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RISK AND RETURN

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When the investor want to invest his money at a higher rate of return there is a higher factor of risk.

As we would be exposing our money to the markets (equity, debt, etc.) and their associated risks. Further, the higher the risk taken, the higher is the expected return. In the bank the money is exposed to no risk, so the return is just at about the inflation rate. In contrast the risk in equity markets is the highest, and the expected returns would also be the highest. Before exposing ourselves to the markets, we can apply common sense and our learning to reduce this risk to acceptable levels.

There are 5 economic factors that affect equity returns: 1. Unanticipated changes in default risk; 2. Unanticipated changes in the term structure of interest rates; 3. Unanticipated changes in the inflation rate; 4. Unanticipated changes in the long-run growth rate of profits for the economy; and 5. Residual market risk.

Which can be classified under the 4 types of investment risk, namely; Business risk, Inflation risk, Interest rate risk and Market risk.

Statistical techniques can be developed to measure each of the above risk factors.

When the investor want to invest his money at a higher rate of return there is a higher factor of risk. As we would be exposing our money to the markets (equity, debt, etc.) and their associated risks. Further, the higher the risk taken, the higher is the expected return. In the bank the money is exposed to no risk, so the return is just at about the inflation rate. In contrast the risk in equity markets is the highest, and the expected returns would also be the highest. Before exposing ourselves to the markets, we can apply common sense and our learning to reduce this risk to acceptable levels.

Which can be classified under the 4 types of investment risk, namely; Business risk, Inflation risk, Interest rate risk and Market risk.

Statistical techniques can be developed to measure each of the above risk factors.

The key insight offered by Dr. Markowitz’s work is that risk of any security, as measured by its standard deviation of return, is not what is important. Instead, it is the correlation or covariance of the security’s return within a diversified portfolio that will determine its risk.

Thus, while the expected return of a portfolio is the market weighted average expected return of the securities comprising the portfolio, the risk of the portfolio is not a linear function of the standard deviation of the risk of the individual security.

By combining securities in a portfolio with characteristics similar to the market, the efficiency of the market would be captured.

The risk of a security as measured by the standard deviation of return can be partitioned into 2 components, namely non-diversifiable and diversifiable.

Nondiversifiable risk are factors common to and affecting all securities. The impact of these factors on a portfolio cannot be avoided. This type of risk is also called market or systemic risk. Once an investor is in the market he cannot avoid it.

Diversifiable risk is the unsystemic risk, which is unique to an individual security. Like a long strike in a factory, which would affect its earnings and profitability. This risk can be avoided by diversifying the portfolio of securities. By holding a portfolio of 10-12 different stocks, an investor can diversify away all unsystemic risk. In this situation of a well-diversified portfolio the only risk is the non-diversifiable or market risk (which in any case cannot be avoided when an investor enters the market).

The Sharpe-Lintner-Mossin analysis states that market risk can be measured by the product of the standard deviation of the return on the market and the “beta” of the security. This beta is estimated using historical data, measures the sensitivity of the return on the security to changes in the market as measured by some market index such as the Nifty or Sensex.

Now, the standard deviation of the market is common to all securities, thus the beta of the security is a proxy for relative systemic risk. Given that the investor should be compensated for the market risk, the beta is a relative measure of market risk.

Expected return = Risk free rate + beta x (expected market return – risk free rate).

This is also called the capital asset pricing model or CAPM and states that the expected return from a security should equal the risk free rate of return plus a risk premium.

Prof. Stephen Ross went on to develop the arbitrage pricing theory or APT. This model allows for more than one factor to systemically affect the prices of all securities. Investors in this case would also want to be compensated for accepting each of these different systemic risks or factors effecting the market. Here:

Expected return = risk free return + beta1x (risk premium for factor1) + beta2 x (risk premium for factor2) + ...+ beta k x (risk premium for factor k)

In this case the investor’s expected return is a composite of the compensation for each of the risks. In both the models above the expected return is not determined by unsystemic risk but the systemic risk.

Now, to make it simple for you it would be a good idea to study the following:

Expected rate of return = [Annual Income + (Ending price - Beginning price)] / Beginning price

Where: Annual income = Dividend; Ending price = selling price

and Beginning price = cost or purchase price.

When we talk about diversification, it also implies not to put all our eggs in one basket. Which means that we would be fool hardy to deploy all our savings into the equity market. We must give due consideration to our life, and look at it from a larger perspective. Then we would sensibly hold assets from various asset classes in our portfolio, to reduce or minimize the various risks listed above.

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