Introduction to Financial Planning

Fernandes, CFPCM
By Steven Fernandes

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Risk & Return

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 Return:-

Means Reward

Primary Motivating Factor

Measurement of Return is necessary to assess

the performance of the Investment Manager.

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 Two Components

 Current Return (Income)

 Capital Return

Total Return = Current Income + Capital

Return
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 Current Return:-
Is measured as the Periodic Income in relation to
The beginning price of the investment

Periodic Cash Flow (income), such as dividend or

Interest generated by the investment

Current Return can be zero or positive

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 Capital Return:-

It is simply the price appreciation / depreciation

Divided by the beginning price of the Asset

For Assets like Equity Stocks, the Capital Return

Predominates

Capital Return can be Negative, Zero or Positive

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 Risk
Meaning:-
Refers to the possibility that the actual outcome
Of an Investment will differ from its expected
Outcome..
Risk means Variability or Dispersion
If an assets return has no variability, it is
Riskless. (Govt bonds, Secured FDs)

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 Examples of Risk associated with
Investments
o Loss of Capital
For eg. Shares, Equity MFs

o Delay in repayment of Capital

For eg. Company FDs

o Non Payment of Interest

Eg. Company FDs,

o Variability of Returns
Eg. Shares, Income funds 8
 Three types of Risk

 Business Risk

 Interest Rate Risk

 Market Risk

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 Business Risk:-

 Risk of Poor Performance due to changes in

Govt policies, high competition, new
technologies, etc.
 Inept & Incompetent Management

 For Eg. Shares , Debentures

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 Interest Rate Risk:-

 Rise in Interest Rate = Fall in Market Prices of

Existing fixed income
Securities

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 Market Risk:-

 Means Fluctuations in Prices

 Major Reason of Fluctuations Changing

Sentiment of Investors
(Euphoria, Exaggerated pessimism)

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 John Train:

The ebb and flow of mass emotion is quite regular:

Panic is followed by relief,
and relief by optimism;
then comes enthusiasm,
then euphoria and rapture,
then the bubble bursts, and public feeling slides off again
into concern, desperation, and finally a new panic

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 TYPES OF RISK

UNIQUE RISK
Specific to that security. For eg. Labour strike, new competitor
Diversifiable or unsystematic risk

MARKET RISK
Economy wide factors like low GDP, high inflation, money
supply, interest rate fluctuations, etc
Systematic risk or Non Diversifiable risk.

TOTAL RISK = Unique Risk + Market Risk

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 Measures of Historical Return:-

Total Return

Relative Return

Cumulative Wealth Index

Arithmetic Mean

Geometric Mean
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Measures of Historical Returns

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Total Return:-
Cash Payment recd. Price change over
during the period + the period
Price of the Investment at the beginning

R = C + (Pe-Pb)
Pb

C- cash payment received

Pe Ending price
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Pb beginning price
Cash Payment End Price Beg. Price
Beginning Price Beginning Price

Current Return Capital Return

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 Example

Price at the beginning of the year = Rs. 60

Dividend Paid at the year end = Rs. 2.40

Price at the end of the year = Rs. 69

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 Solution

Total Return of this Stock

= 2.40 + (69 60)

60
= 0.19 or 19 %

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 Relative Return:-
(In order to avoid negative returns calculations)

Relative Return =

Cash Payments received Price at the

During the period end of the yr.
Price at the beginning of the year

Rr = C+ Pe
Pb 21
 Note:-
Even though the Total Return may be negative,
The Relative Return cannot be negative.. At
worst it can be zero.

Relative Return = 1 + Total Return in Decimals

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 Cumulative Wealth Index (CWI) :-
Total Return = Changes in level of Wealth

CWI = Level of Wealth in absolute terms

So through CWI we calculate the worth of Re. 1

invested at the beginning of the year at the end
of n years..

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 Formula

CWI n = WI0 (Relative Returns for various years)

CWI n = WI0 (1+R1)(1+R2).(1+Rn)

Where:-
 CWI n = Cum. Wealth Index at the end of n years.

 WI 0 = Is the Beginning Index Value, which is

typically one rupee.
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 Example:-
Consider a Stock which earns the following
Returns over a five year period:-

R1 = 0.14 ; R2 = 0.12 ; R3 = -0.08 ; R4 = 0.25 ;

R5 = 0.02

CWI 5 = 1 (1.14) (1.12) (0.92) (1.25) (1.02) = 1.4982

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Arithmetic Mean

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Formula:-

X = Total of all Returns

Number of yrs.

The formula holds true when Probability isnt

given

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Example
Calculate AM for the following Returns
Year Total Return (%)
1 19
2 14
3 22
4 -12
5 5

AM (x) = 19+14+22-12+5 = 9.6%

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Geometric Mean

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Problem with Arithmetic Mean:-

Consider a stock whose price is 100 at the end

Of year 0. The price declines to 80 at the end of
Year 1 & recovers to 100 at the end of year 2.
Assuming that there is no dividend payment
During the two year period. The A.M. would be?

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 Return for Yr. 1 = 80 100 = - 0.20 or 20 %
100

Return for Yr. 2 = 100 80 = 0.25 or 25 %

80

Arithmetic Mean = -20 + 25 = 2.5 %

2
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 Thus even though the return over the two
period is NIL, the Arithmetic Mean works
out to 2.5 % !!!!

Its Misleading!

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 Formula

GM = (Relative Returns)1/n - 1

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 Example:-
Year Total Return (%) Relative Ret.
1 19 1.19

2 14 1.14

3 22 1.22

4 -12 0.88

5 5 1.05
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 Geometric Mean :-

= [ (1.19) (1.14) (1.22) (0.88) (1.05) ] 1/5 1

= 1.089 1 = 0.089

= 8.9 %

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 Note:-

Geometric Mean = CAGR

GM < AM (unless all the return values

being considered are equal)

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Measures of Risk

Standard Deviation of return of security

measures its total risk.
Standard Deviation of return of portfolio
measures the total risk of portfolio
Variance (and standard deviation) considers all
deviations +ve or ve.
Semi Variance considers only negative variations.

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Measures of Risk
Standard Deviation ( )
= Square Root of Variance.

= 2

Financial calculator :

Go to Setup , Stats off, stats , select (1-vari), Exe, Key in data,

take cursor to next empty field, press (shift & stats), 5 : Var, 4
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Measures of Risk (Measuring Historical risk)

Measures of Risk:- (Historical risk)

Most commonly used measures are

Variance ( 2)

2= ( Ri- ) 2
n-1
Where
2 = variance of return
Ri = Return of stock in period I (i = 1,2 n)
= Arithmetic mean 39
n- = number of periods
Measures of Risk
Numerical Eg.
1. Consider the returns from a stock over a 6 year period.
Period 1 2 3 4 5 6
Return
(Ri) 15 12 20 -10 14 9

Step 1: Find out the mean ( ) = (15+12+20-10+14+9) = 10

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Return 15 12 20 -10 14 9
Step 2 : Calculate Deviation ( Ri- ) =
Ri- ) 5 2 10 -20 4 -1

Step 3 : Square of deviation = ( Ri- ) 2 Return

(Ri) 25 4 100 400 16 1

Step 4: Summation of Dev = ( Ri- ) 2 = (25+4+100+400+16+1) = 536

Step 5. Variance 2 = ( Ri- ) 2 = 536/5 =107.2 There fore = 107.2 = 10.353

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n-1
Measures of Risk
(Measuring Expected (Ex Ante) return & risk)

Probability distribution is considered.

The possible outcomes must be mutually
exclusive and collectively exhaustive.
Probability assigned to an outcome may vary
between 0 &1.
The sum of the probabilities assigned to various
possible outcomes is 1
Based on probability distribution of the rate of
return, you can compute 2 key parameters
1. Expected Rate of Return
2. Standard deviation of Return 41
Measures of Risk
(Measuring Expected (Ex Ante) return & risk)
Expected Rate of Return E( R)
E( R) = Ri Pi

Rate of
Return (%)

For eg. Probability

of
Occurrence HLL
0.2 5
0.4 10
0.1 8
0.3 11

E( R) = (0.2) (5) + (.4) (10) +(.1) (8)+ (.3) (11) = 9.1%

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Measures of Risk
(Measuring Expected (Ex Ante) return & risk)

Variance ( 2)

2= Pi ( Ri - E(R) )

Standard Deviation ( )

= 2

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Measures of Risk
(Measuring Expected (Ex Ante) return & risk)

Numerical : Rate of
Return
(%)
Probability
of
Occurrence HLL PiRi Ri- E ( R) (Ri- E ( R) )2 Pi(Ri - E (R ) )
0.3 16 4.8 4.5 20.25 6.075
0.5 11 5.5 -0.5 0.25 0.125
0.2 6 1.2 -5.5 30.25 6.05
11.5 12.25

1. E( R) = (0.3x16)+(.5x11)+(.2x6) = 11.5

2. 2 = Pi ( Ri E(R) )
= (6.075+.125+6.050) = 12.25

3. = 2 = 12.25 = 3.5
Financial Calculator

Go to Setup , Stats on, stats , select (1-vari), Exe, Key in data (returns in x & prob in
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freq) take cursor to next empty field, press (shift & stats), 5 : Var, 3
 Risk
Variance S.D2 (2) of 2 Asset portfolio =
w1212 + w2222 + 2w1w2Covariance(A,B)
where Covariance(A,B) = 12Correlation(A,B)
= 121,2
Covariance is the degree to which the returns of 2 securities vary or
change together
Correlation and Covariance both reflect the degree of co-movement
between 2 variables. Mathematically related
Coefficient of Correlation can vary between 1 and +1
As you add more securities to a portfolio, impact of risk of each
portfolio reduces, at the same time the significance of their
covariance increases.
The key to reducing portfolio risk is to combine assets that are less
than perfectly positively correlated

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 Risk
S.D2 (2) of 3 Asset portfolio =
w1212 + w2222 + w3232 + 2w1w2121,2 +
2w2w3232,3+ 2w1w3131,3
Covariance(A,B) = 12 = 121,2
1,2 = 12 / 12
When the Correlation Coefficient is 1,
representing perfect negative correlation, the
portfolio risk can be driven down to 0.
The weights that drive the standard deviation of
portfolio to 0 are:
w1 = 2 / (1+ 2) , w2 = 1 / (1+ 2)
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 Risk
of Security is a Measure of its performance in relation
to general movement in markets. I.e. % change in
security returns w.r.t % change in market returns
E.g. if Security returns increase by 18% when market
increases by 10% then = 18/10 = 1.8
High means security is very sensitive to market
changes
cannot be negative
= 0 => security does not change even when market
changes I.e. Security is Risk free
= 1 => security moves in line with market
> 1 => security returns are more than changes in
market returns (aggressive securities)
< 1 => security returns are less than changes in
market returns (defensive securities)
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 Risk decomposition
CAPM : Linear relationship between required
rate of return of a security and its beta
Ri = Rf + i (Rm-Rf)
Risk free rate + Risk premium

Where Ri : Expected return or required rate of return on security i

Rf : Risk free rate of return
i : Beta Coeff of security i
Rm : Return on market portfolio

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 Three measures of Performance

Sharpe Ratio Treynor Ratio Jensens

Ratio
= Rp Rf = Rp Rf
SDp B

= (Rp Rf) + B (Rm Rf)

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 Sharpe Ratio

Measures the return in excess of the risk free rate

on a portfolio to the portfolios total risk as
Measured by its Standard Deviation

How much better did you do for risk assumed

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Example:-

Particulars A Market

Return(%) 14 12

Beta 1.1 1

Std. Deviation 0.10

Risk Free Rate(%) 5

Calculate Sharpe Ratio

SR = Rp Rf = 14 5 = 0.9
SD 10

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 Treynor Ratio

Risk to Volatility Ratio

It measures the return earned in excess of those

That could have been earned on a riskless
Investment per unit of market risk assumed

Jack L Treynor
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Particulars A Market
Return(%) 14 12
Beta 1.1 1
Std. Deviation 0.10
Risk Free Rate(%) 5
Calculate Treynor Ratio

TI = Rp - Rf = 14 5 = 8.181
B 1.1

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 Beta

Measure of Systematic Risk

Measure of Non Diversifiable Risk

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 Jensens Alpha

Jensens Performance Index

Ex Post Alpha

( Michael Jensen )

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 Jensens Alpha

This is the difference between a fund's actual

return and those that could have been made on a
benchmark portfolio with the same risk- i.e. beta.

It measures the ability of active management to

increase returns above those that are purely a
reward for bearing market risk.

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Particulars A Market
Return(%) 14 12
Beta 1.1 1
Std. Deviation 0.10
Risk Free Rate(%) 5
Calculate Jensens Alpha

J Alpha = Rp -{ Rf + (Rm Rf)}

= 14 {5+1.1(12-5)}
= 1.3%

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