RISK & RETURN

A person who is making an investment in the expectation of getting some return in the future, but as
future is uncertain, so is the future expected return. This uncertainty associated with the returns from an
investment that introduces risk into an investment.

Return: - It may be defined as the compensation that one gets for not using his liquidity at present or
parting away with his liquidity. For example- If someone buys some security for Rs. 100 instead of
using the money for consumption & sells it for Rs. 120 at a later date, than anything over the invested
amount (here Rs. 20) will be his return. Besides, if he gets any dividend/Interest in the security, it will
also be added to the return. Thus in a common stock, return is the sum of income and
appreciation/depreciation in prices.

Return can be formulated as follows: - R = Dt + (P1−Po)×100

Po

R = Return, Dt = Income during the period t, P1 = Price at the end of the period t
Po = Price at the beginning of the period

Suppose a share of X Itd is currently selling at Rs. 12. An investor who is interested in the share
anticipates that the company will pay a dividend of Rs. 0.50 in the next year. Moreover, he expects to
sell the share at Rs. 17.50 after one year. The expected return from the investment in share will be as
follows:

R = 0.50 + (17.50 - 12) x 100 = 50%

12

Risk: - Risk is defined as the variation of return from the expected return. Higher the variation, more
risky is the security. An investment whose returns are fairly stable is considered to be a low-risk
investment, whereas an investment whose return fluctuates significantly is considered to be a highly
risky investment.

The essence of risk in an investment is the variation in its return. This variation in returns is caused by
number of factors. These factors which produce variations in returns from an investment constitute the
elements of risk.
 Elements of
Risk

Systematic Unsystematic
Risk Risk

Interest Rate Purchasing

Market Risk Business Risk Financial Risk
Risk Power Risk

1. Systematic Risk: - Due to dynamic nature of society the changes occur in the economic, political and
social system constantly. These changes have an influence on the performance of companies and
thereby on their stock prices but in varying degrees. For example, economic and political instability
adversely affects all industries and companies. When an economy moves into recession, corporate
profits will shift downwards and stock prices of most companies may decline. Thus the impact of
economic, political and social changes in system-wide and that portion of total variability in security
returns caused by such system-wide factors is referred to as systematic risk. In simple words,
systematic risk is due to those factors that affect the market as a whole. For ex. Change in economy,
tax reforms etc. This part of risk cannot be reduced by diversification.

A. Interest Rate Risk — This arises due to variability in the interest rates from time to time and
particularly affects debts securities like bonds and debentures as they carry fixed coupon rate of
interest. A change in interest rates establishes an inverse relationship in the price of security i.e. price
of securities tends to move inversely with change in rate of interest. Long term securities show greater
variability in the price with respect to interest rate changes than short term securities. While cash
equivalents are less vulnerable to interest rate risk, the long term bonds are more vulnerable to interest
rate risk.

B. Purchasing Power Risk — It is also known as inflation risk, as it also emanates from very fact that
inflation affects the purchasing power adversely. Nominal return contains both the real return
component and an inflation premium in a transaction involving risk of the above type to compensate
for inflation over an investment holding period. Inflation rates vary over time and investors are caught
unaware when rate of inflation changes unexpectedly causing erosion in value of realized rate of return
and expected return. Purchasing power risk is more in inflationary conditions especially in respect of
bonds and fixed income securities. Purchasing power risk is however less in flexible income securities
like equity shares or common stock where rise in dividend income off-sets increase in the rate of
inflation and provides advantage of capital gains.

C. Market Risk — This is a type of systematic risk that affects prices of any particular share move up
or down consistently for some time periods in line with other shares in the market. A general rise in
share prices is referred to as a bullish trend, whereas a general fall in share prices is referred to as a
bearish trend. In other words, the share market moves between the bullish phase and the bearish phase.

2. Unsystematic Risk:- Sometimes the return from a security of any company may vary because of
certain factors particular to this company, Variability in returns of the security on account of these
factors (micro in nature), it is known as unsystematic risk (Diversifiable). It should be noted that this
risk in addition to the systematic risk affecting all the companies.

A. Business Risk — Business risk emanates from sale and purchase of securities affected by business
cycle, technological changes etc. Business cycle affect all types of securities viz. there is cheerful
movement in boom due to bullish trend in stock prices whereas bearish trend in depression brings
down fall in the prices of all types of securities. Flexible income securities are more affected than fixed
rate securities during depression due to decline in their market price.

B. Financial Risk: It arises due to changes in capital structure of the company. It is also known as
leveraged risk and expressed in terms of debt equity ratio. Excess of debt in the capital structure
indicates that the company is highly geared . Although a leveraged company earning per share are
more but dependence on borrowings exposes it to the risk of winding up for its inability to honors its
commitments towards lenders / creditors.

Note: Total risk is reducing with the increase in the number of securities in the portfolio.
However, ultimately when the size of the portfolio reaches certain limit, it will contain only the
systematic risk of securities included in the portfolio.

Single Security Case:

Expected Return: It is the sum of the products of possible returns with their respective probabilities.

E ( R ) or X (Mean) = ∑ R x P OR ∑X x P

Where R = Possible returns

P = Probabilty of return at R

Calculations of Expected Return

Possible Return (R) / (X) Probability ( P) RXP

20 0.20 4.00
30 0.20 6.00
40 0.40 16.00
50 0.10 5.00
60 0.10 6.00
∑ R X P OR Mean 37.00

Risk: As risk is attached with every return hence calculation of only expected return is not sufficient
for decision making. Therefore risk aspect should also be considered along with the expected return.
The most popular measure of risk is the variance or standard deviation of the probability distribution of
possible returns.