RISK RETURN

RELATIONSHIP
- DR. SHARYN BANGERA
RISK

 Variability in expected returns

 Risk indicates possibility that actual return may not be same as expected
return

 It refers to uncertainty involved in outcome of investment decision

 However, risk differs from uncertainty.

RISK

 Uncertainty cannot be quantified or measured, while risk can be

quantified.

 In risk you can predict the possibility of a future outcome while in

uncertainty you cannot predict the possibility of a future outcome.

 However, in uncertainty the outcome of any event is completely unknown,

and it cannot be measured or guessed

 Probability can be assigned to risk but not to uncertainty

RISK RETURN TRADEOFF

 Higher risk is associated with greater probability of higher return and lower
risk is associated with greater probability of smaller return

 This trade off between risk and return faced by an investor while
considering investment decisions is called risk return trade off

 Risk return tradeoff is an effort to create a balance between the desire for
lowest possible risk and highest possible return
RISK RETURN TRADEOFF
IMPORTANCE OF RISK RETURN
TRADEOFF

 It determines how aggressive an investor wants to be with assets included

in portfolio based on the awareness of his risk tolerance. A portfolio with
greater risk allows for higher returns but with a larger possibility of loss as
well.

 Important in developing an efficient frontier of portfolios of assets

maximising the returns while minimising the overall risk of the portfolio under
modern portfolio theory.
SYSTEMATIC RISK

 It cannot be diversified away

 Arises due to factors external to the organisation and affects the entire
market usually due to macroeconomic variables.
 This risk is caused by factors which are not under control of an organisation
or an individual
 Beta is a measure of systematic risk
 Total Risk = Systematic Risk + Unsystematic Risk
 Systematic risk can be managed through hedging strategies
SYSTEMATIC RISK

 It is also referred to as market risk, since it is risk associated with changes in

market related factors like interest rate, inflation, etc

 Certain types of market risks include – interest rate risk, inflation risk, liquidity
risk, equity price risk, currency risk, socio-political risk, country risk
UNSYSTEMATIC RISK

 This is risk which can be diversified away as it is specific to a security,

company or industry.
 It is also called company specific or firm specific risk
 This risk can be controlled as it can be minimised or eliminated by
diversification by creating a portfolio with securities negatively correlated
MEASURES OF RETURN

Types of
Return

Past Returns / Future Returns

Realised / Expected
Returns Returns

Holding Period Annualised Without With

Returns Returns Probability Probability
PAST RETURNS

 Holding Period Return – It is the total return earned by an investor during a

time period which includes the return from current income
(dividend/interest) and capital appreciation / gains.

HPRt = Dt + (Pt – Pt – 1)
Pt-1
HPRt - Holding period return for time t
Dt -Dividend received during time t
Pt - Price of security at the end of time t
Pt-1 -Price of the security at the beginning of time t
PAST RETURNS

 Annualised Returns – This makes securities comparable, as their returns are

expressed on a yearly basis.

Annualised return = HPRt x 12

Mt
Mt = Number of months in the holding period
EXPECTED RETURN

Based on past return

 Without probability – Expected return without probability is a simple

average of past returns

Ri = 𝜮 Ri
n
EXPECTED RETURN

 Expected return with probability – It is called weighted average, as

probability is assigned to each return

Ri = 𝜮 Pi Ri
MEASURES OF RISK

 Range
 Standard Deviation
 Variance
 Beta
BETA

 Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to

the market as a whole.

 A beta of 0 indicates that the portfolio or security is uncorrelated with the market.

 A beta less than 0 indicates that it moves in the opposite direction of the market.

 A beta between 0 and 1 signifies that it moves in the same direction as the market, with less
volatility.

 A beta of 1 indicates that the portfolio will move in the same direction, have the same volatility
and is sensitive to systematic risk.

 A beta greater than 1 indicates that the portfolio will move in the same direction as the market,
with a higher magnitude, and is very sensitive to systematic risk.
BETA

 Beta is used in the capital asset pricing model (CAPM), which calculates
the expected return of an asset based on its beta and expected market
returns.
REDUCTION OF RISK THROUGH
DIVERSIFICATION

 It helps to reduce unsystematic risk by conscious, logical and scientific

selection of securities which are added to the portfolio to

 Diversification can be achieved by changing the type of asset, industry,

company

 Well diversified portfolio has securities whose correlation with one another
is negative. This ensures that decline in value of one security is offset by
increase in value of the other security.
TYPES OF INVESTMENT RISKS

Investment risk is the likelihood or probability of incurring losses on the investment

Investment risk is further classified into –

1) Market Risk – Risk of investment declining in value, affects the entire market. Types of market risk are:

 Equity risk - risk of loss due to decline in market price of share

 Interest Rate Risk – In case of debt securities, the fall in value of the security due to rise in interest rate

 Currency risk – Losses due to fluctuations in forex rate

TYPES OF INVESTMENT RISKS

2) Concentration Risk – Portfolio concentrated in one type of investment, lack of

diversification

3) Credit Risk – Associated with investment in debt securities, risk of default by the
borrower

4) Liquidity Risk – Inability to convert security (sell) into cash at a fair price and in a
timely manner

5) Reinvestment Risk – Risk of reinvesting interest and principal payments received

at a lower interest rate. Will not apply if intention is to spend the interest or principal
money received.
TYPES OF INVESTMENT RISKS

6) Longevity Risk – Risk of outliving one’s savings, especially faced by retirees.

7) Horizon Risk – Risk of investment horizon getting shortened due to some

unforeseen event like loss of job. May force sale of securities even at a loss.

8) Inflation Risk – Loss in purchasing power, value of investment eroded

especially in case of fixed income debt securities and cash.

9) Business Risk – Risk of business failing – changing competitive scenario,

emergence of new technology
TYPES OF INVESTMENT RISKS

10) Financial Risk – Over-dependence on leverage, risk of non-payment of fixed interest

during recession

11) Regulatory Risk – Risk associated with changing regulations

12) Political / Country Risk – Risk of change in government, changing policies

13) Shortfall Risk – Possibility of portfolio not meeting financial goals