Risk and Return Analysis
Return expresses the amount which an investor actually earned on an investment during a certain period. Return includes the interest, dividend and capital gains; while risk represents the uncertainty associated with a particular task. In financial terms, risk is the chance or probability that a certain investment may or may not deliver the actual/expected returns.
The risk and return trade off says that the potential return rises with an increase in risk. It is important for an investor to decide on a balance between the desire for the lowest possible risk and highest possible return.
Risk Analysis
Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in investment is defined as the variability that is likely to occur in future cash flows from an investment. The greater variability of these cash flows indicates greater risk.
Variance or standard deviation measures the deviation about expected cash flows of each of the possible cash flows and is known as the absolute measure of risk; while co-efficient of variation is a relative measure of risk.
For carrying out risk analysis, following methods are used-
- Payback [How long will it take to recover the investment]
- Certainty equivalent [The amount that will certainly come to you]
- Risk adjusted discount rate [Present value i.e. PV of future inflows with discount rate]
However in practice, sensitivity analysis and conservative forecast techniques being simpler and easier to handle, are used for risk analysis. Sensitivity analysis [a variation of break even analysis] allows estimating the impact of change in the behavior of critical variables on the investment cash flows. Conservative forecasts include using short payback or higher discount rates for discounting cash flows.
Investment Risks
Investment risk is related to the probability of earning a low or negative actual return as compared to the return that is estimated. There are 2 types of investments risks:
- Stand-alone risk
This risk is associated with a single asset, meaning that the risk will cease to exist if that particular asset is not held. The impact of stand alone risk can be mitigated by diversifying the portfolio.
Stand-alone risk = Market risk + Firm specific risk
Where,
- Market risk is a portion of the security's stand-alone risk that cannot be eliminated trough diversification and it is measured by beta
- Firm risk is a portion of a security's stand-alone risk that can be eliminated through proper diversification
- Portfolio risk
This is the risk involved in a certain combination of assets in a portfolio which fails to deliver the overall objective of the portfolio. Risk can be minimized but cannot be eliminated, whether the portfolio is balanced or not. A balanced portfolio reduces risk while a non-balanced portfolio increases risk.
Sources of risks
- Inflation
- Business cycle
- Interest rates
- Management
- Business risk
- Financial risk
Return Analysis
An investment is the current commitment of funds done in the expectation of earning greater amount in future. Returns are subject to uncertainty or variance Longer the period of investment, greater will be the returns sought. An investor will also like to ensure that the returns are greater than the rate of inflation.
An investor will look forward to getting compensated by way of an expected return based on 3 factors -
- Risk involved
- Duration of investment [Time value of money]
- Expected price levels [Inflation]
The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk premium and inflation. This rate generally remains stable; but in the long run there could be gradual changes in the RRFR depending upon factors such as consumption trends, economic growth and openness of the economy.
If we include the component of inflation into the RRFR without the risk premium, such a return will be known as nominal risk free rate [NRFR]
NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1
Third component is the risk premium that represents all kinds of uncertainties and is calculated as follows -
Expected return = NRFR + Risk premium
Risk and return trade off
Investors make investment with the objective of earning some tangible benefit. This benefit in financial terminology is termed as return and is a reward for taking a specified amount of risk.
Risk is defined as the possibility of the actual return being different from the expected return on an investment over the period of investment. Low risk leads to low returns. For instance, incase of government securities, while the rate of return is low, the risk of defaulting is also low. High risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on stocks are much higher than the returns on Government securities, but the risk of losing money is also higher.
Rate of return on an investment cal be calculated using the following formula-
Return = (Amount received - Amount invested) / Amount invested
He risk and return trade off says that the potential rises with an increase in risk. An investor must decide a balance between the desire for the lowest possible risk and highest possible return.
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