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11. Fundamentals of Risk and Return

Concept of Return of Investment and Return on Investment

Investment means putting up capital in an identified investment product to earn returns from it. The investor expects two things from the investment: to earn a return and, more importantly, to get back the capital invested. The preservation or safety of the capital invested is as important a parameter in evaluating an investment as is the return that it is expected to provide.

Return on Capital/investment (ROI) is the comparison of returns with the investment and can be defined for a single period as Return on investment (%) = (Net profit / Investment) × 100

Calculation of Simple, Annualized and Compounded Returns

Simple Return

The simple return for a given period is calculated by dividing the profit earned by the initial investment. The formula for calculating simple return is given below:

Simple Return = (Current Value Initial Value) / Initial Value

Annualized Return

The annualized return is used to calculate the return rate over a period of one year. It is calculated by taking the geometric average of the returns over multiple years. The formula for calculating annualized return is given below:

Annualized Return = [(1+r1) x (1+r2) x (1+rn)]^(1/n) 1

Where r1, r2,, rn are the returns from each year.

Compounded Return

The compounded return is used to calculate the future value of an investment. It is calculated by taking the sum of the returns over multiple years and adding them to the initial investment. The formula for calculating compounded return is given below:

Compounded Return = Initial Value x [(1+r1) x (1+r2) x (1+rn)] Initial Value

Risks in Investments

Risk and return are an integral part of investing. The return that an investment generates cannot be seen in isolation from the risk that has to be assumed to earn it. A high return can be earned only if the investor is willing to take higher risk. Risk in an investment is the volatility and uncertainty in the returns and in the extreme case, the loss of capital invested.

Inflation Risk:

Inflation risk represents the risk that the money received on an investment may be worth less when adjusted for inflation. Inflation risk is also known as purchasing power risk. It is a risk that arises from the decline in the value of the security’s cash flows due to the falling purchasing power of money.

Interest Rate Risk:

Interest rate risk refers to the risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates. Bond prices and interest rates have an inverse relationship.

The relationship between rates and bond prices can be summed up as:

    1. If interest rates fall, or are expected to fall, bond prices go up.
    2. If interest rates rise, or are expected to rise, bond prices decline.
Business Risk:

Business risk is the risk inherent in the operations of a company. It is also known as operating risk, because this risk is caused by factors that affect the operations of the company. Common sources of business risk include cost of raw materials, employee costs, introduction and position of competing products, marketing and distribution costs. Not all businesses are affected by the same risks. Holding a diversified portfolio is an efficient way to diversify this risk.

Market Risk:

Market risk refers to the risk of the loss of value in an investment because of adverse price movements in an asset in the market. The price of an asset responds to information that impacts its intrinsic value.

Credit Risk:

Credit Risk or default risk refers to the possibility that a particular bond issuer will not be able to make expected interest rate payments and/or principal repayment. Debt instruments are subject to default risk as they have pre-committed pay outs. The ability of the issuer of the debt instrument to service the debt may change over time and this creates default risk for the investors.

Liquidity Risk:

Liquidity risk refers to an absence of liquidity in an investment. Thus, liquidity risk implies that the investor may not be able to sell his investment when desired, or it has to be sold below its intrinsic value, or there are high costs to carrying out transactions. All of this affects the realizable value of the investment.

Call Risk:

Call risk is specific to bond issues and refers to the possibility that a debt security will be called prior to its maturity. Call risk usually goes hand in hand with reinvestment risk, discussed below. Call risk is most prevalent when interest rates are falling, as companies trying to save money will usually redeem bond issues with higher coupons and replace them with issues with lower interest rates.

Reinvestment Risk:

Re-investment risk arises from the probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. The risk is that intermediate cash flows may be reinvested at a lower return as compared to the original investment.

Political Risk:

The risk associated with unfavorable government actions – the possibility of nationalization, changes in tax structures, licensing, etc. is called political risk. Because the Government has the power to change laws affecting businesses/securities, almost all businesses are exposed to political risk.

Country Risk:

Country risk refers to the risk related to a country as a whole. There is a possibility that it will not be able to honor its financial commitments. When a country defaults on its obligations, this can affect the performance of all other securities in that country as well as other countries it has relations with. Country risk applies to all types of securities issued in that country.

Measuring risk:

Measuring risk involves identifying, analyzing and assessing the potential for loss in an investment. This can be done by calculating the probability of an investor losing money on an investment, the expected return on the investment, and the potential downside of the investment. It can also involve assessing the potential volatility of an investment, including the potential for large losses or gains. Additionally, measuring risk involves assessing the potential for the investment to reach its expected return and any associated risks such as liquidity, taxes and currency fluctuation.

Concepts of Market Risk (Beta)-

Market risk, also known as systematic risk, is the risk that the value of an investment will decrease due to macroeconomic factors, such as changes in the overall stock market. Market risk is typically measured using beta, which is a measure of an investments volatility relative to the overall market. A beta of 1 means the investments volatility is equal to that of the market, while a beta of less than 1 indicates the investment is less volatile than the market.

Sensitivity Analysis to Assumptions

Sensitivity analysis is a method used to evaluate how different values of an independent variable (a factor that may influence a system) will affect a particular dependent variable (the outcome of the system). It is used to assess the robustness of the system and to identify areas of uncertainty and risk within the system. It is also used to determine what assumptions are most critical to the success of the system. Sensitivity analysis can be used to assess the sensitivity of a system to changes in key inputs and assumptions. This can provide insight into which assumptions are most important and should be monitored closely. The results of sensitivity analysis can be used to inform decisionmaking and inform future research.

Concept of Margin of Safety- 

In simple words, the margin of safety refers to the difference between value and price, when securities are bought at a price significantly below their intrinsic value. Higher the difference between value and price (i.e., a value higher than price), the higher the margin of safety.

Comparison of Equity Returns with Bond Returns-

The returns on equity investments are typically higher than those on bonds. This is because equity investments are subject to greater risks and rewards than bonds, which are generally considered to be safer investments. Equity investments have the potential to generate higher returns than bonds, but also have the potential for greater losses. Bonds are generally considered to be a safer investment because they are backed by a government or other organization and may have specific features that protect investors from certain risks. In addition, bonds generally have a fixed rate of return, which can make them a more attractive option for investors who are looking for a steady, reliable return.

Calculating risk adjusted returns

Risk adjusted returns are a measurement of the return on an investment after taking into account the associated risks. This can be done by calculating the expected return and subtracting the risk associated with the investment. The risk associated with the investment can be measured using different metrics, such as standard deviation, beta, or the Sharpe ratio. Each of these metrics takes into account the expected return and the risk associated with the investment. The higher the risk adjusted returns, the better the investment. Jensens Alpha.

Jensen’s Alpha is a measure of a portfolios excess return relative to a benchmark. It is calculated by subtracting the riskadjusted return of a portfolio from the expected return of the same portfolio. The Alpha measures the portfolios excess return above the expected return, which is an indication of the performance of the portfolio manager relative to the benchmark. The higher the Alpha, the better the portfolio manager has performed. Jensens Alpha can be used to evaluate the performance of a portfolio manager and can help investors make more informed decisions when selecting a portfolio manager.

Sharpe Ratio

Sharpe ratio measures the risk premium earned per unit of standard deviation. The risk premium earned is calculated by subtracting risk-free rate from the investment return. It is calculated as follows:

Sharpe Ratio= (Return on Portfolio – Risk-Free Rate)/ Standard Deviation

Treynor Ratio

Treynor ratio measures the risk premium earned per unit of Beta. The risk premium earned is calculated by subtracting the risk-free rate from the investment return. It is calculated as follows:

Treynor ratio = (Return on Portfolio – Risk-Free Rate)/Beta

Basic Behavioral Biases Influencing Investments

Behavioral biases are unconscious mental processes that can lead to irrational decisions when making investments. Common behavioral biases influencing investments are confirmation bias, herding, anchoring, and overconfidence. Confirmation bias is when investors search for and interpret information that confirms their preexisting beliefs. Herding is when investors follow the decisions of others and do not think for themselves. Anchoring is when investors become overly focused on a single piece of information and use it as the basis for their decisions. Overconfidence is when investors overestimate their own knowledge and ability and make decisions based on unrealistic expectations.

    1. Loss-aversion bias is a cognitive bias that causes investors to be more afraid of losses than they are of gains. It is based on the idea that losses are felt more strongly than gains, and as such, investors are more likely to avoid risks in order to protect against losses. This can lead to an irrational fear of taking risks and may lead to missed opportunities for greater returns. Lossaversion bias can be countered by focusing on the longterm potential gains of an investment and by understanding that accepting some risk is necessary to achieve greater returns.
    2. Confirmation bias is a cognitive bias in which people seek out and interpret information that confirms their preexisting beliefs and ignore or discount information that does not confirm those beliefs. This can lead to irrational decisionmaking and can lead to missed opportunities and suboptimal investments. To avoid confirmation bias, investors should actively seek out and consider information that contradicts their beliefs and challenge their assumptions. They should also seek out opinions from trusted sources who have no vested interest in the investment.
    3. Ownership bias is a cognitive bias in which investors give too much weight to investments they own or previously owned, and not enough weight to investments they do not own. This can lead to suboptimal decisionmaking and missed opportunities. To avoid ownership bias, investors should evaluate all potential investments objectively and not let personal biases influence their decisions. They should also remember that past performance is not necessarily an indicator of future performance.
    4. Gambler’s fallacy is a cognitive bias in which people assume that future outcomes are influenced by past outcomes. This can lead to irrational decisions when it comes to investing, such as assuming that a stock is due for a rise because it has recently fallen. To avoid gamblers fallacy, investors should remember that past events have no influence on future outcomes and should base their decisions on sound research and analysis.
    5. Winner’s curse: Tendency to make sure that a competitive bid is won even after overpaying for the asset. While behaviourally it is a win, financially, it may be a loss.
    6. Herd mentality is a cognitive bias in which people follow the decisions of the majority, even if they do not agree with them. This can lead to irrational investment decisions and missed opportunities. To avoid herd mentality, investors should make decisions based on their own research and analysis and not just follow the decisions of the majority.
    7. Anchoring is a cognitive bias in which people give too much weight to a single piece of information and use it as the basis for their decisions. This can lead to irrational decisionmaking and missed opportunities. To avoid anchoring, investors should consider all available information and data, not just one piece of information. They should also be aware of any biases they may have and try to look at the situation objectively.
    8. Projection bias is a cognitive bias in which people assume that future outcomes will be similar to past outcomes. This can lead to unrealistic expectations and can lead to missed opportunities. To avoid projection bias, investors should remember that the future is unpredictable and should base their decisions on sound research and analysis. They should also be aware of their own biases and try to look at the situation objectively.

Measuring liquidity of equity shares

Liquidity of equity shares can be measured using a variety of metrics. The most commonly used metrics include the bidask spread, the number of shares traded, and the trading volume. The bidask spread is the difference between the highest price a buyer is willing to pay for a stock and the lowest price a seller is willing to accept. The number of shares traded is the total number of shares bought and sold in a given period. The trading volume is the total number of shares traded during a given period. These metrics can be used to measure the liquidity of equity shares and to identify stocks that are more or less liquid.

    1. Stock turnover ratio: This ratio is calculated by dividing the number of shares traded during a given period by the number of outstanding free float shares. Mostly, the time frame used is one year. Free float shares refers to number of shares held by non-promoter group shareholders.
    2. Traded value turnover ratio: This ratio is similar to stock turnover ratio. It is calculated by dividing the traded value of the shares by the market capitalisation of the company.

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Chart Source– Tradingview.com

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