Section | Title | Description |
---|---|---|
11.1 | Understanding Return | Introduces types of return (absolute, CAGR, annualized), and how to compute and interpret returns over time. |
11.2 | Understanding Risk | Explains various types of risk (systematic and unsystematic), and introduces the concept of variability and standard deviation. |
11.3 | Risk-Return Trade-off | Highlights the inverse relationship between risk and expected return using graphical interpretation. |
11.4 | Measurement of Return | Details methods like holding period return, average return, and logarithmic return. |
11.5 | Measurement of Risk | Focuses on standard deviation, variance, beta, and other risk quantifiers, including formulas and real examples. |
11.6 | Beta and Systematic Risk | Defines beta, its relevance in portfolio context, and risk relative to the market index. |
11.7 | Alpha and Risk-adjusted Return | Discusses alpha, Sharpe ratio, and Jensen’s alpha for performance evaluation. |
11.8 | Diversification and Portfolio Risk | Explains how portfolio diversification reduces unsystematic risk through asset correlation. |
Return of Investment refers to the recovery of the original capital that was invested. It means the investor gets back the amount invested, without necessarily earning any profit.
Example:
You invested ₹1,00,000 in a fixed deposit and received ₹1,00,000 at maturity. This is a return of your investment—no profit, no loss.
Return on Investment refers to the gain or profit earned over and above the amount originally invested. It is usually expressed as a percentage and is used to measure the efficiency or profitability of an investment.
Formula:
ROI = (Gain from Investment − Cost of Investment) / Cost of Investment × 100
Example:
You invest ₹1,00,000 in a mutual fund. After one year, its value increases to ₹1,20,000.
Gain = ₹1,20,000 − ₹1,00,000 = ₹20,000
ROI = (20,000 / 1,00,000) × 100 = 20%
Summary:
– Return of investment ensures capital protection.
– Return on investment measures profitability over the capital invested.
Simple return calculates the overall percentage gain or loss from an investment, without adjusting for the time period.
Formula:
Simple Return = (Ending Value − Beginning Value) / Beginning Value × 100
Example: You bought a stock at ₹100 and sold it at ₹120.
=((120 − 100)/100) × 100 = 20%
Annualized return standardizes the return to a yearly basis. It is helpful when comparing investments held for different time periods.
Formula:
Annualized Return = [(1 + Total Return)1/n − 1] × 100
Example: Invest ₹1,00,000 and receive ₹1,21,000 after 2 years.
Total Return = (121000 − 100000) / 100000 = 0.21
=(1 + 0.21)^(1/2) − 1 = 10.02%
CAGR measures the average annual growth rate assuming reinvestment of returns each year. It’s ideal for long-term growth evaluation.
Formula:
CAGR = [(Ending Value / Beginning Value)1/n − 1] × 100
Example: Invest ₹50,000 and it grows to ₹80,000 in 3 years.
=(80000 / 50000)^(1/3) − 1 = 16.65%
All investments carry some level of risk. Understanding the different types of risks is essential to assess the impact on returns and to plan appropriate strategies for investment decisions.
Inflation risk refers to the possibility that rising prices will erode the purchasing power of money. If the rate of return on investment is less than inflation, the real return becomes negative.
Example: A bond yields 5% but inflation is 6%, resulting in a negative real return of –1%.
Interest rate risk affects fixed income securities. When interest rates rise, the price of existing bonds falls, impacting investors who want to sell before maturity.
Example: A bond with 7% coupon becomes less attractive when new bonds offer 8% returns.
This refers to the risk of a company performing poorly due to internal issues like management inefficiency or external factors like market competition, which impacts its profits and stock price.
Credit risk is the risk that a borrower (issuer of a bond) will default on repayment of principal or interest. It is common in corporate and non-sovereign debt instruments.
Example: A low-rated company may miss interest payments on its bonds.
Liquidity risk is the risk of not being able to sell an investment quickly at a fair price. This typically affects investments in assets with low trading volumes.
Example: Selling a small-cap stock may take time or require accepting a lower price.
Call risk occurs when a bond issuer repays the bond before maturity, typically when interest rates fall. Investors then have to reinvest at lower rates.
Reinvestment risk is the risk of having to reinvest interest or principal at a lower rate than the original investment, especially relevant in declining interest rate environments.
Political risk arises from changes in government policies, instability, or regulation that could negatively affect businesses and financial markets.
Example: Sudden taxation or policy changes can disrupt market expectations.
Country risk refers to the risk of investing in a country with economic instability, geopolitical tension, or weak financial systems. It affects foreign and global investments.
Example: An economic crisis in a country could lead to currency devaluation and stock market losses.
Market risk refers to the risk of losses in investments due to broad market movements. It is also known as systematic risk because it impacts all securities in the market and cannot be diversified away.
Examples include interest rate changes, inflation, economic downturns, political events, or global market shifts.
Beta (β) is a measure of a security’s volatility or sensitivity in relation to the overall market (typically the benchmark index like Nifty 50).
It helps investors understand how much risk an individual stock adds to a diversified portfolio.
Interpretation of Beta Values:
Beta (β) = Covariance (Stock, Market) / Variance (Market)
It is derived using regression analysis and statistical tools over historical data.
Example:
A stock has a beta of 1.2. If the Nifty 50 rises by 10%, the stock is expected to rise by 12%. Conversely, if the market falls by 10%, the stock may fall by 12%.
Portfolio managers use beta to construct portfolios suited to investor risk profiles. A high-beta portfolio suits aggressive investors; a low-beta portfolio suits conservative ones.
Sensitivity analysis is a technique used to assess how changes in key assumptions or variables impact the outcome of a financial model or investment decision. It helps investors evaluate the robustness of their projections under different scenarios.
In investment analysis, assumptions are made regarding factors such as revenue growth, profit margins, interest rates, or market conditions. Since these assumptions are uncertain, sensitivity analysis helps test how results would change if these assumptions vary.
Financial models often rely on forecasts. If assumptions change even slightly, the projected value of an investment may change significantly. Sensitivity analysis highlights the most influential variables and helps manage risk.
Example:
Suppose an equity research report values a company at ₹500 per share, assuming 10% annual revenue growth. A sensitivity analysis might show:
This helps analysts and investors understand the risk of relying heavily on a specific assumption, and to prepare for alternate outcomes.
Sensitivity analysis is especially useful in equity research, financial projections, and valuation exercises where decision-making is assumption-driven.
The margin of safety is the difference between the intrinsic value of a stock and its market price. It acts as a cushion for investors against errors in judgment, incorrect assumptions, or unexpected market conditions.
Investors use this principle to buy securities when they are trading significantly below their estimated intrinsic value, thus ensuring a buffer against potential downside risks.
Margin of Safety = Intrinsic Value − Market Price
The larger the margin, the safer the investment.
Example:
If a stock’s intrinsic value is ₹200, but it is currently trading at ₹150, then:
The concept was popularized by Benjamin Graham and is a core principle in value investing. It allows investors to make decisions that favor safety over speculation, especially when market prices are unpredictable.
Equity and bond investments provide different types of returns and serve different investment objectives. Understanding the difference helps investors make better portfolio decisions based on their goals and risk tolerance.
Returns from equities come from two sources:
Equity returns are market-driven and fluctuate based on company performance, investor sentiment, and economic conditions. Equities are more volatile but may offer higher long-term returns.
Example:
An investor buys a share at ₹200. After a year, the price rises to ₹280 and receives a dividend of ₹5.
Total return = ₹85 → Return % = (85 / 200) × 100 = 42.5%
Returns from bonds come mainly through:
Bonds are more stable than equities and provide predictable income. They are considered safer but generally offer lower returns compared to equities.
Example:
A ₹1,000 bond with a 7% coupon rate will pay ₹70 annually.
Return = 7%
Most investors combine both asset classes in their portfolio to balance growth and stability. The proportion depends on the investor’s financial goals and risk profile.
Risk-adjusted returns help evaluate how much return an investment generates relative to the amount of risk taken. This concept allows fair comparison of different investments regardless of their volatility or risk profile.
Two common measures used to calculate risk-adjusted returns are:
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Standard Deviation of Portfolio
Interpretation: A higher Sharpe Ratio indicates better risk-adjusted performance. It tells how much excess return was earned for the volatility endured.
Example:
Portfolio Return = 12%
Risk-Free Rate = 5%
Standard Deviation = 10%
Sharpe Ratio = (12 − 5) / 10 = 0.70
Treynor Ratio = (Portfolio Return − Risk-Free Rate) / Beta of Portfolio
Interpretation: Measures excess return earned per unit of systematic risk (beta). Useful when the portfolio is well-diversified.
Example:
Portfolio Return = 15%
Risk-Free Rate = 6%
Beta = 1.2
Treynor Ratio = (15 − 6) / 1.2 = 7.5
Alpha is the excess return of a portfolio relative to its expected return based on the market (CAPM model).
Interpretation: A positive alpha indicates the portfolio outperformed the market on a risk-adjusted basis. A negative alpha indicates underperformance.
Example:
If expected return = 10% and actual return = 12%, then Alpha = +2%
These measures help investors compare investment options not just by return, but by how efficiently they are achieved relative to the risk taken.
Behavioral biases are psychological patterns or tendencies that often cause investors to make emotional or illogical decisions. Identifying and managing these biases is critical for disciplined investing.
The following are some of the most common biases that influence investor behavior:
Fear of losses makes investors hold losing positions too long or sell winners too early.
Overvaluing owned assets, making it harder to sell or rebalance portfolios.
Believing that recent patterns must reverse, even if outcomes are independent.
Overpaying due to excessive optimism, especially in IPOs or hot stocks.
Following the crowd without independent analysis, leading to bubbles or crashes.
Fixating on a specific number like purchase price, ignoring new information.
Assuming recent trends will continue into the future without change.
Being aware of these biases helps investors stay rational and focused on facts, rather than emotions or popular opinion.
Legendary investors have shared powerful, timeless principles that continue to guide modern investment thinking. These insights emphasize discipline, patience, risk management, and emotional control — all critical to long-term success.
“Be fearful when others are greedy, and greedy when others are fearful.”
“The essence of investment management is the management of risks, not the management of returns.”
“Know what you own, and know why you own it.”
“Time is your friend; impulse is your enemy.”
“You can’t predict, but you can prepare.”
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid.”
“It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.”
These pearls of wisdom highlight that successful investing is more about mindset, consistency, and discipline than constant prediction or perfect timing.
Liquidity refers to how quickly and easily an equity share can be bought or sold in the market without significantly affecting its price. High liquidity allows investors to enter and exit positions with minimal impact.
Measuring liquidity is important because it affects trading efficiency, price stability, and investor confidence. Stocks with high liquidity offer lower transaction costs and tighter bid-ask spreads.
The average number of shares traded over a period. Higher volume generally indicates higher liquidity.
Ratio of traded volume to total outstanding shares. Indicates how frequently shares change hands.
The difference between the buying (bid) and selling (ask) price. Narrow spreads suggest better liquidity.
The availability of buy and sell orders at various price levels. Deeper markets can absorb larger trades.
Indicates the price impact of executing a trade of a specific size. Lower impact cost means better liquidity.
Example:
A stock like Reliance Industries trades millions of shares daily with a narrow bid-ask spread. It has high liquidity compared to a small-cap stock with low trading activity and wider spreads.
Highly liquid shares are ideal for both short-term traders and long-term investors, as they offer ease of execution and better price discovery. Illiquid shares carry higher transaction costs and price slippage.