5. Return vs. Risk
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Balancing Risk and Return
RETURN
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RETURN
Returnis a measure of investmentgain or loss."
The gain or loss for a security in aparticular period, consisting of incomep l u s c a p i t a l g a i n s r e l a t i v e t o
investment.
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Total Return
Long-term investors are interested intotal return, which is the amount your
investment increases or decreases invalue, plus any income you receive
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Total Return
If you buy stock for Rs. 10,000 and sell it for Rs.12,500, and collected Rs. 150 in dividends your returnis Rs. 2,500 + Rs. 150 =Rs. 2650 gain.
Or, if you buy stock for Rs.10,000 and sell it forRs.9,500, and collected Rs. 150 in your return is aRs.500 loss plus Rs. 150. i.e. a return of Rs. 350 loss
You dont have to sell to figure return on theinvestments
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Total Return
You simply subtract what you paid from thecurrent value to get a sense of where
you stand.
To this you add income recd. during the period
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Return as a percentage
Return is usually quoted as apercentage
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Return as a percentage
Return is usuallyquoted as apercentage
WHY ?
To compare toinvestmentsmade atdifferent prices
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Return as a percentage
An Example
A Rs 2,650 total return on an investment ofRs. 10,000 is 0.265, or a 26.5% return.
In contrast, a Rs. 2,650 total return on aninvestment of Rs. 30,000 is an 8.84% return.
So while each investment has increased yourwealth by thesame amount, the performanceof the first is more than thrice as strong as theperformanceof the second
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Yield / Annual Return
Divide thepercentage returnby the number ofyears you ownedthe investment.
If you invested Rs.10,000 three years ago,and the total return to date is Rs.2,650,
your annualized percent return is 8.83(Rs.2,650 Rs.10,000 = 0.2649 3 = 0.0883).
Percentage return
No of years owned
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Real Return
INFLATION
INCOME TAX
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Real Return
You made a fixed deposit of Rs. 10,000at an interest rate of 10%.
Interest earned Rs. 1000.Tax paid (Say @ 20%) Rs. 200
After Tax return Rs. 800
After tax Rate of return 8%
Inflation 8%
Real return 0 %
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Expected Return
Ex Ante Return Before the Event - based on future
expectations
Expected Return
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Expected Return
For example
If you knew a given investment had a 50%chance of earning a 10% return, a 25% chanceof earning 20% and a 25% chance of earning -10%, the expected return would be equal to
7.5%:
= (0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1)
= 0.075= 7.5%
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Actual Return
Ex Post Return -after the facts
Actual Return What investorsactually receive from
their investment
Sales value Purchase value +
Income received
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THE CATCH
Although you expect to have acer t a in re tur n , ther e i s no
guarantee that it will be the actualreturn.
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Required rate of return
The rate of return needed to induceinvestors or companies to invest insomething.
For example, if you invest in a stockyour required return might be 10% peryear. Your reasoning is that if you don'treceive 10% return, then you'd be
better off paying down your outstandingloan that you are paying 10% intereston.
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Risk free rate of return
The theoretical rate of return of ani n v e s t m e n t w i t h z e r o r i s k .
The risk-free rate represents theinterest an investor would expectfrom an absolutely risk-free
investment over a specified period oftime.
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Excess Return
Returns in excess of the risk-freerate or in excess of a marketmeasure (such as an index fund).
In other words, when you have
excess returns you are makingmore money than if you put yourmoney into an risk free asset.
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Abnormal Return
When the return on an asset or securityis in excess of the expected rate ofreturn.
Earning 30% in a mutual fund that issupposed to average 10% would be anabnormal return.
Like winning the lottery
This is something we want to happen.
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CAUTION
The general rule is:
the more risk you take the greaterthe potential for higher return...and loss.
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Example
If you make two investments as following
Investment A B
Purchased 5000 6000
Sold 7000 7500
Income 100 300
Period of holding 6 years 1 year
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Example
You made an investment for 3months for Rs. 5000 and got back Rs.5250. What is the return on your
investment ?
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Example
You purchased an asset for Rs. 3000and sold it for 2800. You earneddividend from it of Rs. 350. What is
the capital gain on your investment?
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RISK
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RISK
The discrepancybetween actual andexpectedreturnis risk
In most cases, risk means thepossibility youll lose some or evena l l o f the money you inves t .
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Measuring Risk
Risk is Measured as
2n
1i
Return)Expected-Return(Possibley)Probabilit(
)(Variance
2
iii
1
)]E(R)[RP(
n
i
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Example of Expected Return andStandard Deviation
Stock BW
Ri Pi (Ri)(Pi)
-.15 .10 -.015
-.03 .20 -.006
.09 .40 .036
.21 .20 .042.33 .10 .033
Theexpected
return, R,
for Stock
BW is .09or 9%
Sum 1.00 .090
E l f E d R d
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Example of Expected Return andStandard Deviation
Stock BW
Ri Pi (Ri)(Pi) (Ri - R )2(Pi)
-.15 .10 -.015 .00576-.03 .20 -.006 .00288
.09 .40 .036 .00000
.21 .20 .042 .00288
.33 .10 .033 .00576
Sum 1.00 .090 .01728
= .01728
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An index of systematic risk.
It measures the sensitivityof a stocksreturns to changes in returns on the
market portfolio.
= COV (RjRp)
j
2
The betafor a portfolio is simply a weightedaverage of the individual stock betas in theportfolio
Beta?
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Taking Risk
If you want the financial security andsense of accomplishment that comeswith investing successfully, you have tob e w i l l i n g t o t a k e s o m e r i s k .
Taking risk doesntmeanyou have to takeflying leaps into untested waters it
means anticipating what the potentialproblems with a certain investment mightbe, and putting a strategy in place tom a n a g e , o r o f f s e t t h e m .
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Risks you can control
Better known as Non SystematicRisks
Risks specificto aparticular securityor assetas against the market as awhole Risks may be specific to a particular asset ,
say stocksin comparison to bonds
Individualshares would have risks specific
to them
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Non- Systematic risks in Stocks
Business Risk Uncertainty of income flows caused by
the nature of a firms business
Risk from Sale to PBIT
Financial Risk Uncertainty caused by the mode of
financing used by the firm for itsinvestments.
Risk from PBIT to PAT
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How to Control ?
By not putting allthe eggs in onebasket
By allocatingand diversifyingyourportfolio
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DIVERSIFICATION
A risk management technique thatmixes a wide variety of investments
within a portfolio. It is designed tominimize the impact of any onesecurity on overall portfolio perform
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ASSET ALLOCATION
The process of dividing a portfolioamong major asset categories such asbonds, stocks or cash.
The purpose of asset allocation is toreduce risk by diversifying the portfolio.
If one of your investments goes down
significantly in value, those losses maybe offset to some degree by gains, oreven stable values, in some of yourother investments.
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Risks you cant control
Better known as Systematic Risks
Risks inherent to theentire market
Cannot be avoided through diversification
Also known as"un-diversifiable risk" or"market risk.
You must learn to accept risk as a normal
part of investing Knowing how to tolerate risk and
avoid panic selling is part of a smartinvestment plan.
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Systematic Risk
Market risk - This is thepossibility that the financialmarkets will drop in valueand create a ripple effect inyour portfolio.
For example, if the stockmarket as a whole losesvalue, chances are yourstocks or stock funds will
decrease in value as welluntil the market returns to aperiod of growth
But the greater threat is the loss of principal that
can result from selling when prices are low.
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Systematic Risk
Interest raterisk - This is thepossibility that interest rates willgo up.
If that happens, inflation increases,
and the value of existing bondsand other fixed-incomeinvestments declines, since theyreworth less to investors than newlyissued bonds paying a higher rate.
Rising interest rates also usually mean lower stockprices, since investors put more money into interest-paying investments because they can get a strongreturn with less risk.
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Systematic Risk
Inflation risk Affectsinterest rates
Reduces Real return
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Systematic Risk
Currency risk - Uncertainty ofreturn is introduced by acquiringsecurities denominated in acurrency different from your own.
Currency fluctuations affect the
value of your overseasinvestments Changes in exchange rates affect
the investors return whenconverting an investment backinto thehomecurrency
May also affect the value of domestic investments incompanies where changes in foreign currencyexchange rate causes business or financial risk
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Systematic Risk
Political risk -With the increasinginteraction of the worlds markets,political climates around the worldcan affect the value of yourdomestic and internationalinvestments.
Country risk is the uncertainty of returns caused bythe possibility of a major change in the political oreconomic environment in a country.
Individuals who invest in countries that have unstablepolitical-economic systems must include a country risk-premium when determining their required rate of return
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Systematic Risk
Recessionrisk.A recession, or period ofeconomic slowdown, means manyinvestments could lose value and makeinvesting seem riskier.
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Systematic Risk
Liquidity Risk - Uncertainty isintroduced by the secondary market for
an investment. How long will it take to convert an
investment into cash?
How certain is the price that will be
received?
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Total Risk
Total
Risk
Unsystematic risk
Systematic risk
STD
DEV
OFPORTFOLIO
RETURN
NUMBER OF SECURITIES IN THE PORTFOLIO
Systematic Risk +Unsystematic Risk
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Volatility
Over the course of a day, amonth, or a year, the priceof your investments mayfluctuate, sometimesdramatically. This constantmovement, known as
volatility It varies from investment
to investment, with someinvestments beingsignificantly more volatile
than others.For example, stock and stock mutual funds tendto change price more quickly than most fixed-income investments, such as bonds.
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Volatility
Volatility poses the biggestinvestment risk in theshort term.
But if you can wait outdownturns in the market,
chances are that the valueof a diversified portfoliowill rebound, and youllend up with a gain.
If you look at the big picture, youll discover that
what seems to be a huge drop in price over theshort term evens out over the long term. In fact,over periods of 15 or 20 years or more, stocks usually the most volatile investments over theshort term have always increased in value.
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Balancing risk and return
Rule 1: Understanding therelationship between risk andreturn
Risk and return are directlyrelated
The greater the risk that aninvestment may lose money, thegreater its potential for providing a
substantial return.
By the same token, the smaller therisk an investment poses, the smaller
the potential return it will provide.
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Balancing risk and return
Rule 1: An ExampleA startup business could becomebankrupt, or it could become amultimillion-dollar company. If youinvest in the stock of this company,you could lose everything or make afortune.
In contrast, a blue chip company isless likely to go bankrupt, but youre
also less likely to get rich by buyingstock in company with millions ofshareholders.
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Balancing risk and return
Rule 2: You can get a better-than-average return on aninvestment with less risk,
You may be willing to
sacrifice potentially greaterreturn to avoid greater risk.
Thats sometimes the case wheninterest rates go up. Investors pulltheir money out of stocks, which aremore risky, and put it in bonds, whichare less risky, because theyre notgiving up much in the way ofpotential return and theyre gainingmore safety
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Balancing risk and return
Diversification ispossibly the greatestway to reduce the risk.This is why mutual funds
are so popular
Rule 3: Diversifyyourportfolio in a way thatsome of yourinvestments have thepotential to providestrong returns whileothers ensure that partof your principal issecure
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Key Concepts
Return
Total return
Percentage return
Annual return Real return
Nominal return
After tax return
Required rare ofreturn
Risk free rate ofreturn
Excess return
Abnormal return
Expected return
Actual return
Yield
Current yield
Bond Coupon
Risk Systematic risk
Unsystematic