Risk and Return

In present world, there are good numbers of financial products available for a person to invest his hard earned money and therefore achieve his financial goals. But before investing it is very important to understand one’s needs and risk appetite. It is always the aim of an individual to increase the returns and at the same time minimize risk. Thus when making an investment decision, it is advisable to consider the risk associated with it. For earning return on investment, the investor has to bear some risk that might be high or low, depending upon the nature of investment.

Concept of Return:

Return is the primary motivating force an individual to part with his hard earned money. It represents the reward for undertaking investment. Since, return is the prime objective of the investment, it is necessary to assess and how the investment has fared during the investment period.

The Two components of Return:

• Current return: The first component that often comes to mind when one is thinking about the return is the periodic cash flow (income), such as dividend or interest, generated by the investment.
• Capital return: The second component of return is reflected in the price change called capital return.

               Total Returns=Current Return +Capital Return

 

Measuring Return:

1. Holding period return: The period during which one has made an investment is known as holding period and return for that period is known as Holding period return.

HPR=(P1-Po+I)/Po  where, P1=End value, Po=Start value, I=Interest/Dividend/Rent

 

2. Compound Annual Growth Rate: This indicates the returns in terms of annual basis as compared to HPR. This evaluates the return in annual term so that comparison of alternate investment is possible. This is year-on-year growth rate of an investment over a specified period of time.

CAGR = ((End Value/Start Value) ^ (1/ (Periods-1))-1

                                                                                                                                               

3. Arithmetic Mean: This is nothing but sum of annual returns divided by number of years. This method shows how much an average growth on an investment has taken place.

Arithmetic Mean = ∑HPR/N

                                                                                                                              

4. Geometric Mean: This indicates nothing but the compound rate of growth as compared to Arithmetic Mean.

Geometric Mean = [(1+R1) (1+R2) (1+R3)....... (1+Rn)]^ (1/n) −1

               

5. Real Rate of Return: This indicates the real rate of return generated on investment after taking into consideration inflation. Inflation is a serious factor to be taken into consideration while measuring your return over a period of time.

Real rate of return= (1+Nominal rate)/(1+Inflation rate) - 1

                                                            

   Concept of Risk:

Risk refers to the possibility that the actual outcome of investment will be different from its expected outcome. The wider the range of possible outcomes, the greater the risk. Risk  has the direct relationship with return. The concept of risk is more relevant as far as investment in Equity, Derivative or Reality is concerned, because there are always chances of (a) low, flat or no return, (b) complete or partial loss of capital

So it is always advisable to for a financial planner to find out his client’s

1. Risk appetite
2. Time Horizon and
3. Client’s return requirement

Source of risk: There are different sources of risk which eventually contribute to volatility in the stock market affecting the performance of the portfolio.

1.  Business risk : Anything that can harm a company’s profitability and which could result into     uncertainty about no profit flows or low profit flows from business is called business risk. It could be due to poor business performance, development of substitute product, competition from business rivals etc.

2. Market risk: Even when the earning power of the corporate sector remains unchanged the price of the particular security fluctuates with the market, this is called Market Risk.

3. Credit risk:  When bond issuers fail to make their promised interest payments or don’t repay principal when it comes due, investors experience credit risk.

4. Interest rate risk:  Rising interest rates are bad news for fixed income investments because bond prices generally move in the opposite direction of interest rates. This risk arises from interest rate fluctuations and is termed as interest rate risk.

 

Classification of Risk:

Risk can be divided into two parts: Systematic risk and Unsystematic risk together they comprise the total risk.

1. Systematic Risk: This is the risk that will have a common influence on all the sectors irrespective of their performance and is known as systematic risk. The price of a share fluctuates widely or falls even when there is no change in its earnings and in spite of impressive growth. This risk is non- diversifiable
2. Unsystematic Risk: This is specific to a particular company or industry. Unsystematic risk inherent in a security can be reduced by spreading the portfolio over a large number of securities that are negatively co- related. Scarcities in raw material supply, labour strike, and management inefficiency are all problems specific to a company and are internal in nature. This risk is diversifiable.

 

     Measuring risk:

    Following are the parameters in measuring the risk on an Investment.

1. Standard Deviation: The usual method of measuring the risk of a security is by calculating its Standard Deviation or Variance. SD captures Unsystematic risk on the portfolio. The standard deviation measure  variability in expected return of the security, which can be taken as a measure of risk. Standard Deviation is nothing but a square root of Variance. The Standard deviation (SD) is probably used more than any other measure to quantify the risk of a security or that of a portfolio of securities. Once the SD of a portfolio is known, the investor has a very good idea of the risk of his earning a rate of return that differs from the expectation. Higher the standard deviation, higher is the risk on a portfolio or a security and vice versa.

 

2. Co-variance: In a portfolio, due to interactive relationships between securities, they move up or down together. If the rates of return on two securities move up together, than the co-variance between the securities will be positive (+). If the rate of return moves in the reverse direction the co-variance of the two securities will be negative (-). If the rates of return are independent, the co- variance will be ‘0’. Ideally speaking, securities with low or negative co-variance will reduce the risk and make the portfolio very attractive.

3. Co-efficient Co-relation: All the securities in the basket of a portfolio are co-related Portfolio theory states that individual investments cannot be viewed simply in their risk and return. The relationship between the return from one investment and the return from the other investments is just as important. Their relation lies between +1.0 and -1.0

Conclusion: Investment means sacrificing the current fund for future return considering time and risk. Risk is the variability of possible returns around the expected return of an investment. Generally, the higher the risk, higher the return on investment and vice versa. But there is no guarantee that you will actually get higher return by accepting more risk.