CONCEPT OF RETURN AND RISK

There are different motives for investment. The most prominent among all is to earn a return on investment.
However, selecting investments on the basis of return in not enough. The fact is that most i nvestors i nvest
thei r funds i n more than one securi ty suggest that there are other factors, besi des return, and
they must be consi dered. The i nvestors not onl y l i ke return but al so di sl i ke risk. So, what is required
is:
i. Clear understanding of what risk and return are,
ii. What creates them, and
iii. How can they be measured?
Return: the return i s the basi c moti vati ng force and the pri nci pal reward i n the i nvestment process.
The return may be defined in terms of (i) realized return, i.e., the return which has been earned, and (ii) expected
return, i.e., the return which the investor anticipates to earn over some future investment period. The expected
return is a predicted or estimated return and may or may not occur. The realized returns in the past allow an
investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of
the investment. The return can be measured as the total gai n or l oss to the hol der over a gi ven
peri od of ti me and may be defi ned as a percentage return on the i ni ti al amount i nvested. Wi th
reference to i nvestment i nequity shares, return is consisting of the dividends and the capital gain or loss at
the time of sale of these shares.

Ri sk:

Ri sk i n i nvestment anal ysi s means that future returns from an i nvestment are unpredi ctabl e. The
concept of ri sk may be defi ned as the possi bi l i ty that the actual return may not be same as
expected. In other words, ri sk refers to the chance that the actual outcome (return) from an
i nvestment wi l l di ffer from an expected outcome. Wi th reference to a fi rm, ri sk may be defi ned
as the possi bi l i ty that the actual outcome of a fi nanci al deci si on may not be same as esti mated.
The ri sk may be consi dered as a chance of vari ati on i n return. Investments havi ng
greater chances of vari ati ons are consi dered more ri sky than those wi th l esser
chances of vari ati ons. Between equi ty shares and corporate bonds, the former i s ri ski er than
l atter. If the corporate bonds are hel d ti l l maturi ty, then the annual i nterest i nfl ows and maturi ty
repayment are fi xed. However, i n case of equi ty i nvestment, nei ther the di vi dend i nfl ow nor the
termi nal price is fixed. Risk should be differentiated with uncertainty: Risk is defined as a situation where
the possibility of happening or non-happening of an event can be quantified and measured: while uncertainty is
defi ned as a si tuati on where thi s possi bi l i ty cannot be measured. Thus, ri sk i s a si tuati on
when probabilities can be assigned to an event on the basis of facts and figures available regarding the decision.
Uncertainty, on the other hand, is a situation where either the facts and figures are not available, or the
probabilities cannot be assigned.
Types of Risk: Systematic Risk:
It refers to that portion of variability in return which is caused by the factors affecting all the firms. It refers to
fluctuation in return due to general factors in the market such as money supply, inflation, economic recessions,
interest rate policy of the government, political factors, credi t pol i cy, tax reforms, etc. these are the
factors whi ch affect al most al l fi rms. The effect of these factors i s to cause the pri ces of al l
securi ti es to move together. Thi s part of ri sk ari ses because every securi ty has a bui l t i n
tendency to move i n l i ne wi th fl uctuati ons i n the market. No investor can avoid or eliminate this risk,
whatever precautions or diversification may be resorted to. The systematic risk is also called the non-diversifiable
risk or general risk.
Types of Systematic Risk:
1.
Market Risk:
market pri ces of i nvestments, parti cul arl y equi ty shares may fl uctuate wi d e l y wi t hi n a s ho r t
s p a n o f t i me e v en t hou g h t h e ea r n i n g s o f t he c o mpa ny a r e no t changi ng. The reasons
for thi s change i n pri ces may be vari ed. Due to one factor or the other, investors attitude may change
towards equities resulting in the change in market price. Change in market price causes the return from
investment to very. This is known as market risk. The market risk refers to variability in return due to change in
market price of i nvestment. Market ri sk appears because of reacti on of i nvestors to di fferent
events. There are di fferent soci al , economi c, pol i ti cal and fi rm speci fi c events whi ch affect the
ma r k e t p r i c e o f e qu i t y s ha r e s . Ma r k et p s y c h ol o g y i s a no t h e r f a c t o r a f f ec t i ng
ma r k e t pri ces. In bul l phases, market pri ces of al l shares tend to i ncrease whi l e i n bear phases
the prices tend to decline. In such situations, the market prices are pushed beyond far out of line with the
fundamental value.
2.
Interest-rate Risk:
interest rates on risk free securities and general interest rate level are related to each other. If the risk free rate of
interest rises or falls, the rate of interest on the other bond securi ti es al so ri ses or fal l s. The i nterest rate
ri sk refers to the vari abi l i ty i n r e t u r n c a u s ed by t h e c ha ng e i n l e v el o f i n t er e s t r a t e s .
S u c h i n t er e s t r a t e r i s k u s u a l l y appears through the change i n market pri ce of fi xed i ncome
securi ti es, i .e., bonds and debentures. Securi ty (bond and debentures) pri ces
have an i nverse rel ati onshi p wi th the level of interest rates. When the interest rate rises, the prices of
existing securities fall and vice-versa.
3.
Purchasi ng power or Infl ati on Ri sk:
T h e i n f l a t i on r i s k r e f er s t o t h e un c e r t a i nt y o f purchasing power of cash flows to be received out
of investment. It shows the impact of i nfl ati on or defl ati on on the i nvestment. The i nfl ati on ri sk
i s rel ated to i nterest rate ri sk because as i nfl ati on i ncreases, the i nterest rates al so tend to
i ncrease. The reason bei ng that the investor wants an additional premium for inflation risk (resulting from
decrease i n purchasi ng power). Thus, there i s an i ncrease i n i nterest rate. Investment i nvol ves
a postponement in present consumption. If an investor makes an investment, he forgoes the opportuni ty to
buy some goods or servi ces duri ng the i nvestment peri od. I f, duri ng thi s period, the prices of goods
and services go up, the investor losses in terms of purchasing power. The inflation risk arises because of
uncertainty of purchasing power of the amount to be received from investment in future.
Unsystematic Risk:
T h e u n s y s t e ma t i c r i s k r e p r e s e n t s t h e f l u c t u a t i o n i n r e t u r n f r o m a n investment
due to factors which are specific to the particular firm and not the market as a whole. These factors are l argel y
i ndependent of the factors affecti ng market i n general . Si nce these factors are uni que to
a parti cul ar fi rm, these must be exami ned separatel y for each fi rm and for each i ndustry. These
factors may al so be cal l ed fi rm-speci fi c as these affect one fi rm wi thout affecting the other firms. For
example, a fluctuation in price of crude oil will affect the fortune of petrol eum compani es but not the
texti l e manufacturi ng compani es. As the unsystemati c ri sk results from random events that tend to be
unique to an industry or a firm, this risk is random in nature. Unsystematic risk is also called specific risk or
diversifiable risk.

Types of Unsystematic Risk:
1.Business Risk:
Business risk refers to the variability in incomes of the firms and expected dividend there from, resulting from the
operating condition in which the fi rms have to operate. For exampl e, i f the earni ng or di vi dends from
a company are expected to increase say, by 6%, however, the actual increase is 10% or 12 %.The variation in
actual earnings than the expected earnings refers to business risk. Some industries have higher business risk than
others. So, the securities of higher busi ness ri sk fi rms are more ri sky than the securi ti es of other fi rms
whi ch have lesser business risk.
2. Financial Risk:
It refers to the degree of l everage or degree of debt fi nanci ng used by a fi rm i n the capi tal
structure. Hi gher the degree of debt fi nanci ng, the greater i s the degree of fi nanci al ri sk. The
presence of i nterest payment bri ngs more variability in the earning available for equity shares. This is also
known as f i na nc i a l l e v e r a g e . A f i r m ha v i n g l e s s e r o r no r i s k f i n a n c i ng h a s l e s s e r o r no
financial risk.
Measurement of risk:
No i n v e s t o r c a n p r ed i c t wi t h c e r t a i n t y wh et h e r t h e i n c o me f r o m a n i n v e s t men t
i n c r e a s e o r d ec r ea s e o r by h o w muc h. S t a t i s t i c a l me a s u r e s c a n be u s ed t o
ma k e p r e c i s e mea s ur eme n t of r i s k a bou t t he e s t i ma t e d r e t u r n s , t o g a u g e t h e e x t e nt
t o whi c h t h e expected return and actual return are likely to differ. The expected return, standard deviation and
variance of outcomes can be computed as: