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Risk Return Analysis of Investment

This document discusses risk and return analysis in investment. It defines key concepts like return, risk, systematic and unsystematic risk. It also discusses how return consists of dividends and capital gains. Investors require higher returns for taking on greater risks. Diversification reduces unsystematic risk but not systematic or market risk. The relationship between risk and return is positively correlated - higher risk requires higher returns. Risk and return analysis is important for investment decisions and portfolio management.

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Anju Prakash
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127 views

Risk Return Analysis of Investment

This document discusses risk and return analysis in investment. It defines key concepts like return, risk, systematic and unsystematic risk. It also discusses how return consists of dividends and capital gains. Investors require higher returns for taking on greater risks. Diversification reduces unsystematic risk but not systematic or market risk. The relationship between risk and return is positively correlated - higher risk requires higher returns. Risk and return analysis is important for investment decisions and portfolio management.

Uploaded by

Anju Prakash
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Risk return analysis of Investment

Concept of Risk & Return Analysis


The concept of risk and return analysis is integral to the process of investing and finance.
financial decisions involve some risk. One may expect to get a return of 15% per annum in
his investment but the risk of "not able to achieve 15% return" will always be there. Return is
simply a reward for investing as all investing involves some risk.

The greater the risk, the greater the return expected.


The objective of risk and return analysis is to maximize the return by creating a balance of
risk. For example, in case of working capital management, the less inventory you keep, the
higher the expected return as less of your money is locked as asset.; but you also have a
increased risk of running out of raw material when you actually need it for production or
maintenance. Which means you loose sale. Thus all companies tries very hard to maintain
minimum inventory as possible without effecting smooth production.

What Is Return on Investment?

Historical return on investment is the annual return of an asset over several years. Research
analysts and professional investors use historical returns, along with industry and economic
data, to estimate future rates of return. You can use actual results and estimated returns to
evaluate various assets, such as stocks and bonds, as well as different securities within
each asset category. This evaluation process helps you pick the right mix of securities to
maximize returns during your investment time horizon.

What Is Investment Risk?

Risk is the likelihood that actual returns will be less than historical and expected returns.
Risk factors include market volatility, inflation and deteriorating business fundamentals.
Financial market downturns affect asset prices, even if the fundamentals remain sound.
Inflation leads to a loss of buying power for your investments and higher expenses and lower
profits for companies.
Business fundamentals could suffer from increased competitive pressures, higher interest
expenses, quality problems and management inability to execute on strategic and
operational plans. Weak fundamentals could lead to declining profits, losses and eventually
a default on debt obligations.

Risk & Return Analysis



Return on security (single asset) consists of
two parts:

Return = dividend + capital gain rate

R = D1 + (P1 – P0)
P0
WHERE R = RATE OF RETURN IN YEAR 1
D1 = DIVIDEND PER SHARE IN YEAR 1
P0 = PRICE OF SHARE IN THE BEGINNING OF THE YEAR
P1 = PRICE OF SHARE IN THE END OF THE YEAR

Portfolio
 A portfolio is a bundle of individual assets or securities.
 All investors hold well diversified portfolio of assets instead of investing in a single
asset.
 If the investor holds well diversified portfolio of
assets, the concern should be expected rate of return & risk of portfolio rather than
individual assets.

Considerations for Investment Decisions

Life events will require adjustments to your financial plan, including the asset mix in your investment
portfolio. For example, the stock component of your portfolio may be high when you start your first
job because you can afford to take more risks and want to grow your investments as quickly as
possible. Your portfolio may change to a balanced mix of stocks and bonds when you start a family
and switch to mostly bonds and dividend-paying stocks as you get closer to retirement.
Market movements may also require periodic portfolio adjustments. For example, you may take
some profits in stocks following a sharp stock market rally or invest in quality stocks at bargain prices
after a sharp market correction.

Importance of risk- return relationship


The relationship between risk and return is a fundamental financial relationship that affects
expected rates of return on every existing asset investment. The Risk-Return relationship is
characterized as being a "positive" or "direct" relationship meaning that if there are
expectations of higher levels of risk associated with a particular investment then greater
returns are required as compensation for that higher expected risk. Alternatively, if an
investment has relatively lower levels of expected risk then investors are satisfied with
relatively lower returns. This risk-return relationship holds for individual investors and
business managers. Greater degrees of risk must be compensated for with greater returns
on investment. Since investment returns reflects the degree of risk involved with the
investment, investors need to be able to determine how much of a return is appropriate for a
given level of risk. This process is referred to as "pricing the risk".

In order to price the risk, we must first be able to measure the risk (or quantify the risk) and
then we must be able to decide an appropriate price for the risk we are being asked to bear.
The entire scenario of security analysis is built on two concepts of security: Return and risk.
The risk and return constitute the framework for taking investment decision. Return from
equity comprises dividend and capital appreciation. To earn return on investment, that is, to
earn dividend and to get capital appreciation, investment has to be made for some period
which in turn implies passage of time. Dealing with the return to be achieved requires
estimated of the return on investment over the time period. Risk denotes deviation of actual
return from the estimated return. This deviation of actual return from expected return may be
on either side – both above and below the expected return. However, investors are more
concerned with the downside risk.
The risk in holding security deviation of return deviation of dividend and capital appreciation
from the expected return may arise due to internal and external forces. That part of the risk
which is internal that in unique and related to the firm and industry is called ‘unsystematic
risk’. That part of the risk which is external and which affects all securities and is broad in its
effect is called ‘systematic risk’.
The unsystematic risk is eliminated through holding more diversified securities. Systematic
risk is also known as non-diversifiable risk as this can not be eliminated through more
securities and is also called ‘market risk’. Therefore, diversification leads to risk reduction but
only to the minimum level of market risk. The investors increase their required return as
perceived uncertainty increases. The rate of return differs substantially among alternative
investments, and because the required return on specific investments change over time, the
factors that influence the required rate of return must be considered

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