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Return and Risk The Basis of

Investment Decisions
Gayatri Mohanty
Return: Why invest?

Cash has an opportunity cost and by holding cash the
opportunity of earning return on the cash is foregone.
Also inflation reduces the purchasing power of cash over
a period of time.
So, when an investor invests his money in some
investment alternative forgoing his present consumption,
it is important that after the period for which he invests
his money he should get a return that will compensate for
the risk assumed by him.
There is also a need to understand the difference
between the expected return (a rate of return that the
investor expects to earn at the end of the investing
period) and the realized return (the actual return earned
by him).

Historical and Expected Return
Historical Return: When you go for an investment how do
you arrive at return that you want your investment to yield? A
lot of your expectation is dependent on the past return that
the investment has yielded or the already realized return.
This is referred to as the historical return (realized return).
It can be derived from the past performance of a security or
investment. In addition historical returns are often used as an
important input in estimating the future (prospective) returns.

Expected Return: The future is uncertain. Investors do not
know with certainty whether the economy will be growing
rapidly or be in recession. Investors do not know what rate of
return their investments will yield (give). Therefore, they base
their decisions on their expectations concerning the future.
The expected rate of return on a stock represents the mean of a
probability distribution of possible future returns on the stock.
Historical and Expected Return
Calculation of Historical Return:
The total return on an investment for a given period
is calculated as:


Cash payment received Price change over
during the period (Dividends) + the period (Capital appreciation)
Price of the investment at the beginning
Total Return =
C + (P
E
P
B
)
P
B
R =
Where; C = Cash payment received during the year
P
E
= The ending price of the investment
P
B
= The beginning price of the investment
Historical and Expected Return
Calculation of Expected Return: The weighted average of all the
possible returns multiplied b y their respective probabilities.



As denoted by the above formula, simply take the probability of each
possible return outcome and multiply it by the return outcome itself. 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%

Although this is what you expect the return to be, there is no guarantee
that it will be the actual return.


=
=
n
i
PiRi R E
1
) (
6
Expected Return
The table below provides a probability distribution for the returns
on stocks A and B
State Probability Return On Return On
Stock A Stock B
1 20% 5% 50%
2 30% 10% 30%
3 30% 15% 10%
4 20% 20% -10%
The state represents the state of the economy one period in the
future i.e. state 1 could represent a recession and state 2 a
growth economy.
The probability reflects how likely it is that the state will occur.
The sum of the probabilities must equal 100%.
The last two columns present the returns or outcomes for stocks
A and B that will occur in each of the four states.
7
Expected Return
In this example, the expected return for stock A
would be calculated as follows:

E(R)
A
= 0.2(5%) + 0.3(10%) + 0.3(15%) +0.2(20%) = 12.5%

Now you try calculating the expected return for stock
B!

8
Expected Return
Did you get 20%? If so, you are correct.

If not, here is how to get the correct answer:

E(R)
B
= 0.2(50%) + 0.3(30%) + 0.3(10%) + 0.2(-10%) = 20%

So we see that Stock B offers a higher expected
return than Stock A.
However, that is only part of the story; we haven't
considered risk.
Real Return and Nominal Return
The returns that we have discussed so far are the
nominal returns and not the real return .
So, what is the difference between the two?
Real return is a rate of return which has taken into
account the rate of inflation prevailing in the system.
As we all know that Rs.100 today will not have the
same value after say 10 years. Similarly, a return that
we will earn on an investment after some years will not
have the same value as it may have today. So, today
when we are making our investment decisions we need
to understand that what will be the real return that we
are going to get from the investment in the future. So,
we need to adjust the inflation against the nominal
return to get the real return from the investment.
Real Return and Nominal Return
Real returns are the gain or loss on your
investments, after factoring in the effects
of inflation. Nominal returns don't factor in
inflation.

1 + Nominal Return
1 + Inflation Rate
- 1
Real Return =
For e.g.: The total return for an equity stock during a year was 18.5 percent.
The rate of inflation during that year was 5.5 percent. Thus the real
(inflation-adjusted) total return was:

1.185
1.055
- 1 = 0.123 or 12.3 percent
Risk
Concept of Risk:
The actual returns that an investor receives from a
stock may vary from his expected return and the this
probability of variance itself is the risk.
Risk is expressed in terms of variability of return.
An investor before investing in securities must properly
analyze the risks associated with these securities.
Sometimes the term risk and uncertainty are used
interchangeably but in case of uncertainty the possible
events and probabilities of their occurrence are not
known, whereas in case of risk they are known. So,
risk and uncertainty are different from each other.

Risk
So, risk is explained theoretically as the
fluctuation in returns from a security. A security
that yields consistent returns over a period of
time is termed as risk less security or risk free
security.
Risk is inherent in all walks of life. Since an
investor cannot foresee the future definitely, so
risk always prevails for an investor and he needs
to assess it and accordingly invest depending
upon his preference for the level of risk.



Business Entities are Exposed to
Many Risks
Interest Rate Risk
Exchange Risk
Liquidity Risk
Default (Credit) Risk
Internal Business
Risk
External Business
Risk
Financial Risk
Market Risk

Marketability Risk
Operational Risk
Environmental Risk
Production Risk
Political Risk
Events of God
Portfolio Risk
And many more

Types of Risks
Systematic Risk
Unsystematic Risk


Systematic Risk
It is the risk that is caused by external factors such
as economic, political and sociological conditions.
It affects the functioning of the entire market.
Since these risks arise due to external factors they
are beyond the control of the company affected, and
hence are uncontrollable or referred to as
undiversifiable risk.
They are of three types:
Market risk
Interest rate risk
Purchasing power risk

Market Risk
Jack Clark Francis, Ph.D., Professor of Economics and
Finance at Bernard Baruch College in New York has defined
market risk as that portion of the total variability of returns
that is caused by the alternating forces of bull and bear
markets.
When the stock market moves upwards, it is known as bull
market. On the other hand, when the stock market moves
downwards, then it is known as bear market.
The two forces that affect the market are:
Tangible events: Earthquake, war, political uncertainty and
decrease in the value of money are some of the examples of tangible
events.
Intangible events: It is related to market psychology. Political unrest
or fall of government affects the market sentiments. Inflow of foreign
funds may make the market psychology positive.

Interest Rate Risk
It is the risk caused by the variations in the market interest rates.
Prices of debentures, bonds, etc. are mainly affected by the interest
rate risk (as demand for bonds and debentures varies directly with the
ups and downs of the interest rates). As interest rates (on public sector
bonds) rise, bond prices fall and vice versa.
The rationale being that as interest rates increase, the price of the
bonds have to fall in order to make the yield of the particular bond more
attractive for the investor lest he shall invest elsewhere.
If interest rates increase, the cost of borrowed funds also increase
thereby decreasing the distributable profits of the companies and
hence the stock prices also fall.
The causes of interest rate risk are as follows:
Changes in the governments monetary policy
Changes in the interest rate of treasury bills
Changes in the interest rate of government bonds

Purchasing Power Risk (Inflation Risk)
Variations in returns are caused by the loss of purchasing power of currency.
So, the purchasing power risk is the probable loss in the purchasing power of the
returns to be received in the future. This is related to the interest rate risk as a
change in interest rate ultimately leads to a change in inflation rate as well.
There are mainly two types of inflation:

Demand-pull inflation: The demand for goods and services remains higher
than the supply.
Cost-push inflation: There is a rise in price due to the increase in the cost of
production.


Real future value =





Real Rate of Return =
where r = Rate of Return
IR = Inflation Rate



Nominal future value
1.0 Inflation Rate +
1.0 r
1.0
1.0 IR
+

+
Unsystematic Risk
It is a type of risk which is unique, specific
and related to a particular industry.
Managerial inefficiency, changes in
preferences of the consumers, availability of
raw material, labour problems, etc. are
some of the causes of unsystematic risk.
These risks are however diversifiable and
can even be reduced to negligible
proportions.
These are of two types:
Business risk
Financial risk

Business Risk
It is the risk that is caused by the inefficiency of a
company to manage its growth or stability of
earnings.
It can be classified as:
Internal business risk (Operational Risk): It is the risk that is
associated with the operational efficiency of a company:
(1) Fluctuations in the sales
(2) Research and Development
(3) Personnel Management
(4) Fixed Cost
(5) Single Product

External business risk: It is the risk that is the result of
operating conditions imposed on the firm by the external
environment:
(1) Social and regulatory factors
(2) Political risks
(3) Business cycle

Financial Risk
It is associated with the capital structure of the company, which
consists of equity and borrowed funds.
The use of debt financing by the company to finance a larger
proportion of assets causes larger variability in returns to the
investors in the faces of different business situation.
During prosperity the investors get higher return than the average
return the company earns, but during distress investors faces
possibility of vary low return or in the worst case erosion of capital
which causes the financial risk.
The larger the proportion of assets finance by debt (as opposed to
equity) the larger the variability of returns thus lager the financial
risk.
A financial risk can be avoided by analyzing the capital structure of
the company, however it is the cost a company has to pay if it
chooses to take advantage of financial leverage.
The payment of interest affects the eventual earnings of the
company.

Minimizing Risk Exposure
Market Risk Protection
1. Study price behavior of stocks, avoid cyclical
stocks.
2. Measure risk of stocks by standard deviation
and beta etc. The NSE News bulletin provides
the beta values of stocks. Calculate the level of
risk associated with a stock and choose stocks
depending upon your risk tolerance.
3. Be prepared to hold stocks through adversities,
and time purchase and sales correctly.
Minimizing Risk Exposure
Interest Rate Risk Protection
1. Hold securities till maturity, avoid selling during
periods of fall in interest rate.
2. Invest in treasury bills and bonds of short term
maturity and reinvest the money when the
prevailing interest rates are favorable.
3. Invest in bonds of different maturity dates to
have liquidity for investment over a wide horizon
of time.

Minimizing Risk Exposure
Inflation Risk Protection
1. Bonds and debentures with fixed interest are
not helpful in hedging against inflation.
2. Invest in short term securities and avoid long
term investments during high inflation as the
rising CPI will undo all real benefits of a long
term investment.
3. Diversify into real estate, precious metals,
arts and antiques or securities. Though a
perfect hedge against inflation is not
guaranteed but yes, the loss exposure can
be minimized.
Minimizing Risk Exposure
Protection against Business and Financial
Risks
1. Analysis of strengths and weaknesses of the
industry to which the company belongs.
2. Analysis of profitability trend of the company.
Companies with inconsistency in earnings are
better avoided.
3. Analysis of the capital structure of the
company. During a boom investment in a
highly levered company may be recommended
but not during recession.
Risk Measurement
Total Risk = General risk + Specific risk
= Systematic risk + Unsystematic risk
An efficient measurement of risks provides an appropriate
quantification of risk.
Standard deviation is used as a tool for measuring the
risk, which is a measure of the variables around its mean.
The following formula is used to calculate standard
deviation:

( )
2
2
1
1
1
n
t
t
R R
n
o
=
=


Standard deviation = Variance
Where; = Standard Deviation or risk
n = Number of observations
R
t
= Return for period t

R = Average return

Example
The rate of return of equity shares of Wipro
Ltd., for past six years are given below:
Year 1 2 3 4 5 6
Rate of
Return (%)
12 18 -6 20 22 24
Calculate the average rate of return, standard
deviation and variance.
(consider the data to be representing the entire
population)
Solution
Average rate of return = 15%
Variance = 102.33
SD = 10.11%

Measure of Systematic Risk
The systematic risk is calculated by (beta), a
measure of the volatility of a security or a portfolio in
comparison to the market as a whole. Beta is used in
the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on
its beta and expected market returns.


where; Rj = Return on security j
Ke = Cost of equity (i.e. of security j)
Rf = Risk free rate of return
Rm= Market rate of return
j = Beta or the systematic risk of security j


j f m f e j
) R R ( R k R | + = =

Measure of Systematic Risk
The security return is calculated as

Todays security return = X 100



Todays market return =

and the return on security is given by:
R
i
=
i
+
i
R
m
+ e
i
Where R
i
= Return on stock i

i
= Intercept
i
= Slope (beta) of stock i R
m
= Return of the market index
e
i
= The error term

Yesterdays price
Todays price Yesterdays Price
Todays index Yesterdays
index
Yesterdays index
X 100
Calculation of

n XY (X)(Y)

nX
2
- (X)
2



=
= y x
Example
Date NSE index (X) Bajaj Auto Stock
Prices (Y)
October 5 904.95 597.80
October 6 845.75 570.80
October 7 874.24 582.95
October 8 847.95 559.85
October 9 849.10 554.60
October12 835.80 545.10
October13 816.75 519.15
October14 843.55 560.70
October15 835.55 560.95
October16 839.50 597.40
Calculate the .

Solution
Index
Return (X)
X
2
Bajaj Auto
Stock
Return (Y)
XY
-6.54 42.77 -4.52 29.56
3.37 11.36 2.13 7.18
-3.01 9.06 -3.96 11.92
0.14 0.02 -0.94 -0.13
-1.57 2.46 -1.71 2.68
-2.28 5.20 -4.76 10.85
3.28 10.76 8.00 26.24
-0.95 0.90 0.04 -0.04
0.47 0.22 6.50 3.06
Total -7.09 82.75 0.78 91.32
Answers
= 1.19
= 1.02



Interpretation of
+ ve (1, more than one, less than one)
- ve
= 1

> 1

< 1

Standard Deviation from Expected
Return
The expected rate of return [E(R)] is the
sum of the product of each outcome
(return) and its associated probability.
Risk associated with a security can be
calculated from its expected returns by the
following formula:


| |
N
2
1
i=1
= P r -E(r)

Practical Problems
1. Assume that you are a portfolio manager
and have to advise your client between the
securities of two companies the returns on
the securities are given below:




On the basis of risk and return which
security will you choose?
Probability Security A Security B
0.5 4 0
0.4 2 3
0.1 0 3
Solution
Security A is to be chosen.
Reason:
Security
A
Security
B
Risk () 1.327 1.5
Expected
Return E(R)
2.8 1.5
Practical Problems
2. Following data give the market return and
the Sun Companys scrips return for a
particular period:

Index Return
(Rm)
Scrip return (Ri)
0.50 0.30
0.60 0.60
0.50 0.40
0.60 0.50
0.80 0.60
0.50 0.30
0.80 0.70
0.40 0.50
0.70 0.60
Calculate the
beta of the Sun
Companys
scrip.

Also calculate
the scrip return if
the market
return is 2.

Solution
= 0.75
=0.05
Scrip return when market return is 2 = 1.55


Question
3. Mr. Mohan wants to buy Ant company
stock which is currently selling at Rs 60
without dividend payment. There is equal
probability for the Ant stock to be sold at Rs
65 and Rs 80 during the next year. What is
the expected return and risk if 300 shares
are bought? Transaction cost is ignored.
Solution
3. = (56.25)
1/2
= 7.5
(a) Expected Return
E(r) = 12.5 300 = Rs. 3750
(b) If 300 shares are bought,
Risk = 7.5 300 = Rs. 2250.