Risk and Return on Investment PDF

2. Risk and Return on Investment Risk and Return tradeoff The term return refers to income from a security after a defined period either in the form of interest, dividend or market appreciation in security value. Risk is the possibility of loss in the future. Risk- Return Relationship I...

2. Risk and Return on Investment Risk and Return tradeoff The term return refers to income from a security after a defined period either in the form of interest, dividend or market appreciation in security value. Risk is the possibility of loss in the future. Risk- Return Relationship Investments with high risk tend to have high returns and vice versa. Another way to look at it is that for a given level of return, it is human nature to prefer less risk to more risk. Therefore, the higher the risk of an investment, the higher its returns have to be to attract investors. The appropriate risk-return combination will depend on financial objectives. Some people prefer a low risk, steady income stream while others don’t mind taking on more risk for the chance of making higher returns. Relationship between risk and return means to study the effect of both elements on each other. Relationship between Risk and Return I Direct Relationship between Risk and return a) High Risk – High Returns b) Low Risk – Low Returns 2. Negative Relationship between Risk and Return a) High Risk Low return – Lotteries b) Low Risk – high return – Government bonds Measuring returns – ROI Return on investment is a financial ratio used to calculate the benefit and investor will receive in relations to their investment cost. It is most commonly measured as net income divided by the original capital cost of the investment. The higher the ratio, the greater the benefit earned ROI = Net Income / investment amount KAVITHA M, ASSISTANT PROFESSOR, DEPARTMENT OF COMMERCE Page 1 Benefits of The ROI formula Simple and Easy to calculate Universally understood Limitations of the ROI formula It will not consider the factor of time. It is susceptible to manipulation. Absolute Return The yield created by an investment over a period of time is referred to as return. Absolute return is measuring of return in terms of amount or percentage without considering time of investment. Absolute return is a calculation of an investment’s success in terms of how money we have gained or lost from the transaction. Absolute returns = sp – Cp * 100 CP Advantages: 1. It is straight forward to calculate and understand for all users 2. It is unaffected by period and bench mark comparison. Disadvantages of Absolute return It is not easy to compare with other asset classes. It is a fault measure when comparing different time frames. It does not compare against any benchmark, which results in determining the relative performance. It is not comparable. Annualized Return That is the annual return on the investor’s investment. An annualised rate of return can also be calculated using a percentage value. If the return is positive it is considered as gain. Annual Return = Final value of investment – initial value of investment / initial value of investment * 100 KAVITHA M, ASSISTANT PROFESSOR, DEPARTMENT OF COMMERCE Page 2 Advantages: It is very easy to calculate and simple This considers earnings after tax and depreciation It helps to compare with other product project. This method gives a clear picture of the profitability of a project. This method is useful to measure current performance of the firm. Disadvantages It creates problem in decision making. It does not consider cash flows which are important. Extended Internal Rate of Return (XIRR) XIRR, is the rate which calculates the returns on the total investment made with increments, paid through out the period under consideration. XIRR comes to an investor’s aid when investments are made into mutual funds at randomly spaced intervals. Moreover, redemptions are also processed at irregular time intervals. The time periods will differ for each cash flow. Each particular investment will offer a different rate of return at a given date of measurement. Types of Risks in Investment 1. Systematic risk 2. Unsystematic risk Systematic risk Systemic risk is caused by the changes in government policy, the act of nature such as natural disaster, changes in the nation’s economy, international economic components etc. Can not be controlled and avoided. Types of Systematic Risk Market risk - It refers to risk arising out of change of market price of securities / shares that cause a significant fall in the event of a stock market. KAVITHA M, ASSISTANT PROFESSOR, DEPARTMENT OF COMMERCE Page 3  Economic Risk – The economy is constantly changing as the markets fluctuate. Some positive changes are good for the economy. While negative events can reduce sales. Competition risk – While a business may be aware that there is always some competition in their industry. Interest rate Risk – Fluctuation in the interest rate also one of risk facing by company. Currency Risk –It is the risk of losing money because of a movement in the exchange rate. Inflationary risk (Purchasing power risk)- Increase in the prices of goods also leads to inflationary risk. Political Risk – It is mainly due to political instability in any economy. It involves business decisions. Unsystematic risk Unsystematic risk is the risk that is unique to a specific company or industry, It is also called as non systematic risk, specific risk, Unsystematic risk can be avoided through diversification. Can be controlled Types of Unsystematic Risk Business Risk – The risk when a company performs below average is known as business Risk. Liquidity Risk - Liquidity Risk – The being unable to sell your investment at a price. Financial Risk/ Credit Risk - Financial Risk – The business risk may involve credit extended to customers. Operational Risk – People risk, Political risk, Operational Risk – That mistakes can happen internally, technical problems people or power cut. Many operational risks are also people related. An employee might make mistakes that cost time and money. Legal and Regulatory risk – This risk arises from Rules and regulations of business. Reputation Risk - Unhappy customer, product failure, negative press, can adversely impact of company’s brand. KAVITHA M, ASSISTANT PROFESSOR, DEPARTMENT OF COMMERCE Page 4 Difference between Systematic Risk and Unsystematic risk Systematic Risk Unsystematic Risk 1. It Impact on entire market or segment. 1. It Impact on specific industry. 2. It can not be controlled, reduced and avoided 2. It can be controlled, reduced and avoided by by business management. business management. Eg: Inflation Recession Ex: Managerial change, Labour change 3. Systematic Risk is caused by external factors 3. Unsystematic risk is caused by internal including geopolitical, economic and sociological. factors, micro economic factors. 4. Example – Purchasing power risk, interest 4. Example – Business specific risk and financial rate risk, and market risk. risk. 5. Systematic risk is known as non diversifiable 5. Unsystematic risk is also known as risk, not diversifiable risk diversifiable risk, not systematic risk. 6. Directly related with economic system 6. It is not directly related with economic system, rather it is more about business or company related. Risk Management in stock market Follow the trend of the market – A market trend may last a single day, a month or a year and again short-term trends operate within long term trends. Portfolio diversification – Another useful risk management strategy in the stock market is to diversify risk by investing in a portfolio. In a portfolio we can diversify our investment to several companies, sectors and assets classes. There is a probability that while the market value of a certain investment decreases that of the other may increase. Hedging – Hedging refers to the use of derivative instruments, such as Futures and options contracts, for risk management in equity. A future contracts helps to fix the price for a future buy/ sell transaction in the future. By this way we can cut down the risk of price fluctuations. KAVITHA M, ASSISTANT PROFESSOR, DEPARTMENT OF COMMERCE Page 5  Investing in dividend –paying stock companies that have a history of consistent dividend payments are usually strong, established companies. Adding our portfolio to that can reduces risk. Opting for Blue chips: Established companies, can be more stable, stock prices of those companies will also be stable. By investing in these companies risk can be reduced. Blue chip stocks are shares of very large and well – recognised companies with a long history of sound financial performance. Requiring a Margin of safety Buy low, sell high. Is a popular mantra in the financial industry. Invest for Long term – Long term investment gives better returns compare to short term investment. Measuring of Risks in Investment AlPha – Alpha is an estimated numeric value of a stock’s expected excess return that cannot be attributed to the market’s volatility. Example, if a stock has an alpha of 1.20, that means analysts expect 20% increase in the stock price, not affected by market fluctuations. Beta - Beta measures the volatility or systematic risk of a fund in comparison to the market or the selected benchmark index. A beta of one indicates the fund is expected to move in combination with the benchmark. Betas below one are considered less volatile than the benchmark, while those over one are considered more volatile than the benchmark. Standard deviation Standard deviation is commonly used to measure the historical volatility. It indicates how much of the current return is deviating from its expected historical normal returns. 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