Risk and Return

Risk and Return

These are the 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.

Risk

The combination of danger & opportunity is considered a risk. If the risk is described from the perspective of investment then it takes the form of uncertainty in the 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 a risk. For example, if an investor purchases the share of a particular company for a 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 a particular investment is also represented by the difference or variation in the possible outcomes.

Another reference describing risk is related to 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 a single investment is regarded as a stand-alone risk.

Portfolio Risk

The risk that is related to portfolio investment is called portfolio risk. In this case, the entire risk of the portfolio is considered. Portfolio risk has further two classifications

1. Diversifiable Risk
2. Market Risk

Diversifiable 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 investors. These random events may be successful marketing campaigns, losing a court case, winning a major contract or losing a 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.

Market Risk

It is also called Systematic or Non –diversifiable or Beta risk. Market risk cannot be reduced through the 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. These are possible events but their 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.

More From Business Study Notes:- Risk Management

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 a subjective factor although certain numbers are calculated from standard deviation. The reason behind this fact is that there are different kinds of risks 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 an 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 manner as “NO pain – No gain”. Whenever there is a presence of risk, there must also be the presence of return. If an investor has a certain amount that is safe then he will not invest that amount in a risky project unless there is the presence of some additional return against taking that risk. The investor likes to invest in that investment that can provide him additional return. So the expectation of an additional return by investors against the bearing of additional risk is quite logical. But mostly the investors are risk averse.

Example

Following are some daily life examples of Risk & Return

Diversification

Diversification is understood better with the sentence “don’t put all the eggs in one basket”. 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 changes in the interest rates, some investments in the portfolio may go down while others may go up.

Expected Return

In case of consideration of the risk of certain investments, the different possible outcomes are pointed out by analyzing the expected return. When there is an idea of the variation of the possible outcomes of a particular investment, then risk can be measured.

The overall Return on Stock = Dividend Yield + Capital Gain Yield

In a simple sense, the return is proportional to capital gain which further is proportional to the 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 events will occur actually.

Expected ROR <r> = pi x ri

Where pi shows the probability of the event “i” occurring and RI shows the Rate of Return (ROR) if the event “i” occurs. The probability provides weightage to the return. The most likely or Expected ROR is the sum of the weightage of all the possible outcomes.

Example

Suppose an investor is making a 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 calculating 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> = p_i x r_i

<r> = p1 (r1) + p2 (r2) + p3 (r3)

<r> = 0.4 (10%) + 0.3 (40%) + 0.3 (-20%)

Expected ROR <r> = +4% + 12% – 6% = 10%

In the above diagram, the Rate of Return is graphed on the x-axis & probability is graphed on the y-axis. All three outcomes are represented by bars. In this diagram, the value of the 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 the 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, the risk is measured.

Risk = Stand Dev =   ∑(r_i – <r_i>)² x p_i

It is clear that variance = Standard Deviation²

So, Stand. Dev = [∑(r_i – <r_i>)² x p_i]^0.5

Stand. Dev = [(10-10)² x 0.4 + (40-10)² x 0.3 + (-20-10)² x 0.3]^0.5

S.D = [0 + 270 +270]^0.5 = [540]^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 a 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 a 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 the 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 a better value as it represents loss but the required rate of return is 10%.