Risk & Return, a trade off
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.
Risk & Return Trade Off
When one says high risk, high returns, it means that chance of getting high returns are most uncertain or lower. To be blunt, an investor can get high return if he or she is willing to sustain a total losse like in a lottery.
One may purchase a share in the stock-exchange in the hope of making a big profit over a short period of time. This is not investing but gambling as there is no guarantee that one will get the desired returns. Some shares in the past have shown a tremendous growth but such occurrences are rare.
Risk & Return
Two Major Investment Soundness Indicators
1 - Internal Rate of Return (IRR)
Simply put, IRR is a rate of return just like Annual Compound Growth Rate or Annualized ROI (Return on Investment). To be formal, it is a rate of discount which equates the future cash flow to the present investment or opportunity.
It is widely used as it conveys rate of return in % which can be easily compared with any of the following called hurdle rates:
- Average Weighted Cost of Fund
- Opportunity cost
- Desired Rate of Return
- Market Rate.
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.
2- Net Present Value
NPV works out present value of a future income stream. It discounts future income of each year by multiplying by a corresponding Present Value Interest Factor (PVIF). It means if some income is expected in fourth year, the relevant PVIF would also be of the fourth year. Besides, PVIF is decided keeping in view a discount rate based on the same factor used for comparing IRR such as:
- Average Weighted Cost of Fund
- Opportunity cost
- Desired Rate of Return
- Market Rate.
3 - NPV and IRR compared:
While IRR is a rate, NPV is a value based on a particular discount rate. (NPV is also known as dollar-weighted rate of return).
Applying NPV using different discount rates will result in different values and consequently different decisions. The IRR method always gives the same results and decision would have to be made keeping in view the factors cited above.
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.
Shares and Bond
Recent variations in valuation methods
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.
The Adjusted Present Value (APV) Method
In this method, first a base-case is found by calculating NPV based entirely on equity finance, not a shred of debt. Then this base is adjusted with for tax-benefits through debt financing. In essence, APV valuation is the same as discounted cash flow but there would be some adjustment due to different capital structure. It is designed for projects with debt. The formula is :
APV = Base-case NPV + PV of financing effect
The Profitability Index (PI) Method
This is modeled after the NPV Method. It measures the total present value of future cash inflows divided by the initial investment. This method tends to favor smaller projects and is best used by firms with limited resources and high costs of capital. This is the same as Cost-Benefit Ratio used for appraising public welfare project.
The Bailout Payback Method
A variation of the Payback Method. It includes the ‘junk’ value of any equipment purchased in its calculations
The Real Options Approach.
It allows flexibility and encourages constant reassessment based on the riskiness of the project's cash flows. It takes into account various business opportunities in the form of option.
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.
Capital Asset Pricing Model
For an investor, it is imperative to find out how much risk he or she is taking. There are various technique to work-out level of risk. Some are briefly stated below:
CAPITAL ASSET PRICING MODEL (CAPM)
It is an important technique to observe the relationship between risk and reward. It is a model for pricing of security. A security market line (SML) is drawn which shows riskiness of a security or share. It guides an investor how much return to expect given a certain risk in a particular stock market. In other words, it proves the old maxim, “Higher the Risk, Higher the Reward”. It shows the reward-to-risk ratio for any security compared to overall market risk. According to CAPM expected return on a security or portfolio should be equal to (i) a rate on a risk-free security in a specific market and (ii) a risk premium.
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.
2. ARBITRAGE PRICE MODEL (APM)
Another model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. Often considered as an alternative to CAPM. The difference is that APM is more general and flexible as it takes into account many factors such as inflation, industrial production, prevailing interest rates. In this way, CAPM would be termed as a special case of APM with one factor of market risk premium.
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”.
It shows efficiency or return in excess of the compensation for the risk borne. It assesses managers’ performance. Briefly stated, Alpha is a risk-adjusted measure of ROI.
The amount of risk that the stock contributes to the market portfolio. A widely fluctuating stock will have a high standard deviation as well as a high beta.
Market Efficiency Hypothesis
It is a presumption that stocks would always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.
Fama and French _ Three Model Factor
The basic idea of the approach is the use of a time series (first pass) regression to estimate betas and the use of a cross–sectional (second pass) regression to test the hypothesis derived from the CAPM
A fundamental analysis method of analyzing a firm's costs of capital as it uses additional financial leverage, and how that relates to the overall riskiness of the firm. The measure is used to summarize the effects this type of leverage has on a firm's cost of capital (over and above the cost of capital as if the firm had no debt).
A financial model that employs multiple factors in its computations to explain market phenomena and/or equilibrium asset prices. The multi-factor model can be used to explain either an individual security or a portfolio of securities. It will do this by comparing two or more factors to analyze relationships between variables and the security’s resulting performance.
An investor in securities (shares and bonds) is faced with two types of risk: Market Risk and Inflation Risk. A good investor should know how much risk to take. First, risk should be identified, second it should be assessed and third it should be managed. Points to be pondered at are (i) How much one is willing to lose, (ii) Is there enough liquidity to buy and sell promptly, (iii) determination of profit or loss limits, (iv) buying stock only an acceptable price level and (v) selling when the price reaches at a predetermined level corresponding to the profit target. These are nothing but prudent guidelines to save the investor from losses.
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'.
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