Risk and Return

Two sides of the Investment

Coin

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Overview
Investment decisions are influenced by various motives.
Some invest in a business to acquire control and enjoy the
prestige.
Some invest in expensive yatchs and famous villas to display
their wealth.

Most investors however, are largely guided by the

pecuniary movite of earning a return on their investment.
For earning returns, investors have to almost invariably
bear some risk.
In general, risk and return go hand in hand.
While investors like returns, they abhor risk.
Investment decisions, therefore, involve a tradeoff
between risk and return.
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Return
Return is primary motivating force that drives
investment.
It represents the reward for undertaking
investment.
Sine the game of investing is about returns
(after allowing for risk), measurement of
realized (historical) returns (ex post
facto) is necessary to access how ell the
investment manager has done.
In addition, historical returns are often used as
a important input in estimating future
(prospective) returns.
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The components of Return

The return of an investment consists of
two components:
Current return
Capital return

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Current Return
Periodic cash flow (income) such as
dividend or interest, generated by
the investment in various
instruments.
Current return is measured as the
periodic income in relation to the
beginning price of the investment.

Current Income
Current Return/Yie ld
Beginning price
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Capital Return
Reflected in the price change
Capital gain/loss
It
is
simply
the
price
appreciation/depreciation divided by
the
beginning
price
of
the
asset/security.
Ending Price - Beginning Price
Capital Return/ Capital Gain/Loss Yield
Beginning Price
P P
1 0
P0
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Total Return
Total Return Current Return Capital Return
In case of Share,
Total Return Dividend Yield Capital gain/loss yield
In case of Bond,
Total Return Coupon Yield Capital gain/loss yield

The current return can be zero or

positve
The capital return can be negative,
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Risk
Risk refers to the possibility that the actual
outcome of an investment will differ from its
expected outcome.
More specifically, most investors are concerned
about the actual outcome being less than the
expected outcome.
The wider the range of possible outcomes, the
greater the risk.
Risk is the variability in possible returns.
In investment analysis, its measured by:
Variance / Standard Deviation
Beta
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Sources of Risk
Risk emanates from several sources.
The three major ones are:
Business Risk
Interest Rate Risk
Market Risk

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Business Risk
Risk of poor business peformance. (Operating Risk)
May be caused by variety of factors:

Heightened competition
Emergence of new technologies
Development of subtitute products,
Shifts in consumer preference
Inadequate supply of essential inputs
Changes in governmental policies, and so on.

Principle factor may be inept and incompetent

management.
It can affect the interest of shareholders and even
bond/debenture holders (default risk)
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Interest Rate Risk

The changes in interest rate have a
bearing on welfare of investors.
As interest rate goes up, the market
price of existing fixed income securities
falls and vice versa.
It also affects equity prices, albeit some
what indirectly.
The changes in the relative yields of
debentures and equity shares influence
equity prices.
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Market Risk
Changing psychology of the investors.
There are periods when investors become bullish and
their investment horizons lengthen.
Investors optimism, which may broder on euphoria,
during such periods drives share prices to great heights.
The buoyancy created in the wake of this development
is pervasive, affecting almost allshares.
On the other hand, when a wave of pessimism (which
often is an exaggerated response to some unfavourable
political or economic development) sweeps the market,
investors turn bearish and myopic.
Prices of almost all equity shares register decline as fear
and uncertainty prevade the market.
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The ebb and flow of mass emotion is quite regular: Panic is

followed by relief, and relief by optimism; then comes
enthusiasm, then euphoria and rapture, then the bubble brusts,
and public feeling slides off again to concern, desperation, and
finally a new panic

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You need to get deeply into your bones, the sense that any
market, and certainly the stock market, moves in cycles, so that
you will infallibly get wonderful bargains every few years, and
have a chance to sell again at ridiculously high prices a few
years later

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Types of Risk
Total Risk Unique Risk Market Risk

Diversifiable Risk Undiversifiable Risk

Unsystematic Risk Systematic Risk

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Unique Risk Diversifiable

Risk Unsystematic Risk
Portion of total risk which stems from firm specific
factors.
Examples of sources:

Development of new products

Labour strike
Emergence of new competitor. Etc...
Events of this nature primarily affect the specific
firm and not all firms in general.
Hence unique risks of a stock can be washed
away by combining it with other stocks
In a diversified portfolio, unique risks of different
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stocks tend to cancel

Market Risk
Undiversifiable Risk
Systematic Risk

Portion of total risk which is

attributable to economy-wide macro
factors like
Growth rate of GDP
Level of government spending,
Money supply,
Interest rate structure
Inflation rate etc..

These factors affect all firms to a

greater or lesser degree, investors
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Measuring Historical Return

Cash payment received during period Price change over period
Price of the investment at the beginning
C (PE PB )
R
PB

Total Return over the period

where,
R Total return over the period
C Cash payment received during the period
PE Ending Price
PB Beginning Price
Cash Payment Ending Price - Beginning Price

Beginning Price
Beginning Price


Current Return
(Dividend Yield)
(Coupon Yield)

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Capital Return
(Capital Gain/Loss Yield)

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Return Relative
When a Cumulative Wealth Index
or a Geometric Mean has to be
calculated, we need to calculate
Return Relative (coz, negative
return cannot be used)
C PE
Return Relative
PB
1 Total Return
Return Relative cannot be negative. At worst, it is zero.
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Cumulative Wealth Index

Total Return reflects changes in the
level of wealth.
Sometimes its useful to measure the
level of wealth (or price), rather than
the change.
To do this, we must measure the
cumulative effect of returns over
time, given some stated intitial
amount, which is typically rupee one.
The
cumulative
wealth
index,
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Cumulative Wealth Index

CWI n WI 0 (1 R 1 )(1 R 2 ).......(1 R n )
where,
CWI n Cumumative Wealth Index at the end of n years
WI 0 The beginning index value which is typically rupee one
R i Total return for the year i (i 1,2,3....n)
For eg., if CWI 5 1.498, it means that one rupee invested at the beginning of year 1
would be worth Rs 1.498 at the end of year 5
Total Return

CWI n
1
CWI n -1

where,
R n Total return for period n
CWI Cumulative wealth index
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Summary Statistics
While Total Return, Return Relative,
and Wealth Index are useful measures
of return for a given period of time, in
investment analysis, we also need
statistics that summarize a series of
total returns.
Two most popular summary statistics
are:
Airthmetic Mean
Geometric SBK
Mean
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Airthmetic Mean
n

R
t 1

where,
R Airthmetic Mean
R i i value of the total return (i 1,2...n)
th

n number of total returns

n number of observations (periods, years)
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Contd....
When you want to know the central
tendency of series of returns, the
airthmetic mean is the appropriate
measure.
It represents the typical performance
for a single period.
However, when you want to know the
average compound rate of growth
that has actually occured over
multiple periods, the airthmetic
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Example
Consider a stock whose price is 100 at the end of
year 0.
The price declines to 80 at the end of year 1 and
recovers to 100 at the end of year 2.
Assuming that there is no dividend payment during
the two year period, the annual returns and their
airthmetic mean are as follows:
Return for year 1 = (80-100)/100 = - 20%
Return for year 2 = (100 80)/ 80 = 25%
Airthmetic Mean Return = (-20%+25%)/2 =
2.5%
Thus we find that though the return over the two
year period is nil, the airthmetic mean works out to
be 2.5%.
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So this measure of average return can be

Geometric Mean
GM 1 R 1 1 R 2 ..........1 R n

where,
GM Geometric Mean Return
R i Total return for period i (i 1,2...n)
n Number of time periods

(1 Geometric Mean) 2 (1 Airthmetic Mean) 2 (Standard Deviation)2

The geometric mean reflects the compound rate of growth over time.
GM = 8.9 % means, an investment of Rs 1 produces a cumulative ending wealth
of 1x (1+ 0.089)5 = Rs 1.532
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Contd...
Geometric Mean is always lower than
Airthmetic mean, except in the case
where all the return values being
considered are equal.
The difference between GM and AM
depends upon the variability of the
distribution.
The greater the variability, the
greater the difference between the
two means.
(1 Geometric Mean) (1 Airthmetic Mean) (Standard Deviation)
The relationship between the three is
2

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Airthmetic Mean Vs.

Geometric Mean
In the world of investments, the
focus is mostly on knowing the
central tendency of a series of
returns.
Hence Airthmetic mean is commonly
employed.
Why should the Airthmetic mean be
preferred to Geometric mean ?
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AM vs GM (contd..)
Consider an example:
Suppose the equity share of Modern
Pharma has an expected return of
15% each year with a standard
deviation of 30%.
Assume that there are two equally
possible outcomes each year, +45%
and 15% (Mean plus or minus one
Std. Deviation).
The AM of these returns is 15%

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Contd..
An investment of one rupee in the
equity share of Modern Pharma would
grow over a two year period asProbabilities
follows:
0.25

1.45
1
0.85
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2.10

0.25

1.23
1.23

0.25

0.72

0.25
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Contd..
The median (middle outcome) and mode
(the most common outcome) are given by
GM = 11%, which over a two-year period
compounds to 23% (1.11 2 = 1.23).
The expected value of all possible outcomes,
however is equal to:
(0.25 X 2.10)+(0.50 X 1.23) + (0.25 X 0.72) =
1.32
Now, 1.32 = 1.152
This means that the expected value of the
terminal wealth is obtained by compounding
up the AM, notSBKGM.
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Contd...
Put differently, the AM is the appropriate mean
because an investment that has uncertain returns
will have a higher expected terminal value than an
investment that earns its compound of GM with
certainty every year.
In the above example, compounding at the rate of
11% for two years produces a terminal value of Rs
1.23, for an investment of Rs 1.
But, holding the uncertain investment which
yields:
High returns (45% per year for two years
in a row)
Middling returns (45% in year 1 followed
by -15% in year
2 or vice versa)32
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Real Returns
The returns so far discussed, without
elimination of inflation content is
called nominal returns, or money
returns.
Real Return after adjusting for the
inflation
factor.
(1
Nominal Return)
(1 Real Return)(1 Inflation Rate)
1 Nominal Return
Real Return
1
1 Inflation Rate
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Measuring Historical Risk

Risk refers to the possibility that the
actual outcome of an investment will
differ from the expected outcome.
Refers to variability or dispersion.
If an assets return has no variability,
its riskless.
Measure:
Variance and Standard Deviation
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Variance and Standard

Deviation
R
n

Variance, 2

i 1

i R

n 1

R
n

Standard Deviation, 2

i 1

n 1

where,
R i return of the stock in period i (i 1,2,3....n0
R Airthmetic Mean Return
n number of returns
Note : (n - 1) is used, not " n". This is done technically to correct
for the loss of one degree of freedom.
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Criticism of Variance and

Std. Deviation
It consideres all deviations, negative
as well as positive. Investors
however, do not view positive
deviations unfavourably in fact,
they welcome it. Hence, some
researchers have argued that only
negative
deviations
should
be
considered while measuring risk.
Hence some suggest the use of semivariance.
Semivariance
is
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Contd...
However, as long as returns are distributed
symmetrically, variance is simply = 2 x
Semi-variance and it doesnot make any
difference whether variance is used or
semi-variance.
When the probability distribution is not
symmetrical around its expected value,
variance alone does not suffice. In addition
to variance, the skewness of the
distribution should also be used.
Variance can be used by assuming that
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the historical returns of the stock are

Risk Aversion and Required

Returns
Take an example:
You are in a game show, where you are given the
option to open one among two boxes and take
away whatever you find in the box.
One box contains Rs 10,000
Another box is empty
(Of course the expected return with equal
probability of two outcomes is Rs 5,000)
You are not sure which box should you open.
Sensing your vacillation, host offers you a certain
Rs 3,000 if you forfeit the option to open the box.
You dont accept his offer. He raises his offer to Rs
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3,500

Contd...
Now you feel indifferent between a cerain
return of Rs 3,500 and a risky (uncertain)
expected return of Rs 5,000.
This means that a cerain amount of Rs
3,500 provides you with the same
satisfaction as a risky expected value of Rs
5,000
Thus your certainty equivalent (Rs 3,500)
is less than the risky expected value (Rs
5,000)
Emperical evidence suggests that most
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individuals, SBK if
placed in 39a similar

Contd..
The relationship of a persons
certainty
equivalent
to
the
expected monetary value of a
risky investment defines his attitute
toward risk.
If the certainty equivalent is less than
the expected value, the person is riskaverse
If the certainty equivalent is equal to
expected value, the person is riskSBK - KUSOM
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neutral.

Contd...
In general, investors are risk-averse.
This means that risky investments
must offer higher expected returns
than less risky investments to induce
people to invest in them.
However, we are talking about
expected returns; the actual return
on a risky investment may well turn
out to be less than the actual return
on a less risky investment.
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Risk Premiums
Investors assume risk so that they are
rewarded in the form of higher return.
Risk premium may be defined as the
additional return investors expect to
get, or investors earned in the past,
for assuming additional risk.
There are three well known risk
premiums:
Equity Risk Premium
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Bond Horizon
Premium

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Contd...
Equity Risk Premium:
This is the difference between the return on
equity stocks as a class and the risk free rate
represented commonly by the return on Treasury
Bills.
Bond Horizon Premium:
This is the difference between the return on
long-term government bonds and the return on
Treasury Bills.
Bond Default Premium:
This is the difference between the return on
long-term corporate
bonds (which
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43 have some

Measuring Expected (ex

ante) return and risk
When you invest in a stock, the return from it can
take various possbile values with various
probabilities.
Hence, you can think returns in terms of
probability distribution.
The probability of an event represents the
likelihood of its occurance.
When you define the probability distribution of
rate of return remember that:
The possible outcomes must be mutually exclusive and
collectively exhaustive.
The probability assigned to an outcome may vary
between 0 and 1.
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The sum of the probabilities assigned to various possible

Expected Rate of Return

The expected rate of return is the
weighted average of all possible
returns multiplied by their respective
n
probabilities.
E R i Ri
i 1

where,

E R expected return from the stock

Ri return from stock under state i

i probability that the state i occurs

n number
possible states of the45world
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Variance and Standard

Deviation of Return
The variance of a probability distribution is the
sum of the squares of the deviations of actual
returns from the expected return, weighted by
nprobabilities.
associated
2
2
i Ri E ( R )
i 1

where,

2 variance of returns
Ri Return for the ith possible outcome

i probability associated with the ith possible outcome

E ( R ) expected return
Standard Deviation,

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Continuous Probability
Distributions
In finance, probability distributions are commonly
regarded as continuous, even though they may
actually be discrete.
In a continuous probability distribution, probabilities
are not assigned to individual points as in the case
of discrete distribution.
Instead, probabilities are assigned to intervals
between two points on a continuous curve.
Hence, when a continuous probability distribution is
used, the following kinds are questions are
answered:
What is the probability that the rate of return will fall
between say, 10% and 20%?
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What is the probability that the rate of return will be less

The Normal Distribution

The normal distribution, a continuous probability
distribution, is the most commonly used
probability distribution in investment finance.
Normal distribution resembles a bell shaped
curve.
It appears that stock returns, at least over short
time intervals, are approximately normally
distributed.
The following features of the normal distribution
may be noted:
It is completely characterized by just two
parameters, viz. Expected return and standard
deviation of return.
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Band
Probability
One standard deviation 68.3%
Two standard deviation
95.4%
Three standard deviation 99.7%
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