Risk & Return, a trade off

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By hafeezrm

What is a risk?
Dictionary meaning of risk could be exposure, hazard, uncertainty, and chance. It
conveys a negative sense like possibility of incurring loss or misfortune or injury. It is the
probability that a hazard may turn into a disaster or, in other words, the probability that a
disaster may happen. Fortunately, risk can be foreseen and managed by various ways
such as (i) passing it on to others through insurance, guarantees and sub-contracting, (ii)
sharing it by formation of consortium or syndicates, or (iii) reducing it by diversification
of possessions or portfolio.

What is a return?
It means compensation, gain, income, reward, pay off or yield. It would be notice that the
word ‘return’ conveys a positive sense as against the word ‘risk’ which forewarns of
dangers.

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Risk & Return Trade Off

When one says high risk, high returns, it means that chance of getting high returns are
most uncertain or lower. To be blunt, an investor can get high return if he or she is
willing to sustain a total losse like in a lottery.
One may purchase a share in the stock-exchange in the hope of making a big profit over a
short period of time. This is not investing but gambling as there is no guarantee that one
will get the desired returns. Some shares in the past have shown a tremendous growth but
such occurrences are rare.

Source: wikipedia.org

Risk & Return

Two Major Investment Soundness Indicators
1 - Internal Rate of Return (IRR)
Simply put, IRR is a rate of return just like Annual Compound Growth Rate or
Annualized ROI (Return on Investment). To be formal, it is a rate of discount which
equates the future cash flow to the present investment or opportunity.

It is widely used as it conveys rate of return in % which can be easily compared with any
of the following called hurdle rates:

• Average Weighted Cost of Fund

• Opportunity cost
• Desired Rate of Return
• Market Rate.

The internal rate of return is also useful in ranking competing investment projects.

There are, however, some problems with IRR when used alone.

• It neglects size of the project and treat big and small projects on equal footing.
• It presumed that cash flows are re-invested at a constant rate i.e. at the same IRR.
• When cash flows change from negative or positive, or vice versa, a unique
internal rate of return cannot be calculated

Usually, a financial calculator is used for finding out IRR but it can be found manually
through and error.

2- Net Present Value

NPV works out present value of a future income stream. It discounts future income of
each year by multiplying by a corresponding Present Value Interest Factor (PVIF). It
means if some income is expected in fourth year, the relevant PVIF would also be of the
fourth year. Besides, PVIF is decided keeping in view a discount rate based on the same
factor used for comparing IRR such as:

• Average Weighted Cost of Fund

• Opportunity cost
• Desired Rate of Return
• Market Rate.

3 - NPV and IRR compared:

While IRR is a rate, NPV is a value based on a particular discount rate. (NPV is also
known as dollar-weighted rate of return).
Applying NPV using different discount rates will result in different values and
consequently different decisions. The IRR method always gives the same results and
decision would have to be made keeping in view the factors cited above.

Both NPV and IRR are based on a discounted cash flow and lead to the same conclusion
when a single project is under consideration. However, both may differ in a decision-
context when there are mutually exclusive projects based on different durations or
different scales or both. In such cases, NPV is preferred.

Shares and Bond

Recent variations in valuation methods
MIRR

The Modified Internal Rate of Return assumes that the positive cash flows are
immediately re-invested until the end of the project. To make these calculations, it is
common practice to use the weighted average cost of capitalas interest rate on the
positive cash flows. This is an improvement over IRR which assumes that positive
cashflows are immediately re-invested at the same rate as the IRR. This means that when
a project earns a very low rate of return say 2%, any income from the project is
reinvested at the same low rate. This is obviously an un-wise decision which is taken care
of by MIRR.

The Adjusted Present Value (APV) Method

In this method, first a base-case is found by calculating NPV based entirely on equity
finance, not a shred of debt. Then this base is adjusted with for tax-benefits through debt
financing. In essence, APV valuation is the same as discounted cash flow but there would
be some adjustment due to different capital structure. It is designed for projects with debt.
The formula is :

APV = Base-case NPV + PV of financing effect

The Profitability Index (PI) Method

This is modeled after the NPV Method. It measures the total present value of future cash
inflows divided by the initial investment. This method tends to favor smaller projects
and is best used by firms with limited resources and high costs of capital. This is the same
as Cost-Benefit Ratio used for appraising public welfare project.

The Bailout Payback Method

A variation of the Payback Method. It includes the ‘junk’ value of any equipment
purchased in its calculations

The Real Options Approach.

It allows flexibility and encourages constant reassessment based on the riskiness of the
project's cash flows. It takes into account various business opportunities in the form of
option.

Dietz Method
As per Investopedia, this is a method of evaluating a portfolio's return based upon a time
weighted analysis. This can be modified to measure the return on the portfolio than a
simple geometric return method. This is because the Modified Dietz Method identifies
and accounts for the timing of all random cash flows while a simple geometric return
does not.

Capital Asset Pricing Model

RISK ASSESSMENT
For an investor, it is imperative to find out how much risk he or she is taking. There are
various technique to work-out level of risk. Some are briefly stated below:

CAPITAL ASSET PRICING MODEL (CAPM)

It is an important technique to observe the relationship between risk and reward. It is a
model for pricing of security. A security market line (SML) is drawn which shows
riskiness of a security or share. It guides an investor how much return to expect given a
certain risk in a particular stock market. In other words, it proves the old maxim, “Higher
the Risk, Higher the Reward”. It shows the reward-to-risk ratio for any security compared
to overall market risk. According to CAPM expected return on a security or portfolio
should be equal to (i) a rate on a risk-free security in a specific market and (ii) a risk
premium.

CAPM over-simplifies the investment conditions like no taxes, all investors having
identical investment horizons and opinions about expected returns, volatility and
correlation of available investments. CAPM differentiates between random risk and
market risk (also called systematic risk). Systematic risk is the risk that remains after no
further diversification benefits can be achieved. Such a risk can be measured through
using beta. If beta = 0, the investment is risk-free, if beta =1, the investment would give
the same return as a particular market, if beta >1, investment is riskier than market index,
if beta <1, investment is less riskier than market indication.

2. ARBITRAGE PRICE MODEL (APM)

Another model based on the idea that an asset's returns can be predicted using the
relationship between that same asset and many common risk factors. Often considered as
an alternative to CAPM. The difference is that APM is more general and flexible as it
takes into account many factors such as inflation, industrial production, prevailing
interest rates. In this way, CAPM would be termed as a special case of APM with one
factor of market risk premium.

3. Other MODELS
Apart from this, there are other models like Fama And French Three Factor Model and
Multi-Factor Model. These are briefly described at the end of this hub under “Relevant
Terms”.

RELEVANT TERMS

It shows efficiency or return in excess of the compensation for the risk

Alpha borne. It assesses managers’ performance. Briefly stated, Alpha is a risk-
adjusted measure of ROI.
The amount of risk that the stock contributes to the market portfolio. A
Beta widely fluctuating stock will have a high standard deviation as well as a
high beta.
Market It is a presumption that stocks would always trade at their fair value on
Efficiency stock exchanges, making it impossible for investors to either purchase
Hypothesis undervalued stocks or sell stocks for inflated prices.
Fama and The basic idea of the approach is the use of a time series (first pass)
French _ Three regression to estimate betas and the use of a cross–sectional (second
Model Factor pass) regression to test the hypothesis derived from the CAPM
A fundamental analysis method of analyzing a firm's costs of capital as it
uses additional financial leverage, and how that relates to the overall
Hamada
riskiness of the firm. The measure is used to summarize the effects this
Equation
type of leverage has on a firm's cost of capital (over and above the cost
of capital as if the firm had no debt).
A financial model that employs multiple factors in its computations to
explain market phenomena and/or equilibrium asset prices. The multi-
Multi-factor factor model can be used to explain either an individual security or a
Model portfolio of securities. It will do this by comparing two or more factors
to analyze relationships between variables and the security’s resulting
performance.
Conclusion
An investor in securities (shares and bonds) is faced with two types of risk: Market Risk
and Inflation Risk. A good investor should know how much risk to take. First, risk should
be identified, second it should be assessed and third it should be managed. Points to be
pondered at are (i) How much one is willing to lose, (ii) Is there enough liquidity to buy
and sell promptly, (iii) determination of profit or loss limits, (iv) buying stock only an
acceptable price level and (v) selling when the price reaches at a predetermined level
corresponding to the profit target. These are nothing but prudent guidelines to save the
investor from losses.

At the same time, one should have a well-diversified port-folio (possession of a variety of
shares and bonds). It is recommended to diversify your investment in at least six or more
different stocks.

A piece of advice: Act quickly to get out of losing situation -'Never trade with money you
can't afford to lose'.