📘 Chapter 11: Fundamentals of Risk and Return – Outline
| 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. |
📘 11.1 Concept of Return of Investment and Return on Investment
📌 Return of Investment
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 (ROI)
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.
📘 11.2 Calculation of Simple, Annualized and Compounded Returns
📊 Simple Return
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
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%
📈 Compounded Annual Growth Rate (CAGR)
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%
📘 11.3 Risks in Investments
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
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
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.
📌 Business Risk
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
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
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
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
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
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
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.
📘 11.5 Concepts of Market Risk (Beta)
📌 What is Market Risk?
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.
📌 What is Beta?
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 = 1: Stock moves in line with the market.
- Beta > 1: Stock is more volatile than the market.
- Beta < 1: Stock is less volatile than the market.
- Beta = 0: No correlation with market movement.
- Beta < 0: Moves in opposite direction to market (very rare).
📌 Formula to Calculate Beta
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.
📘 11.6 Sensitivity Analysis to Assumptions
📌 What is Sensitivity Analysis?
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.
📌 Why It Matters
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:
- If growth is 8%, fair value drops to ₹470
- If growth is 12%, fair value rises to ₹530
This helps analysts and investors understand the risk of relying heavily on a specific assumption, and to prepare for alternate outcomes.
📌 Applications in Research
- Used in Discounted Cash Flow (DCF) models to test output against input variability
- Helps in scenario planning and risk mitigation
- Assists in identifying key drivers of business performance
Sensitivity analysis is especially useful in equity research, financial projections, and valuation exercises where decision-making is assumption-driven.
📘 11.7 Concept of Margin of Safety
📌 What is Margin of Safety?
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.
📌 Formula
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:
- Margin of Safety = ₹200 − ₹150 = ₹50
- Percentage Margin of Safety = (50 / 200) × 100 = 25%
📌 Importance for Investors
- Provides protection against analytical errors or wrong assumptions
- Reduces downside risk in volatile markets
- Encourages value investing discipline and long-term thinking
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.
📘 11.8 Comparison of Equity Returns with Bond Returns
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.
Equity Returns
Returns from equities come from two sources:
- Capital appreciation: Increase in share price over time
- Dividends: Periodic payouts made by companies to shareholders
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%
Bond Returns
Returns from bonds come mainly through:
- Coupon payments: Fixed interest paid periodically
- Capital preservation: Return of the face value at maturity
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%
📌 Summary of Comparison
- Risk: Equities are high-risk; bonds are low-risk
- Return: Equities offer potentially higher returns; bonds provide fixed income
- Volatility: Equities are volatile; bonds are more stable
- Investor Suitability: Equities suit long-term, growth-focused investors; bonds suit income-focused or conservative investors
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.
📘 11.9 Calculating Risk-Adjusted Returns
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:
1️⃣ Sharpe Ratio
📌 Sharpe Ratio Formula
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
2️⃣ Treynor Ratio
📌 Treynor Ratio Formula
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
3️⃣ Alpha
📌 Alpha (α)
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.
📘 11.10 Basic Behavioral Biases Influencing Investments
📌 What are Behavioral Biases?
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:
🔻 Loss-aversion bias
Fear of losses makes investors hold losing positions too long or sell winners too early.
🔁 Ownership bias
Overvaluing owned assets, making it harder to sell or rebalance portfolios.
🎲 Gambler’s fallacy
Believing that recent patterns must reverse, even if outcomes are independent.
🎯 Winner’s curse
Overpaying due to excessive optimism, especially in IPOs or hot stocks.
👥 Herd mentality
Following the crowd without independent analysis, leading to bubbles or crashes.
📌 Anchoring
Fixating on a specific number like purchase price, ignoring new information.
🔮 Projection bias
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.
📘 11.11 Some Pearls of Wisdom from Investment Gurus across the World
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.”
— Warren Buffett
“The essence of investment management is the management of risks, not the management of returns.”
— Benjamin Graham
“Know what you own, and know why you own it.”
— Peter Lynch
“Time is your friend; impulse is your enemy.”
— John C. Bogle
“You can’t predict, but you can prepare.”
— Howard Marks
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid.”
— Charlie Munger
“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.”
— George Soros
These pearls of wisdom highlight that successful investing is more about mindset, consistency, and discipline than constant prediction or perfect timing.
📘 11.12 Measuring Liquidity of Equity Shares
📌 What is Liquidity?
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.
📌 Common Measures of Liquidity
📊 Trading Volume
The average number of shares traded over a period. Higher volume generally indicates higher liquidity.
🔁 Turnover Ratio
Ratio of traded volume to total outstanding shares. Indicates how frequently shares change hands.
💹 Bid-Ask Spread
The difference between the buying (bid) and selling (ask) price. Narrow spreads suggest better liquidity.
📈 Market Depth
The availability of buy and sell orders at various price levels. Deeper markets can absorb larger trades.
📉 Impact Cost
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.
