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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.

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