Chapter one: risk and return

The Concept of Risk Vs Return

Investment decisions are backed by various motives. Some people make investment to acquire
control and enjoy prestige associated with it, some to display their wealth and some just for the
sake of putting their excess money in some place or the other. But most of the people invest with
an aim to get certain benefits in future. These future benefits are the returns you get on the
investment. Return is the driving force behind investment. It represents rewards for making an
investment.

In the case of a fixed income security like a debenture, the returns you get are in the form of
periodic interest payments and repayment of principal at the end of the maturity period.

Similarly, in the case of an equity share, the returns are in the form of dividends and the price
appreciation of the share.

Meaning of Risk
 It is the possibility that actual future returns will deviate from expected returns
 It is the variability of returns
 It is a chance of unfavorable event to occur
From the perspective of financial analysis then, it is the possibility that the actual cash flow will
be different from forecasted cash flows (returns). Therefore if an investment’s returns are known
for certainty the security is called a risk free security. An example on this regard is Government
treasury securities. This is basically because virtually there is no chance that the government will
fail to redeem these securities at maturity or that the treasury will default on any interest payment
owed.

When it comes to investments, there are always some levels of uncertainty associated with future
holding period returns. Such uncertainty is commonly known as the risk of the investment. Then
the question will be what causes the uncertainty (or volatility) of an investment’s returns? The
answer depends on the nature of the investment, the performance of the economy, and other
factors. In other words, when you “dissect” the uncertainty of an investment’s return, you will
realize that it is made up of different components.

MEASURES OF RETURN AND RISK

The purpose of this chapter is to help you understand how to choose among alternative
investment assets. This selection process requires that you estimate and evaluate the expected
risk-return trade-offs for the alternative investments available. Therefore, you must understand
how to measure the rate of return and the risk involved in an investment accurately. To meet this
need, in this section we examine ways to quantify return and risk. The presentation will consider
how to measure both historical and expected rates of return and risk.

We consider historical measures of return and risk because this chapter and other publications
provide numerous examples of historical average rates of return and risk measures for various
assets, and understanding these presentations is important. In addition, these historical results are
often used by investors when attempting to estimate the expected rates of return and risk for an
asset class.

The first measure is the historical rate of return on an individual investment over the time period
the investment is held (that is, its holding period). Next, we consider how to measure the average
historical rate of return for an individual investment over a number of time periods. The third
subsection considers the average rate of return for a portfolio of investments. Given the measures
of historical rates of return, we will present the traditional measures of risk for a historical time
series of returns (that is, the variance and standard deviation). Following the presentation of
measures of historical rates of return and risk, we turn to estimating the expected rate of return
for an investment. Obviously, such an estimate contains a great deal of uncertainty, and we
present measures of this uncertainty or risk.