11. Fundamentals of Risk and Return

Table of Contents

Concept of Return of Investment and Return on Investment

Return on Investment (ROI) is a financial metric used to evaluate the profitability of an investment. It is calculated by dividing the net profit or gain from an investment by the cost of the investment, and expressing the result as a percentage.

ROI = (Gain from Investment – Cost of Investment) / Cost of Investment

Return of Investment (ROI) refers to the return of the initial investment amount, without taking into consideration any gains or losses made on the investment. It is simply the return of the original capital invested.

ROI and ROI are two different concepts, and it is important to understand the difference between the two when evaluating an investment opportunity. While ROI measures the profitability of an investment, ROI measures the return of the initial investment amount.

Calculation of Simple, Annualized and Compounded Returns-

Type of Return Description Formula
Simple Return The profit earned divided by the initial investment. Simple Return = (Current Value – Initial Value) / Initial Value
Annualized Return The return rate over a period of one year calculated by taking the geometric average of the returns over multiple years. Annualized Return = [(1+r1) x (1+r2) x … (1+rn)]^(1/n) - 1
Compounded Return The future value of an investment calculated by taking the sum of the returns over multiple years and adding them to the initial investment. Compounded Return = Initial Value x [(1+r1) x (1+r2) x … (1+rn)] – Initial Value
Types of Risks in Investments

Types of Risks in Investments

Measuring Risk:

    • Calculating the probability of losing money on an investment
    • Assessing the expected return and potential downside of the investment
    • Assessing potential volatility of the investment, including the potential for large losses or gains
    • 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 or systematic risk is the risk that the value of an investment will decrease due to macroeconomic factors
    • Market risk is measured using beta, which is a measure of an investment’s volatility relative to the overall market

Sensitivity Analysis to Assumptions:

    • Method used to evaluate how different values of an independent variable will affect a particular dependent variable
    • Used to assess the robustness of the system and to identify areas of uncertainty and risk within the system
    • Used to determine what assumptions are most critical to the success of the system
    • Can be used to assess the sensitivity of a system to changes in key inputs and assumptions

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-

Equity investments generally have higher returns compared to bonds because they involve higher risks and rewards. However, equity investments also carry the potential for greater losses. Bonds, on the other hand, are generally considered safer because they have a fixed rate of return and are backed by a government or organization that offers some protection to investors.

Calculating risk-adjusted returns

Risk-adjusted returns are a way of measuring the return on an investment after taking into account the associated risks. This can be calculated by subtracting the risk associated with the investment from the expected return. Different metrics, such as standard deviation, beta, or the Sharpe ratio, can be used to measure the risk associated with an investment. Higher risk-adjusted returns are generally better.

Jensen’s Alpha measures a portfolio’s excess return relative to a benchmark and can be used to evaluate the performance of a portfolio manager. It is calculated by subtracting the risk-adjusted return of a portfolio from the expected return of the same portfolio. The higher the Alpha, the better the portfolio manager has performed.

The Sharpe Ratio measures the risk premium earned per unit of standard deviation. The risk premium is the excess return earned over the risk-free rate of return, and the standard deviation measures the volatility of the investment returns.

The Treynor Ratio measures the risk premium earned per unit of Beta. Beta measures the volatility of the portfolio relative to the market. The risk premium is the excess return earned over the risk-free rate of return. The higher the Treynor Ratio, the better the portfolio has performed relative to its level of market risk.

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.

Type of Risk Description Example
Inflation Risk The risk that the money received on an investment may be worth less when adjusted for inflation. An investor buys a bond with a fixed interest rate of 4%, but inflation rises to 5%. The investor's purchasing power decreases.
Interest Rate Risk The risk that bond prices will fall in response to rising interest rates, and rise in response to declining interest rates. An investor buys a bond with a fixed interest rate of 4%. Interest rates rise to 5%, and the bond's price falls.
Business Risk The risk inherent in the operations of a company. A company's new product launch fails, resulting in a decline in revenue and stock price.
Market Risk The risk of the loss of value in an investment because of adverse price movements in an asset in the market. A stock price falls due to negative news about the company's financial performance.
Credit Risk The possibility that a particular bond issuer will not be able to make expected interest rate payments and/or principal repayment. A company defaults on its bond payments, causing bondholders to lose their investment.
Liquidity Risk An absence of liquidity in an investment. An investor cannot sell their shares in a company because there are no buyers in the market.
Call Risk The possibility that a debt security will be called prior to its maturity. A company redeems its bond issue with higher coupons and replaces them with issues with lower interest rates.
Reinvestment Risk The probability that income flows received from an investment may not be able to earn the same interest as the original interest rate. An investor receives cash flows from a bond with a high interest rate, but reinvests them at a lower rate due to changing market conditions.
Political Risk The risk associated with unfavorable government actions. The government changes tax laws, causing a company's profits to decrease.
Country Risk The risk related to a country as a whole. A country defaults on its financial obligations, causing its securities to lose value.
Behavioral Bias Description Potential Consequences Ways to Counteract
Confirmation Bias Seeking and interpreting information that confirms preexisting beliefs Missed opportunities, suboptimal investments Actively seek out and consider information that contradicts beliefs, challenge assumptions, seek opinions from trusted sources with no vested interest
Herding Following the decisions of others without thinking for oneself Irrational investment decisions, missed opportunities Make decisions based on own research and analysis, not just follow the majority
Anchoring Giving too much weight to a single piece of information Irrational decision-making, missed opportunities Consider all available information and data, not just one piece of information, be aware of personal biases, try to look at the situation objectively
Overconfidence Overestimating one's own knowledge and ability Irrational decision-making based on unrealistic expectations Acknowledge limitations, seek out diverse perspectives, consider alternative viewpoints
Loss-Aversion Bias Fear of losses outweighing potential gains Missed opportunities for greater returns, irrational fear of taking risks Focus on long-term potential gains, understand that accepting some risk is necessary to achieve greater returns
Ownership Bias Giving too much weight to investments owned or previously owned Suboptimal decision-making, missed opportunities Evaluate all potential investments objectively, not let personal biases influence decisions, remember that past performance is not necessarily an indicator of future performance
Gambler's Fallacy Assuming future outcomes are influenced by past outcomes Irrational decision-making based on past events having no influence on future outcomes Remember that past events have no influence on future outcomes, base decisions on sound research and analysis
Winner's Curse Overpaying for an asset to ensure a competitive bid is won Financially it may be a loss despite the behavioral win Make decisions based on sound financial analysis and avoid overpaying for an asset

Measuring liquidity of equity shares

Measuring liquidity of equity shares is crucial for investors to evaluate the ease and speed with which they can buy or sell shares in the market without impacting the price. While there are various metrics to measure liquidity, some commonly used ones include the bid-ask spread, the number of shares traded, and the trading volume.

The bid-ask 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. A smaller bid-ask spread typically indicates higher liquidity, as it implies there are more buyers and sellers willing to trade at similar prices.

The number of shares traded is the total number of shares bought and sold in a given period, while trading volume refers to 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.

In addition to these metrics, stock turnover ratio and traded value turnover ratio are other commonly used measures to assess liquidity. The stock turnover ratio is calculated by dividing the number of shares traded during a given period by the number of outstanding free float shares, usually over a one-year time frame. Free float shares refer to the number of shares held by non-promoter group shareholders.

On the other hand, the traded value turnover ratio is calculated by dividing the traded value of the shares by the market capitalisation of the company. This ratio is similar to the stock turnover ratio but takes into account the market value of the company as well.

By understanding and using these liquidity metrics, investors can make informed decisions about investing in stocks that align with their investment goals and risk tolerance.

Mock-Test-

0 votes, 0 avg
9

NISM Series-XV: Research Analyst Certification

CHAPTER 11: FUNDAMENTALS OF RISK AND RETURN

1 / 45

1. Which risk refers to the absence of liquidity in an investment?

2 / 45

2. Which measure of return accounts for the time value of money and reinvested returns?

3 / 45

3. Which risk is inherent in the operations of a company?

4 / 45

4. Which type of return considers the investment period and allows for comparison?

5 / 45

5. What is the main measure of liquidity in the traded value turnover ratio?

6 / 45

6. Which risk refers to the risk of the loss of value in an investment due to adverse price movements in the market?

7 / 45

7. Which risk refers to the possibility that a bond issuer will not be able to make expected interest rate payments and/or principal repayment?

8 / 45

8. What is systematic risk?

9 / 45

9. What is the gambler's fallacy?

10 / 45

10. Is business risk also known as operating risk?

11 / 45

11. Which bias involves interpreting information to confirm existing beliefs?

12 / 45

12. What is Return on Investment (ROI) for a single period?

13 / 45

13. Which measure calculates the risk premium per Beta?

14 / 45

14. What does ownership bias reflect?

15 / 45

15. What is reinvestment risk?

16 / 45

16. When should one be cautious while using ROI numbers?

17 / 45

17. What is political risk?

18 / 45

18. Is dividend a small component of the total returns from equity?

19 / 45

19. What does a higher Jensen's Alpha indicate?

20 / 45

20. What is loss-aversion bias?

21 / 45

21. Which risk arises from the decline in the value of security's cash flows due to the falling purchasing power of money?

22 / 45

22. What is the time frame typically used for calculating the stock turnover ratio?

23 / 45

23. What is the relationship between interest rates and bond prices?

24 / 45

24. What does projection bias involve?

25 / 45

25. What does the Treynor Ratio measure?

26 / 45

26. What is the formula for calculating Compound Annual Growth Rate (CAGR)?

27 / 45

27. Which bias leads to the search for information that confirms one's beliefs?

28 / 45

28. What is unsystematic risk?

29 / 45

29. What is the objective of stock exchanges regarding liquidity?

30 / 45

30. What is call risk?

31 / 45

31. What is anchoring bias?

32 / 45

32. What happens to reinvestment risk when interest rates rise?

33 / 45

33. How is stock turnover ratio calculated?

34 / 45

34. Which measure of return is the accepted standard in financial markets?

35 / 45

35. Which measure factors in the difference in risk?

36 / 45

36. What does herd mentality in investing refer to?

37 / 45

37. Which bias can prevent investors from benefiting from market corrections?

38 / 45

38. What is country risk?

39 / 45

39. What does the Sharpe Ratio measure?

40 / 45

40. What does the traded value turnover ratio measure?

41 / 45

41. Which shares are considered in the calculation of stock turnover ratio?

42 / 45

42. What is the calling feature in bonds?

43 / 45

43. What does the winner's curse involve?

44 / 45

44. What is Jensen's Alpha?

45 / 45

45. What is the purpose of investment for an investor?