RISK AND RETURN

Selection of suitable avenue for investment depends on various factors. An integrated approach on the part of an investor is necessary in this regard. Any rational investor before investing, analysis the risk associated with the particular stock. The actual return he receives from a stock may vary from his expected return and the risk is expressed in terms of variability of return. Investor in general would like to analyse the risk factors and a thorough knowledge of the risk helps him to plan his portfolio in such a manner so as to minimize the risk associated with the investment.

RETURN
The return means the profit earned on the capital invested in the business. It is expressed as a percentage. The return on an investment is the profit required to establish and maintain the investment. Investors invest their funds to make a profit which is known as a return. The goal of the investment is to maximise the investors utility and maximising expected returns. Return is a precise statistical term and it is measurable. There are different measurement techniques, some are :

Types of Returns
1) Holding Period Return: In the typical security investment, an investor purchases and pays for the security at the beginning of the holding period and then sells at the end of the time period. During the holding period, he receives interest/dividend/bonus etc. Thus the holding period return on the investment is equal to:

Returns = [ (Selling Price Purchase Price + Div-Int-Bonus ) / Purchase Price ] x 100

2) Annualized Returns: Annualised returns are returns during a specific year or period. For eg. holding period is just 2 months than statistically it will be : Returns = [ (Selling Price Purchase Price + Div-IntBonus ) / Purchase Price ] x 100 x (12 / 2)
3) Expected Returns: Under conditions of risk, investors realize that an investment can actually yield a number of different returns and they are able to associate or estimate each possible returns which its respective probability of occurring. These probabilities may be determined using precise mathematical methods and past data or by using subjective judgment assessments.

Probability distributions of returns represent the total risk of the investment. The larger and more spread out the distribution the greater the risk of the investment and vice versa. The expected return is calculated by using the following formula:

Where ,

E(R) = the expected return on an investment n = number of possible returns Ri = the ith possible return Pi = The probability of ith return Ri

Thus, the expected rate of return is equal to the sum of each possible return times its probability of occurrence.

RISK
Risk is a chance of loss. Investment risk exists in almost all types of Investments. In case of every investment, there is a chance of loss. It may be loss of interest, dividend or principal amount of investment. Like returns, which is quantitatively measured instrument, Risk is not precise quantified. The various types of risks may be classified as follows :

1. Default Risk: Issuer company going bankrupt 2. Business Risk: Particular business falling for eg. mobile phone caused concerns to Landline phone business 3. Financial Risk: Companys financial problems 4. Purchasing Power Risk: Inflation 5. Interest Rate Risk 6. Market Risk 7. Liquidity Risk 8. Systematic and Unsystematic Risk: Also called Market Risk which is inherent to the entire market. For eg. Interest Rates, War, recession etc. On the other hand, unsystematic risk is company or industry specific risk.

Measurement of Risk
The risk associated with a stock refers to the variability of its rate of return. The investors should be able to quantify and measured risk. The probability distribution of the possible returns on the investment represents an investments total risk. The following are different methods of measuring risk.

Range: Simplest measure of the dispersion of a distribution is the range of returns. The range is equal to the highest value of the distribution less the lowest possible value in a distribution.

2. Variance: Variance is the better measure of

risk than the range. It takes into account the derivations of all possible returns from their mean or expected value. Var =
3. Standard Deviation: Standard deviation

has statistical properties that are useful for computing probabilities. The higher the standard deviation, the higher the risk.

General Risk-Return Relations

Risk are return are probably the two main concerns of all investors and we might say that they are two sides of the investment coin. The relationship between the two for an investment is that investors will want more return from investment that have greater risk. Thus, investment with higher risk levels should have higher levels of returns. When it comes risk and return, equity shares are treated as highest risky and highest return instruments whereas instrument issued by government is treated as lowest return and almost zero risky.

Investors make investment decisions designed to maximize their expected utility. The expected utility of an investment means the total benefit that an investor expects to receive from the investment. We assume that investors seek to maximize expected utility. For this purpose, investors must find the combination of risk and expected return that yields the most satisfaction or high level of utility. Investors could regard the risk-return trade-off in three distinct ways as follows:

Investors could be risk seeking: higher risk for increment of returns Investors could be risk indifferent: higher risk with higher investments Investors could be risk averse: greater increment of returns to compensate for each additional unit increase in risk.

Understanding the measuring return and risk is fundamental to the investment process and increases an awareness of the investment problem. Most investors are risk average. They must be aware of the risk in different investments. To have a higher return the investor should be able to accept the fact that he has to be faced with greater risks. The investors attempt to maximize their wealth at the minimum risk. When risk is established, it can be reduced to a minimum but it cannot be completely eliminated. Risk and return are related. The higher the risk a person is willing to accept the better the returns he is able to achieve.

Practical Questions - Returns

Q. 1: Calculate the returns in the following example.
A Ltd
Price as on 31-03-2005 Price as on 31-03-2006 Dividend for the year 20 15 1

B Ltd
10 15 1

Q. 2: Mr. Ashok purchased 100 shares of Zee Ltd four years ago at Rs. 50 each. The company paid the following dividends
Year 1 Year 2 Year 3 Year 4

DPS

3.5

2.5

3.5

The current market price of the share is Rs. 58. What rate of return has he earned on his investment if he sells the shares now. Calculate Holding Period Returns and Annualised Returns.