5. Return vs. Risk

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Balancing Risk and Return

RETURN


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RETURN

Returnis a measure of investmentgain or loss."

The gain or loss for a security in aparticular period, consisting of incomep l u s c a p i t a l g a i n s r e l a t i v e t o

investment.
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Total Return

Long-term investors are interested intotal return, which is the amount your

investment increases or decreases invalue, plus any income you receive


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Total Return

If you buy stock for Rs. 10,000 and sell it for Rs.12,500, and collected Rs. 150 in dividends your returnis Rs. 2,500 + Rs. 150 =Rs. 2650 gain.

Or, if you buy stock for Rs.10,000 and sell it forRs.9,500, and collected Rs. 150 in your return is aRs.500 loss plus Rs. 150. i.e. a return of Rs. 350 loss

You dont have to sell to figure return on theinvestments


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Total Return

You simply subtract what you paid from thecurrent value to get a sense of where

you stand.

To this you add income recd. during the period


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Return as a percentage

Return is usually quoted as apercentage


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Return is usuallyquoted as apercentage

WHY ?

To compare toinvestmentsmade atdifferent prices


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An Example

A Rs 2,650 total return on an investment ofRs. 10,000 is 0.265, or a 26.5% return.

In contrast, a Rs. 2,650 total return on aninvestment of Rs. 30,000 is an 8.84% return.

So while each investment has increased yourwealth by thesame amount, the performanceof the first is more than thrice as strong as theperformanceof the second


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Yield / Annual Return

Divide thepercentage returnby the number ofyears you ownedthe investment.

If you invested Rs.10,000 three years ago,and the total return to date is Rs.2,650,

your annualized percent return is 8.83(Rs.2,650 Rs.10,000 = 0.2649 3 = 0.0883).

Percentage return

No of years owned


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Real Return

INFLATION

INCOME TAX


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Real Return

You made a fixed deposit of Rs. 10,000at an interest rate of 10%.

Interest earned Rs. 1000.Tax paid (Say @ 20%) Rs. 200

After Tax return Rs. 800

After tax Rate of return 8%

Inflation 8%

Real return 0 %


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Expected Return

Ex Ante Return Before the Event - based on future

expectations

Expected Return


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Expected Return

For example

If you knew a given investment had a 50%chance of earning a 10% return, a 25% chanceof earning 20% and a 25% chance of earning -10%, the expected return would be equal to

7.5%:

= (0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1)

= 0.075= 7.5%
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Actual Return

Ex Post Return -after the facts

Actual Return What investorsactually receive from

their investment

Sales value Purchase value +

Income received
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THE CATCH

Although you expect to have acer t a in re tur n , ther e i s no

guarantee that it will be the actualreturn.


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Required rate of return

The rate of return needed to induceinvestors or companies to invest insomething.

For example, if you invest in a stockyour required return might be 10% peryear. Your reasoning is that if you don'treceive 10% return, then you'd be

better off paying down your outstandingloan that you are paying 10% intereston.
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Risk free rate of return

The theoretical rate of return of ani n v e s t m e n t w i t h z e r o r i s k .

The risk-free rate represents theinterest an investor would expectfrom an absolutely risk-free

investment over a specified period oftime.


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Excess Return

Returns in excess of the risk-freerate or in excess of a marketmeasure (such as an index fund).

In other words, when you have

excess returns you are makingmore money than if you put yourmoney into an risk free asset.
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Abnormal Return

When the return on an asset or securityis in excess of the expected rate ofreturn.

Earning 30% in a mutual fund that issupposed to average 10% would be anabnormal return.

Like winning the lottery

This is something we want to happen.
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CAUTION

The general rule is:

the more risk you take the greaterthe potential for higher return...and loss.


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Example

If you make two investments as following

Investment A B

Purchased 5000 6000

Sold 7000 7500

Income 100 300

Period of holding 6 years 1 year


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Example

You made an investment for 3months for Rs. 5000 and got back Rs.5250. What is the return on your

investment ?


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Example

You purchased an asset for Rs. 3000and sold it for 2800. You earneddividend from it of Rs. 350. What is

the capital gain on your investment?


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RISK


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RISK

The discrepancybetween actual andexpectedreturnis risk

In most cases, risk means thepossibility youll lose some or evena l l o f the money you inves t .


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Measuring Risk

Risk is Measured as

2n

1i

Return)Expected-Return(Possibley)Probabilit(

)(Variance

2

iii

1

)]E(R)[RP(

n

i


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Example of Expected Return andStandard Deviation

Stock BW

Ri Pi (Ri)(Pi)

-.15 .10 -.015

-.03 .20 -.006

.09 .40 .036

.21 .20 .042.33 .10 .033

Theexpected

return, R,

for Stock

BW is .09or 9%

Sum 1.00 .090

E l f E d R d


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Example of Expected Return andStandard Deviation

Stock BW

Ri Pi (Ri)(Pi) (Ri - R )2(Pi)

-.15 .10 -.015 .00576-.03 .20 -.006 .00288

.09 .40 .036 .00000

.21 .20 .042 .00288

.33 .10 .033 .00576

Sum 1.00 .090 .01728

= .01728


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An index of systematic risk.

It measures the sensitivityof a stocksreturns to changes in returns on the

market portfolio.

= COV (RjRp)

j

2

The betafor a portfolio is simply a weightedaverage of the individual stock betas in theportfolio

Beta?


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Taking Risk

If you want the financial security andsense of accomplishment that comeswith investing successfully, you have tob e w i l l i n g t o t a k e s o m e r i s k .

Taking risk doesntmeanyou have to takeflying leaps into untested waters it

means anticipating what the potentialproblems with a certain investment mightbe, and putting a strategy in place tom a n a g e , o r o f f s e t t h e m .


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Risks you can control

Better known as Non SystematicRisks

Risks specificto aparticular securityor assetas against the market as awhole Risks may be specific to a particular asset ,

say stocksin comparison to bonds

Individualshares would have risks specific

to them


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Non- Systematic risks in Stocks

Business Risk Uncertainty of income flows caused by

the nature of a firms business

Risk from Sale to PBIT

Financial Risk Uncertainty caused by the mode of

financing used by the firm for itsinvestments.

Risk from PBIT to PAT


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How to Control ?

By not putting allthe eggs in onebasket

By allocatingand diversifyingyourportfolio


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DIVERSIFICATION

A risk management technique thatmixes a wide variety of investments

within a portfolio. It is designed tominimize the impact of any onesecurity on overall portfolio perform


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ASSET ALLOCATION

The process of dividing a portfolioamong major asset categories such asbonds, stocks or cash.

The purpose of asset allocation is toreduce risk by diversifying the portfolio.

If one of your investments goes down

significantly in value, those losses maybe offset to some degree by gains, oreven stable values, in some of yourother investments.
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Risks you cant control

Better known as Systematic Risks

Risks inherent to theentire market

Cannot be avoided through diversification

Also known as"un-diversifiable risk" or"market risk.

You must learn to accept risk as a normal

part of investing Knowing how to tolerate risk and

avoid panic selling is part of a smartinvestment plan.


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Systematic Risk

Market risk - This is thepossibility that the financialmarkets will drop in valueand create a ripple effect inyour portfolio.

For example, if the stockmarket as a whole losesvalue, chances are yourstocks or stock funds will

decrease in value as welluntil the market returns to aperiod of growth

But the greater threat is the loss of principal that

can result from selling when prices are low.


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Systematic Risk

Interest raterisk - This is thepossibility that interest rates willgo up.

If that happens, inflation increases,

and the value of existing bondsand other fixed-incomeinvestments declines, since theyreworth less to investors than newlyissued bonds paying a higher rate.

Rising interest rates also usually mean lower stockprices, since investors put more money into interest-paying investments because they can get a strongreturn with less risk.


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Systematic Risk

Inflation risk Affectsinterest rates

Reduces Real return


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Systematic Risk

Currency risk - Uncertainty ofreturn is introduced by acquiringsecurities denominated in acurrency different from your own.

Currency fluctuations affect the

value of your overseasinvestments Changes in exchange rates affect

the investors return whenconverting an investment backinto thehomecurrency

May also affect the value of domestic investments incompanies where changes in foreign currencyexchange rate causes business or financial risk


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Systematic Risk

Political risk -With the increasinginteraction of the worlds markets,political climates around the worldcan affect the value of yourdomestic and internationalinvestments.

Country risk is the uncertainty of returns caused bythe possibility of a major change in the political oreconomic environment in a country.

Individuals who invest in countries that have unstablepolitical-economic systems must include a country risk-premium when determining their required rate of return


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Systematic Risk

Recessionrisk.A recession, or period ofeconomic slowdown, means manyinvestments could lose value and makeinvesting seem riskier.


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Systematic Risk

Liquidity Risk - Uncertainty isintroduced by the secondary market for

an investment. How long will it take to convert an

investment into cash?

How certain is the price that will be

received?


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Total Risk

Total

Risk

Unsystematic risk

Systematic risk

STD

DEV

OFPORTFOLIO

RETURN

NUMBER OF SECURITIES IN THE PORTFOLIO

Systematic Risk +Unsystematic Risk


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Volatility

Over the course of a day, amonth, or a year, the priceof your investments mayfluctuate, sometimesdramatically. This constantmovement, known as

volatility It varies from investment

to investment, with someinvestments beingsignificantly more volatile

than others.For example, stock and stock mutual funds tendto change price more quickly than most fixed-income investments, such as bonds.


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Volatility

Volatility poses the biggestinvestment risk in theshort term.

But if you can wait outdownturns in the market,

chances are that the valueof a diversified portfoliowill rebound, and youllend up with a gain.

If you look at the big picture, youll discover that

what seems to be a huge drop in price over theshort term evens out over the long term. In fact,over periods of 15 or 20 years or more, stocks usually the most volatile investments over theshort term have always increased in value.


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Balancing risk and return

Rule 1: Understanding therelationship between risk andreturn

Risk and return are directlyrelated

The greater the risk that aninvestment may lose money, thegreater its potential for providing a

substantial return.

By the same token, the smaller therisk an investment poses, the smaller

the potential return it will provide.


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Rule 1: An ExampleA startup business could becomebankrupt, or it could become amultimillion-dollar company. If youinvest in the stock of this company,you could lose everything or make afortune.

In contrast, a blue chip company isless likely to go bankrupt, but youre

also less likely to get rich by buyingstock in company with millions ofshareholders.


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Rule 2: You can get a better-than-average return on aninvestment with less risk,

You may be willing to

sacrifice potentially greaterreturn to avoid greater risk.

Thats sometimes the case wheninterest rates go up. Investors pulltheir money out of stocks, which aremore risky, and put it in bonds, whichare less risky, because theyre notgiving up much in the way ofpotential return and theyre gainingmore safety


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Diversification ispossibly the greatestway to reduce the risk.This is why mutual funds

are so popular

Rule 3: Diversifyyourportfolio in a way thatsome of yourinvestments have thepotential to providestrong returns whileothers ensure that partof your principal issecure
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Key Concepts

Return

Total return

Percentage return

Annual return Real return

Nominal return

After tax return

Required rare ofreturn

Risk free rate ofreturn

Excess return

Abnormal return

Expected return

Actual return

Yield

Current yield

Bond Coupon

Risk Systematic risk

Unsystematic

5. Return vs. Risk

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