Balancing Risk and Return

RETURN
RETURN
Return is a measure of investment
gain or loss. "

The gai n or l oss for a securi ty i n a
particular period, consisting of income
p 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.



Total Return
Long-term investors are interested in
total return, which is the amount your
investment increases or decreases in
value, plus any income you receive
Total Return
If you buy stock for Rs. 10,000 and sell it for Rs.
12,500, and collected Rs. 150 in dividends your return
is Rs. 2,500 + Rs. 150 =Rs. 2650 gain.

Or, if you buy stock for Rs.10,000 and sell it for
Rs.9,500, and collected Rs. 150 in your return is a
Rs.500 loss plus Rs. 150. i.e. a return of Rs. 350 loss
You dont have to sell to figure return on the
investments
Total Return
You simply subtract what you paid from the
current val ue to get a sense of where
you stand.

To this you add income recd. during the period

Return as a percentage

Return is usually quoted as a
percentage


Return as a percentage

Return is usually
quoted as a
percentage

WHY ?


To compare to
investments
made at
different prices
Return as a percentage

An Example

A Rs 2,650 total return on an investment of
Rs. 10,000 is 0.265, or a 26.5% return.

In contrast, a Rs. 2,650 total return on an
investment of Rs. 30,000 is an 8.84% return.

So while each investment has increased your
wealth by the same amount, the performance
of the first is more than thrice as strong as the
performance of the second



Yield / Annual Return
Divide the
percentage return
by the number of
years you owned
the 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
Real Return
INFLATION
INCOME TAX
Real Return
You made a fixed deposit of Rs. 10,000
at 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 %

Expected Return
Ex Ante Return
Before the Event - based on future
expectations
Expected Return


Expected Return
For example

If you knew a given investment had a 50%
chance of earning a 10% return, a 25% chance
of 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%

Actual Return
Ex Post Return - after the facts

Actual Return
What investors actually receive from
their investment
Sales value Purchase value +
Income received
THE CATCH




Although you expect to have a
cer t ai n r et ur n, t her e i s no
guarantee that it will be the actual
return.
Required rate of return
The rate of return needed to induce
investors or companies to invest in
something.
For example, if you invest in a stock
your required return might be 10% per
year. Your reasoning is that if you don't
receive 10% return, then you'd be
better off paying down your outstanding
loan that you are paying 10% interest
on.
Risk free rate of return
The theoretical rate of return of an
i n v e s t me n t wi t h z e r o r i s k .

The risk-free rate represents the
interest an investor would expect
from an absolutely risk-free
investment over a specified period of
time.


Excess Return

Returns in excess of the risk-free
rate or i n excess of a market
measure (such as an index fund).


In other words, when you have
excess returns you are making
more money than if you put your
money into an risk free asset.


Abnormal Return

When the return on an asset or security
is in excess of the expected rate of
return.

Earning 30% in a mutual fund that is
supposed to average 10% would be an
abnormal return.

Like winning the lottery

This is something we want to happen.


CAUTION



The general rule is:

the more risk you take the greater
the potential for higher return...
and loss.

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

Example
You made an investment for 3
months for Rs. 5000 and got back Rs.
5250. What is the return on your
investment ?


Example
You purchased an asset for Rs. 3000
and sold it for 2800. You earned
dividend from it of Rs. 350. What is
the capital gain on your investment?

RISK
RISK
The discrepancy between actual and
expected return is risk

In most cases, ri sk means the
possibility youll lose some or even
al l of t he money you i nvest .

Measuring Risk
Risk is Measured as
2
n
1 i
Return) Expected - Return (Possible y) Probabilit (
) ( Variance

2
i i i
1
)] E(R )[R P (

n
i
Example of Expected Return and
Standard Deviation
Stock BW
R
i
P
i
(R
i
)(P
i
)

-.15 .10 -.015
-.03 .20 -.006
.09 .40 .036
.21 .20 .042
.33 .10 .033

The
expected
return, R,
for Stock
BW is .09
or 9%
Sum 1.00 .090
Example of Expected Return and
Standard Deviation
Stock BW
R
i
P
i
(R
i
)(P
i
) (R
i
- R )
2
(P
i
)
-.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
An index of systematic risk.
It measures the sensitivity of a stocks
returns to changes in returns on the
market portfolio.
= COV (R
j
R
p
)

j
2
The beta for a portfolio is simply a weighted
average of the individual stock betas in the
portfolio
Beta?
Taking Risk
If you want the financial security and
sense of accomplishment that comes
with investing successfully, you have to
b e wi l l i ng t o t a k e s o me r i s k .

Taking risk doesnt mean you have to take
flying leaps into untested waters it
means anticipating what the potential
problems with a certain investment might
be, and putting a strategy in place to
m a n a g e , o r o f f s e t t h e m .
Risks you can control
Better known as Non Systematic
Risks
Risks specific to a particular security
or asset as against the market as a
whole
Risks may be specific to a particular asset ,
say stocks in comparison to bonds
Individual shares would have risks specific
to them


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 its
investments.
Risk from PBIT to PAT



How to Control ?

By not putting all the eggs in one
basket

By allocating and diversifying your
portfolio
DIVERSIFICATION

A risk management technique that
mixes a wide variety of investments
within a portfolio. It is designed to
minimize the impact of any one
security on overall portfolio perform
ASSET ALLOCATION
The process of dividing a portfolio
among major asset categories such as
bonds, stocks or cash.

The purpose of asset allocation is to
reduce risk by diversifying the portfolio.

If one of your investments goes down
significantly in value, those losses may
be offset to some degree by gains, or
even stable values, in some of your
other investments.
Risks you cant control
Better known as Systematic Risks
Risks inherent to the entire 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 smart
investment plan.
Systematic Risk
Market risk - This is the
possibility that the financial
markets will drop in value
and create a ripple effect in
your portfolio.
For example, if the stock
market as a whole loses
value, chances are your
stocks or stock funds will
decrease in value as well
until the market returns to a
period of growth
But the greater threat is the loss of principal that
can result from selling when prices are low.
Systematic Risk
Interest rate risk - This is the
possibility that interest rates will
go up.
If that happens, inflation increases,
and the value of existing bonds
and other fixed-income
investments declines, since theyre
worth less to investors than newly
issued bonds paying a higher rate.
Rising interest rates also usually mean lower stock
prices, since investors put more money into interest-
paying investments because they can get a strong
return with less risk.
Systematic Risk
Inflation risk Affects
interest rates

Reduces Real return
Systematic Risk
Currency risk - Uncertainty of
return is introduced by acquiring
securities denominated in a
currency different from your own.
Currency fluctuations affect the
value of your overseas
investments
Changes in exchange rates affect
the investors return when
converting an investment back
into the home currency
May also affect the value of domestic investments in
companies where changes in foreign currency
exchange rate causes business or financial risk
Systematic Risk
Political risk - With the increasing
interaction of the worlds markets,
political climates around the world
can affect the value of your
domestic and international
investments.
Country risk is the uncertainty of returns caused by
the possibility of a major change in the political or
economic environment in a country.
Individuals who invest in countries that have unstable
political-economic systems must include a country risk-
premium when determining their required rate of return

Systematic Risk
Recession risk. A recession, or period of
economic slowdown, means many
investments could lose value and make
investing seem riskier.
Systematic Risk
Liquidity Risk - Uncertainty is
introduced 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?
Total Risk
Total
Risk
Unsystematic risk
Systematic risk
S
T
D

D
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V

O
F

P
O
R
T
F
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L
I
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R
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T
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R
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NUMBER OF SECURITIES IN THE PORTFOLIO
Systematic Risk +
Unsystematic Risk
Volatility
Over the course of a day, a
month, or a year, the price
of your investments may
fluctuate, sometimes
dramatically. This constant
movement, known as
volatility
It varies from investment
to investment, with some
investments being
significantly more volatile
than others.
For example, stock and stock mutual funds tend
to change price more quickly than most fixed-
income investments, such as bonds.

Volatility

Volatility poses the biggest
investment risk in the
short term.
But if you can wait out
downturns in the market,
chances are that the value
of a diversified portfolio
will rebound, and youll
end up with a gain.
If you look at the big picture, youll discover that
what seems to be a huge drop in price over the
short 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 the
short term have always increased in value.
Balancing risk and return
Rule 1 : Understanding the
relationship between risk and
return
Risk and return are directly
related
The greater the risk that an
investment may lose money, the
greater its potential for providing a
substantial return.
By the same token, the smaller the
risk an investment poses, the smaller
the potential return it will provide.
Balancing risk and return
Rule 1 : An Example
A startup business could become
bankrupt, or it could become a
multimillion-dollar company. If you
invest in the stock of this company,
you could lose everything or make a
fortune.
In contrast, a blue chip company is
less likely to go bankrupt, but youre
also less likely to get rich by buying
stock in company with millions of
shareholders.
Balancing risk and return
Rule 2 : You can get a better-
than-average return on an
investment with less risk,
You may be willing to
sacrifice potentially greater
return to avoid greater risk.
Thats sometimes the case when
interest rates go up. Investors pull
their money out of stocks, which are
more risky, and put it in bonds, which
are less risky, because theyre not
giving up much in the way of
potential return and theyre gaining
more safety
Balancing risk and return
Diversification is
possibly the greatest
way to reduce the risk.
This is why mutual funds
are so popular
Rule 3 : Diversify your
portfolio in a way that
some of your
investments have the
potential to provide
strong returns while
others ensure that part
of your principal is
secure
Key Concepts
Return
Total return
Percentage return
Annual return
Real return
Nominal return
After tax return
Required rare of
return
Risk free rate of
return


Excess return
Abnormal return
Expected return
Actual return
Yield
Current yield
Bond Coupon
Risk
Systematic risk
Unsystematic