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By hafeezrm
What is a risk?
Dictionary meaning of risk could be exposure, hazard, uncertainty, and chance. It
conveys a negative sense like possibility of incurring loss or misfortune or injury. It is the
probability that a hazard may turn into a disaster or, in other words, the probability that a
disaster may happen. Fortunately, risk can be foreseen and managed by various ways
such as (i) passing it on to others through insurance, guarantees and sub-contracting, (ii)
sharing it by formation of consortium or syndicates, or (iii) reducing it by diversification
of possessions or portfolio.
What is a return?
It means compensation, gain, income, reward, pay off or yield. It would be notice that the
word ‘return’ conveys a positive sense as against the word ‘risk’ which forewarns of
dangers.
Source: wikipedia.org
It is widely used as it conveys rate of return in % which can be easily compared with any
of the following called hurdle rates:
The internal rate of return is also useful in ranking competing investment projects.
There are, however, some problems with IRR when used alone.
• It neglects size of the project and treat big and small projects on equal footing.
• It presumed that cash flows are re-invested at a constant rate i.e. at the same IRR.
• When cash flows change from negative or positive, or vice versa, a unique
internal rate of return cannot be calculated
Usually, a financial calculator is used for finding out IRR but it can be found manually
through and error.
Both NPV and IRR are based on a discounted cash flow and lead to the same conclusion
when a single project is under consideration. However, both may differ in a decision-
context when there are mutually exclusive projects based on different durations or
different scales or both. In such cases, NPV is preferred.
The Modified Internal Rate of Return assumes that the positive cash flows are
immediately re-invested until the end of the project. To make these calculations, it is
common practice to use the weighted average cost of capitalas interest rate on the
positive cash flows. This is an improvement over IRR which assumes that positive
cashflows are immediately re-invested at the same rate as the IRR. This means that when
a project earns a very low rate of return say 2%, any income from the project is
reinvested at the same low rate. This is obviously an un-wise decision which is taken care
of by MIRR.
Dietz Method
As per Investopedia, this is a method of evaluating a portfolio's return based upon a time
weighted analysis. This can be modified to measure the return on the portfolio than a
simple geometric return method. This is because the Modified Dietz Method identifies
and accounts for the timing of all random cash flows while a simple geometric return
does not.
CAPM over-simplifies the investment conditions like no taxes, all investors having
identical investment horizons and opinions about expected returns, volatility and
correlation of available investments. CAPM differentiates between random risk and
market risk (also called systematic risk). Systematic risk is the risk that remains after no
further diversification benefits can be achieved. Such a risk can be measured through
using beta. If beta = 0, the investment is risk-free, if beta =1, the investment would give
the same return as a particular market, if beta >1, investment is riskier than market index,
if beta <1, investment is less riskier than market indication.
3. Other MODELS
Apart from this, there are other models like Fama And French Three Factor Model and
Multi-Factor Model. These are briefly described at the end of this hub under “Relevant
Terms”.
RELEVANT TERMS
At the same time, one should have a well-diversified port-folio (possession of a variety of
shares and bonds). It is recommended to diversify your investment in at least six or more
different stocks.
A piece of advice: Act quickly to get out of losing situation -'Never trade with money you
can't afford to lose'.