Parth Verma The Valuation School

CHAPTER 11

FUNDAMENTALS OF RISK AND RETURNS

Learning objectives

• Return on investment
• Simple, Annualised and compounded return
• Investment & Market Risk
• Sensitivity analysis
• Margin of safety
• Equity & Bind returns
• Calculation of risk adjusted return
• Behavioural biases that influence investment returns

11.1 CONCEPT OF INVESTMENT & RETURN ON INVESTMENT

• Investment means buying an asset or item that will generate some money or
appreciate in future.

• Expectation from investments

-To earn returns (profits)

-To get back the principal amount in the worst case

• Evaluation of Investments can be done based on:

1. Level of return.
2. Volatility in Return
3. Nature of return : Periodic or capital appreciation
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• Returns must be calculated on capital invested & not in money/profit terms.

• Return on Capital / Investment % (ROI) = Net Profit / Investment * 100.

• A higher ROI is better for investors.

11.2 CALCULATION OF SIMPLE, ANNUALISED AND COMPOUNDED RETURN

S

• Calculation of return helps in:

1. Deciding the correct investment product for high returns.

2. Comparison of different investments.
3. Evolution of performance of investment relative to benchmark.

• Investment returns can be in the form of :

1. Periodic payouts like interest, dividend & rent.

2. Appreciation in the value of investment.

• ROI is the return earned over a particular period.

• Example : Investor purchased 150 shares of XYZ ltd at Rs.25 & commission to broker =
Rs.20.

Now,

Shares sold at Rs.30 &

Commission to broker = Rs. 20

Also,

Investor received dividend = Rs 1/ share.

Total Cost Total Sales

( No of share * Price ) + Brokerage ( No of share * Price ) - Brokerage

= (150 * 25) +20 = (150 * 25) - 20
=Rs. 3770 =Rs. 4480
Simple Returns

= Total Returns (Current Value) - Total Cost (Original Value) / Total cost (Original Value)

So for total returns = Dividend + Total Sales

= (150*1) +4480
= Rs 4630

Simple Return
=(4630 - 3770)/3770
= 0.23

Simple return (%) = 0.23% * 100 = 23%

• Simple return is also called Single Period Return or Absolute Return.. And this does not
consider the period over which the return was earned.

• But Annualised Returns are calculated over a uniform period i.e., one year.

• Annualised Return = (Absolute Return / No of months or days of investment) * 12

months / 365 days.

• For the previous example, suppose investment duration = 15 months

then,

Annualised Return = ( 23% / 15 )* 12 = 18.4%

• but annualised return does not consider the time value of money (the value of money
at present > value of money in future)

• The above problem is resolved using CAGR.

• CAGR assumes that investment returns can be reinvested to earn more returns.

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• So, for the previous example if the investment
time is 5 years i.e., n = 5

then,

Note:

• In this example, we have ignored the time factor of the dividend which would increase
the CAGR by some points if we consider it.

• CAGR is the smoothest rate of return. CAGR is the accepted standard measure of ROI
except for returns of less than 1 year period.

CAGR FOR MULTIPLE CASH FLOWS :

Let's take an example to understand this

1. Investor buys hares on 31 July 2011 for Rs.150.

2. Receives dividend of Rs. 5 on 31/10/2011.
3. Receives dividend of Rs. 6 on 31/10/2012.
4. Receives dividend of Rs. 4 on 31/10/2013.
5. Sold the share at Rs.165 on 15/01/2014.

- This cannot be solved using direct CAGR formula.

- or multiple cash flows we use XIRR function in Excel.
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 Parth Verma The Valuation School

11.3 RISK IN INVESTMENT

• You all have heard of "Investments are subject to market risk."

• The more high return expectations attract more risk also.

• Example :

Banks Fixed Deposit(FD) = Low risk, Low Reward/ Return

Equity = High Risk, High Reward/ return

• The nature and extent of risk also depend on type of investor.

Example: A retired investor may invest in low-risk products regardless of returns to fulfil
his expenses and avoid loss of capital from high-risk investments.

• Some common risks in investment are:

1. Inflation risk:

• Increase in the prices of goods and services over a period of time is called inflation.

• It is also called as purchasing power risk as it arises from a decline in the value of cash
due to the falling purchasing power of money.
• Inflation risk declines the purchasing power of money.

• Inflation risk is highest in fixed return instruments like bonds, FDs and debentures.
And it is fairly less risky for equity shares.

• Example :

a) For bonds,
Bond coupon = 8%
Inflation = 7%
Rate of return = 1%

If inflation shoots up then,

Bond Coupon = 9%
Inflation = 10%
Rate of return = -1%

b) In case of equity shares, if inflation shoots up then, businesses will increase the selling
price of their products which results in good profits in nominal terms & reflects as higher
stock prices.

Example:

Hyperinflation in Venezuela from 2016 onwards resulted in

-Bonds investment becomes worthless but on the other hand,

-Caracas Stock Exchange increased over 1000 in the same duration.

2.Interest rate risk:

• Interest rate is inversely proportional to Bond Price.

• When interest rate increases then, Bond prices fall.
And when,
Interest rates fall then,
Bond prices rise.

• Interest rates & Bond prices have an inverse relationship.

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• Example :

-Investors invest in a 5-year bond at Rs.100 on an 8% annual interest rate

-After 1 year RBI cut policy interest rates,
and now a 5-year bond is issued at a 7.5% rate.

-So for maximum returns, investors buy the old bonds at 8% and avoid new bonds at 7.5%
-This will increase the market price of old bonds.
-The price will rise up to a level at which the IRR of cash flows from old bonds is about
7.5%

• And the opposite will happen if RBI increases the policy rates.

• Bond investments are volatile due to interest rate fluctuations. This risk also extends to
debt funds.

• Interest rate risk on equity :

When the Interest rate increases then,

equity prices fall.
Because of lesser borrowing which results in lesser flow of funds, and vice versa.

3. Business Risk

• This is caused by the factors that affect the operations of the company.

• That's why it is also called Operating Risk.

• Example: Fluctuations in cost of raw materials, employee costs, competitive peers and
their products, marketing and distribution costs etc.

• Diversification is an efficient way to handle this risk.

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 Parth Verma I The Valuation School
4. Market Risk :

• Loss of value in an investment because of unfavourable price movements in the markets

is called as market risk.
• Example :

a) Interest Rate Risk

Interest rate rise

Bond Price fall (As it reduces cash flows from existing bonds)

b) Currency Risk

Appreciation in currency reduces the earnings of export-oriented companies.

• Market risk affects these investments where transactions happen at current

applicable prices like equity, bonds, gold, real estate and others.

• Investments such as deposits and small saving schemes are not marketable securities,
thus they have no market risk but they also do not gain in value.

5. Credit Risk :

• When a borrower fails to repay the loan which results in financial loss to the lender is
called a credit risk.

• It is also known as default risk.

• Debt instruments are subject to default risk. However sovereign governments do not
have default risk with local currency borrowing as the government can raise funds by
taxation or by printing more currency.

• SEBI has standardised the symbols used by credit rating agencies.

• AAA,A1 symbols indicate the highest creditworthiness while "D" represents default
status.

• Lower credit rating, Higher credit risk and higher interest rate
Higher credit rating, lower credit risk and lower interest rate.

• A diversified portfolio of bonds reduces default risk.

 Parth Verma The Valuation School

6.Liquidity risk:

• It refers to the absence of a buyer or seller in an investment.

• An investor may not be able to buy or sell his investment at desired prices.

• Example:

-Corporate bonds in India are not liquid(especially for retailers). Even if there is a buyer, the
price may be lower due to a lack of liquidity.

-Investment in real estate is also subject to liquidity risk.

• Some investments have a lack in a period during which investors cannot exit the
investment.

• For example : SVG (Sovereign Gold Bond) as of 17 July 2020 has a difference of around
2% between best bid & best ask price. The quality of trade is also very low.

7. Call Risk:

• It is specific to bond issues and refers to the possibility that a bond issuer/ debt security
will be called prior to its maturity.

• This generally occurs when interest rates are falling and to save money companies redeem
higher coupon bonds issues and replace them with lower coupon bonds.
 Parth Verma The Valuation School

8. Reinvestment Risk

• It occurs when income from an investment may not be able to earn the same interest as an
original interest rate.

• Reinvestment rates can be high or low depending on the levels of interest rates-
If the interest rate is high, then reinvestment risk is low and vice versa.

9. Political Risk

• As the government has the power to change laws which affect business directly or indirectly,
there is always a political risk for business if there is an unfavourable action taken by the
government.

• Change of government is also a political risk.

10. Country Risk

• When a country fails to deliver its financial commitments or defaults on its obligation, this
affects the overall economy and market of that country.

• No investor wants to invest in a bust/failed/poor economy.

As we have discussed different types of Investment risk, can be categorised:

a) Systematic risk:

• Risks whose impact is felt across investment categories and it cannot be diversified.

• Therefore, it is also called non diversifiable risks.

• It is caused by changes in government policies, external factors, wars or natural calamities

which affect the whole economy or market.

• Example: Inflation risk, exchange rate risk, interest rate risk and reinvestment risk.

b)Unsystematic Risk:

• It is specific to individual securities or small classes of investments and, hence can be

diversified.
• That's why it is also called diversifiable risk.

• Example: Credit risk, Business risk and liquidity risk.

• All the investments have a component of both systematic and unsystematic risk.

Example:

1. Ashima invests in bond issues.

It has 2 risks: credit risk (unsystematic risk) and interest rate risk(systematic risk)

2. Ajay invests in infra shares.

It has 2 risks: Business risk (unsystematic risk) and market risk(systematic risk)

11.4 MEASURING RISK

• Before measuring the risk, it is necessary to understand these 3 ways in which

risks are defined:

1. Measure of uncertainty:

• It's the very common way to define risk that of uncertainty and unpredictability.

• It is calculated as the standard deviation of the returns of the assets:

Average rate of return of asset

No of observation

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2. Measure of sensitivity

• It measures risk based on the sensitivity of asset prices to various risk factors.

• Some of the risk measures for certain assets are:

a) Beta:

Measures the sensitivity of stock performance to overall market performance. It is used

mostly for equities.

b)Duration:

Measures sensitivities of bond price to small changes in interest rate.

c) Delta

Measures sensitivity of an option price for a small change in underlying asset price.

3.Measure of loss

• It is defined as the amount of loss one may experience.

• Value at risk (VAR) is a commonly used probability-based risk metric.

• It measures the maximum loss one may suffer on a particular level of confidence.

• For example: If the VAR(%) of a portfolio is 12%, it indicates that there is 1% probability
that loss would exceed 12%

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11.5 CONCEPT OF MARKET RISK (BETA)

• Beta is a measure of systematic risk, it measures the volatility of the investment

relative to the market (index).

• Beta = 1. Security prices move with the market.

Beta < 1, security price will be less volatile than the market
Beta > 1, security price will be more volatile than the market

• Example: If a stock beta is 1.2, then it is theoretically 20% more volatile than the
market both on up and down moves.

• CAPM uses beta and expected market returns to calculate the expected return of an
asset.

• However, many value investors don't pay attention to Beta.

• Value investor Seth Klarman criticises the idea of using a single number (i.e., beta) to
describe the risk in a security. He emphasizes that past price volatility is an unreliable
indicator of future investment performance.

You can read the whole paragraph here:

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11.6 SENSITIVITY ANALYSIS TO ASSUMPTIONS

• Security analysis involves using different kinds of financial models for valuation.

• This also includes some assumptions for future aspects of business.

• So for a proper and accurate output, the input must be based on calculations and if
required, then with proper assumptions after researching, collecting and evaluating
information.

• Example: In the DCF model, discounting rate is a primary input

• Sensitivity analysis looks at multiple scenarios for discounting rate and the impact on
final value.

• In general, best worst and most likely scenarios are taken into consideration.

11.7 CONCEPT OF MARGIN OF SAFETY

• The margin of safety term is popularised by Mr. Benjamin Graham and his followers
notably Mr. Warren Buffet.

• It refers to the difference between value and prices, securities are bought at a price
below their intrinsic value.

• The higher the difference between price and value, the higher the margin of safety.

• It provides room for error or safety with minimal downside risk but doesn't guarantee a
successful investment.

• Also determining intrinsic value ("true" worth) is highly subjective. There is no standard
for how wise the margin should be in margin of safety.

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 Parth Verma The Valuation School

11.8 COMPARISON OF EQUITY AND BOND RETURNS

Bonds:

• The bond return comes from coupon income and some gains in value as a result of the
interest rate decline.
• Less risky than equity means low returns.
• The primary risk in bond investment is the default risk. The higher the credit risk,
greater the interest that the investor will receive.

Equity:

• Equity returns come from appreciation in the value of the investment. Dividend is also a
component.
• More risky than bonds means high returns.
• Share value is always influenced by the performance of the company and external
economic factors that impact the business.
• Warren Buffet stated,

If rate of return on stocks > Rate of return on bonds: Buy Stocks

If rate of return on bonds > Rate of return on stocks: Buy Bonds

11.9 CALCULATING RISK ADJUSTED RETURN

• It may not be appropriate to compare one high-risk strategy/ portfolio with another
strategy with absolute returns.

• Therefore, it is appropriate to use risk-adjusted return measures which are as follows:

1. Jensens Alpha

• Alpha refers to the excess return earned on an investment compared to its benchmark.
It doesn't measure level of risk.

• Whereas, Jensens' alpha refers to the excess return earned by a portfolio over and
above the cost of equity that is calculated using CAPM and it also factors risk.
 • It is calculated as:

Jensens Alpha = return on portfolio - (Rf + Beta *Market Risk premium)

• Higher the Jensens Aplha, the between it is.

2. Sharpe Ratio

• It measures the risk premium earned per unit of standard deviation. It is most widely
used for measuring risk-adjusted returns.

• It is calculated as :

Sharpe Ratio = (Return on portfolio - Risk-free rate)/ standard deviation

• The higher the shape ratio, the better it is.

3. Treynor Ratio

• It measures the risk premium earned per unit of Beta.

• The higher the ratio, the better it is.

• It is calculated as :

Treynor Ratio = (Return on portfolio - Risk free rate)/ Beta

11.10 BASIC BEHAVIOURAL BIASES INFLUENCING INVESTMENTS

• According to conventional finance theory, human beings strive to maximise their wealth
but their emotions and psychology influence their decisions.

• Graham sir also stated in his book "The Intelligent Investor", that markets are more
psychological and less logical.

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• Behavioural Finance = Behavioural & Psychological Theory + Conventional Economics and
Finance.

• Simon Savage, a hedge fund manager stated that behavioural bases are inherent and by
acknowledging these biases one can build a defence mechanism to avoid these
vulnerabilities.

• Main behavioural biases

1. Loss Aversion Bias:

• Pain of loss is twice as strong as the pleasure of gain

• It refers to the tendency to avoid losses and then the fear of loss leads to inaction
• Avoiding riskier asset classes like equity, and holding a losing position in the hope of
recovery are types of this bias.

2. Confirmation Bias

• It is also called as my side bias, it is the tendency to prove one's own decision right every
time.
• For example: When a trader buys a stock for a reason and that reason doesn't work then
he tries to make up more reasons for owning the position

3. Ownership Bias

• It reflects the tendency to place higher value on position as things owned by us appear
most valuable to us.
• It is also known as the endowment effect.

4. Gamblers fallacy

• Investing by predictions based on the past without research and tend to believe that if
something happens more frequently than normal will happen less frequently in future and
vice versa.(presumably as a means of balancing nature)

5. Winners curse

• Tendency to win every time even after overpaying for the asset

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 Parth Verma The Valuation School

6. Herd Mentality

• It is an outcome of uncertainty and a belief that others have better information which
results in following others' investment decisions.
• Most of the individuals don't go against the crowd. Economist John Maynard Keynes said,
It is better for the reputation to fail conventionally than to succeed unconventionally" in
this context.

7. Anchoring

• It is the human tendency to rely heavily on the 1st piece of information.

• New information is ignored and investor hold on to that 1st information only that may no
longer be relevant.

8. Projection Bias

• It occurs when we incorrectly assume that our current needs will be same as our future
needs.
• As a result, we make decisions based on how we feel right now instead of how we might feel
in future.

11.11 SOME PEARLS OF WISDOM FROM INVESTMENT GURUS

• Stock Market contains bull & bear cycles.

-Bulls = When buyers are strong

-Bears = When sellers are strong

• Bull market happens when businesses are expanding & growing, demand for their products &
services grow which results in more profits.

• But unrealistic expansion in prices tends to correct itself also. This leads a way to bear market
when stock prices fall and correct.

• Bear market leads to stress for several businesses as they face lower demand for their
products & services which results in less or no profit or even losses.
• And when prices fell below intrinsic values creating attractive valuations, buyers again
start coming into that stock.

• This way Bull & Bear cycle maintains the discipline of the market.

Here are some other pearls of wisdom from some of these great masters:

1. Benjamin Graham:
"To achieve satisfactory investment results is easier than most people realize; to achieve
superior results is harder than it looks."

2. Charlie Munger:
"Understanding how to be a good investor makes you a better business manager and vice
versa."

3. David Dreman:
"Psychology is probably the most important factor in the market – and one that is least
understood."

4. John Tempelton:
"Invest at the point of maximum pessimism."

5. Peter Lynch:
"Go for a business that any idiot can run – because sooner or later, any idiot is probably
going to run it."

6.Walter Schloss:
"If you can't find good value investing positions, park your money in cash."

7.Warren Buffett:
"Rule No.1 is never lose money. Rule No.2 is never forget rule number one."

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 11.12 MEASURING LIQUIDITY OF EQUITY SHARES

• One main objective of stock exchanges is to provide liquidity i.e. ease of buying and
selling

• It can be achieved when there are large number of buyers and sellers for a
particular stock.

• Liquidity can be measured by:

1. Stock Turnover Ratio:

• Calculated by dividing the number of shares traded during a given period by the
number of outstanding free float shares (number of shares held by non-
promoters).

• Mostly, the time frame is of 1 Year for this.

2. Traded value turnover ratio:

• Calculated by dividing the traded value of the shares by the market capitalisation
of the company.

Parth Verma The Valuation School