Stand. Dev = 0.5
Stand. Dev = 23.24
Interpretation of Result
The first point is to clarify the units of standard deviation. As variance is estimated in terms of percentage (%), so the unit of standard deviation is also in percentage (%).
It is statistically proven fact that if there is normal probability distribution & expected rate of return is symmetric then 68.2% of the time, the actual return will range between -1 standard deviation and +1 standard deviation of the expected return.
+/-1 standard deviation = 10% which means that from -13.24% (10% – 23.24%) to 33.24% (10% + 23.24%).
There is 68.2% chance that after one year the return on investment of stocks of company XYZ will range between -13.24% to 33.24%. Another important point to understand is that in normal probability distribution, the area from -1 standard deviation to +1 standard deviation under the curve is 68.2%. So it can be said that 68.2% (two thirds) of the times the real value of the return will lie somewhere from -13.68% and 33.24%. It is clear from the answer that -13.24% is not better value as it represents loss but the required rate of return is 10%.