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Investment Risk Definition - Types | Risk & Return Analysis

Any intelligent investor analyzes the risk associated with it before investing in a stock. The return depends on the amount of risk. It is a fact that equity investing is more risky than other investments in the financial market. Actual return may differ from expected return and risk is expressed as the variability of earnings. Investment Management.

Risk and return cannot be separated from each other. Ignoring the risk and expecting only return is an age-old investment idea. Therefore, the investment process should be understood from both the risk and return aspects. It is generally understood that higher the risk, higher will be the return, but higher risk does not ensure higher return. Therefore, investors should analyze the risk factors as knowledge about risk helps in planning a portfolio with minimum risk.

Investment Risk Definition

According to the dictionary, risk is the possibility of loss or injury. Risk refers to variability in returns. It is a situation in which the actual return is less than the expected return. Hence, risk means deviation from expected return. Risk and uncertainty are integral to investment decisions. Technically, risk is a situation where the possible consequences of a decision are known. Uncertainty is a situation where probabilities cannot be predicted. Although risk and uncertainty are used interchangeably.

Business Environment Definition

The main force driving risk is "price and interest". Risk is also affected by external and internal factors. External factors that are uncontrollable are called systematic risk. The risk arising from the internal environment of the firm is known as disorganized risk.

Investment Risk Definition - Types | Risk & Return Analysis
Investment Risk Definition - Types | Risk & Return Analysis


Types Of Risk

There are two types of risk – systematic risk and unsystematic risk.

Systematic Risk

Unsystematic Risk

  • Business Risk
  • Financial Risk

Sytematic Risk

Systematic risk is a non-modifiable risk. It affects the entire market. Economic conditions, political conditions and social changes affect the securities market. Economic conditions, political conditions and social changes have such an effect on all securities that all stock prices move in the same direction. For example, during periods of high demand, the prices of all securities increase, indicating that the economy is moving towards growth.

The economic downturn that developed and developing countries in 2008 affected the stock markets across the world. The US economic crisis affected stock markets around the world. The economic, political, social and legislative factors are outside the control of the company or the investor. These cannot be ignored by the investor. This means that systematic risk cannot be avoided. Systematic risk is of the following types

Market Risk

Jack Clark Francis has defined market risk as that part of the total variability of return that arises due to the 'bull' and 'bear' components. Both tangible and intangible events can affect the market. During the 'bull' and 'bear' phase, the prices of more than 80 percent of the securities increase or decrease with the index of the stock market. When the securities market index moves up, it is called a 'bull market'. In a bull market, the index moves from a low point to a high point.

The beer market is the opposite of the bull market; The index moves from the highest point to the lowest point. Sock prices fall in the beer market. The forces affecting the stock market can be tangible or intangible.

(i) Tangible Events – These are real events such as war, earthquake, political uncertainty and decrease in the value of current currency.

(ii) Intangible Events – These are related to market psychology. This psychology is influenced by real events.

Interest Rate Risk

The interest rate risk is the variability in returns due to changes in the market interest rate. The interest rates for bonds, preference stock and equity stock change continuously. Interest rate risk can be reduced by investing in diversified securities. A government bond or bonds issued by a financial institution such as IDBI are risk-free bonds. Although government bonds offer a lower rate of interest, they prove to be better for the investor in the long run as they have an assured return. Therefore, interest rate risk can be avoided by buying government securities.

Generally, interest rate risk affects the following:

(i) Bond return

(ii) Cost of taking loan.

(i) Bond Return - Changes in interest rates occur due to changes in the monetary policy of the government and changes in the interest rates of Treasury bills and government bonds. These cause changes in bond prices and returns, resulting in changes in the investment pattern as well. Their summary is as follows:-

  • When the interest rate increases, new issuances come in the market with a higher rate of interest, thereby reducing the value of the old issuers.
  • When the interest rate falls, new bonds come into the market with a lower return, which increases their prices.
  • When the government brings new bonds of higher interest rate into the market, the investor prefers to invest in government bonds instead of private sector bonds.
  • Similarly, when there is a downturn in the stock market, investors invest in the bond market to get an assured rate of return.

(ii) Cost of Borrowing Fluctuating or fluctuating interest rate affects the cost of borrowing. This stock affects the traders and companies in the following way.

  • Most stock traders trade in the stock market by borrowing. Increase in cost affects the profitability of traders.
  • The interest rate affects not only securities traders but also companies. Because companies do their business with borrowed funds. A major part of the profit goes as interest on the borrowed capital.

Purchasing Power Risk

It is also known as inflation risk. This risk arises due to increase in the prices of goods and services. Inflation is responsible for the decrease in purchasing power. Inflation refers to the continuous increase in prices which is a serious risk for the long term investor. Purchasing power risk in India is linked to inflation and rising prices. An increase in prices leads to a decrease in the income of the investor so it is a risk to the investor. Inflation in India is classified as

  • (i) Demand-pull inflation 
  • (ii) Cost-push inflation.

(i) Demand-pull inflation- Under this, the demand for goods and services exceeds their supply.

(ii) Cost-push inflation- Under this, prices rise due to increase in costs. The increase in the cost of raw material, labor, equipment leads to an increase in the cost of production which results in an increase in the prices as well. The producer recovers the high cost of production from the consumers.

Unsystematic Risk

Unsystematic risk that affects the internal environment of the firm or industry is individual and unique to the firm or industry. Due to this the income of the company also changes. The latent risk arises due to following reasons.

  1. (i) Financial leverage.
  2. (ii) Managerial inefficiency.
  3. (iii) Technological changes in the production process
  4. (iv) Non-availability of raw material
  5. (v) Change in consumer preferences
  6. (vi) Labor problems.

The nature of the above mentioned components varies from industry to industry, and from company to company. These factors should be analyzed separately for each industry and firm. The financial leverage of companies - the debt-equity ratio of companies also varies. There are also risk factors involved in the method and nature of obtaining finance and also in repaying the loan. Changes in consumer preferences affect consumer products such as televisions, washing machines, refrigerators, etc. All these components constitute latent risk. There are two types of latent risk in a business organization.

  1. Occupational risk
  2. Financial risk

Business Risk

Business risk is related to the difference between revenue and income before tax and interest. This risk arises due to the liquidity environment of the business. The variability in projected operating income reflects business risk. For example, consider two companies 'A' and 'B'. The operating income of a company 'A' can increase to a maximum of 16 percent and a minimum of 8 percent. The operating income of Company 'B' can be either 14 per cent or 11 per cent. When the two companies are compared, it is found that Company 'A' has higher business risk as its operating income is more variable than Company 'B'.

Business risk can be divided into internal business risk and external business risk.

Business Risks

Internal Business Risk

  1. Fluctuations In Sales
  2. Research and Development
  3. Human Resource Management
  4. Fixed Cost
  5. Single Product

External Business Risk

  1. Social and Regulatory Factors
  2. Political Factors
  3. Business Cycles

Internal Business Risk

Internal business risk is related to the operating efficiency of the firm. Operational efficiency is reflected in the achievement of the company's objectives and fulfillment of the promises made to the investors. Operating efficiency is affected by the following factors

Fluctuations in Sales

A company has to maintain its sales level. In this regard, the company creates a large customer base with the help of various distribution channels. Different types of sales force are helpful in this regard. So, make the company your customers. Because after the loss of customers, the operating income of the company decreases.

Research and Development

Sometimes the product becomes obsolete. Management has to undertake research and development activities to get rid of the problem of obsolescence.

Human Resource Management

Human resource management also contributes to the operational efficiency of the firm. Frequent strikes and lockouts disrupt the production process resulting in increase in fixed capital cost. This also affects productivity. Productivity of labor can be increased by giving adequate incentives.

Fixed Cost

If the fixed cost is more in the total cost then it will create internal risk. Because during times of low demand for the product, the company cannot reduce fixed costs. High fixed costs affect the profitability of the firm.

Single Product

A firm producing a single product may have a high degree of internal business risk. A decrease in the demand for a single product can be fatal for the firm.

External Business Risk

External business risk arises due to circumstances that would have been beyond the control of the firm. is. The external environmental factors that affect the activities of the firm are

  1. Social and regulatory components
  2. Government's Monetary and Fiscal Policy
  3. Business cycle, or
  4. Social and Regulatory Factors – Price Control, Quantity Control,
  5. General economic environment

Import/export controls and environment control reduce the profitability of the firm. This risk is higher in public sector companies such as telecom, banking and transport. The government's tariff policy (for the telecom sector) has a direct impact on earnings.

Social and Regulatory Factors

Price control, quantity control, import/export control and environment control reduce the profitability of the firm. This risk is higher in public sector companies such as telecom, banking and transport. The government's tariff policy for the telecom sector has a direct impact on earnings.

Political Risk

This risk arises due to changes in the policies of the government. With the change in the ruling party, there is also a change in the policies.

Business Cycle

There may be change in the income of the company due to business cycle. Due to the economic slowdown, the production of many industries may decline. The impact of the business cycle varies from company to company. Sometimes companies are forced to close the business due to insufficient capital and customer base. These risk factors are external to the companies. And it's out of control.

Financial Risk

Financial risk is related to the capital structure of the company. The capital structure consists of equity capital and debt capital. Due to debt and preference capital, the company has to pay interest and dividend at a predetermined rate. The rest of the income remains available to the equity shareholders. The payment parity of interest affects the amount payable to investors, debt-finance increases the variability of the return and affects the expectations regarding the return of ordinary shareholders.

Financial risk and business risk are somewhat related to each other. Business risk is the relationship between revenue and EBIT analyzed in the income statement, while financial risk lies between EBIT and EBT.

Measurement of Risk

It is not enough to understand the nature of risk, but the investor or analyst must also have the ability to express it in quantitative terms. Expressing a stock's risk in quantitative terms makes comparison to other stocks easier. The measurement of risk may not be 100% accurate because risk arises due to many factors, such as social, economic, political and managerial. Measurement gives us an idea of ​​the possible amount of risk.

Tools For Measuring Risk

Measurement of Risk Probability Distribution, Standard Deviation, Regression Analysis, Beta, Alpha.

Variance

The value of the deviation represents the risk of a stock. Under the statistical measure of deviation, the returns of assets are used to measure risk. For example, if one wants to measure the risk associated with a stock, he has to consider the return of the stock over a period. Deviation from the mean value Measuring past risk using past data can be done through correlation.

When future risk is measured, the help of potential return is taken. If the variable has a normal distribution, then the theory of normal distribution can be applied to find the probability of deviation. Otherwise subjective estimation of probability will have to be made. For example, if the price of a stock is changing according to the normal distribution, then the mean return can be taken based on the past returns of the stock. After that, the probability of Sock return below the mean can be found using standard normal probability distribution.

If the stock price does not have a normal distribution, then subjective approximation of the probability of return is required. Using it, the investor can find out the expected return on the stock. The divergence is then calculated to reflect the potential stock return risk.

Standard Deviation

Standard Deviation is the most useful method to calculate variability. It is the measure of the values ​​of the variables around the mean. In other words, it is the square root of the sum of the squared deviations of variable values ​​from the mean divided by the number of observations

If we compare the stock of Company 'A' and Company 'B' (Table 1), we find that the potential return of both the companies is same but the spread is not the same. Company-A is more risky than company-B because its stock returns are uncertain. Company- and average stock of company-B is 12 but company-A is more risky than company-B.

Beta

Beta explains the relationship between stock return and index return. The important part of the regression equation is 3 or beta. If the regression line is exactly 45° then beta will equal 1+0.

(i) Beta = +1.0.

A one percent change in the market index return will also result in a one percent change in the stock return.

(i) Beta = +0.5

A change of one percent in the stock market return index will result in a 0.5 percent change in the stock return.

(iii) Beta = +2.0

A one percent change in the stock market index will result in a 2 percent change in the stock return.

A negative value of beta indicates that the stock return will move in the opposite direction to the market return. 

Alpha

The distance between the alpha-intersection and the horizontal axis is called (a) alpha. This is an indicator that stock returns are independent of market returns. A positive value of alpha is a good sign. A positive alpha value is an indicator of profitable returns.

Correlation Coefficient

  • Pij - E-R B
  • Rxi = xth possible return for security i.
  • Rxj = nth possible return for security j.
  • Rij = expected return for i and j.
  • Pxij = joint probability that Rxi and Rxj will occur simultaneously.
  • N = total number of joint possible returns.

This formula is usually calculated by the computer. The degree of correlation or correlation between securities indicates that diversification cannot reduce the risk of the portfolio below the risk level of the two securities. If there is a negative correlation between the securities, the portfolio risk can be reduced to a great extent. Correlation also shows the extent to which the portfolio has eliminated illiquid risk.

Protection Against Risk

Every investor wants protection from risk. This can be done with careful planning and understanding the nature of the risk. The following paragraph describes how an investor can protect himself from various types of risks.

Protection Against Market Risk

(i) An investor should study the behavior (fluctuations) of the stock price.

(ii) Can measure risk with the help of beta value and take decisions according to risk tolerance

(iii) The investor should hold the stock for a minimum period of time to take advantage of the rising trend of the market.

(iv) The investor should be careful about the buying and selling timing of the security. You should buy when prices are low and sell when prices are high.

Protection Against Interest Rate Risk

(i) Hold the investment till the maturity date. Selling in the middle can result in capital loss due to a fall in the interest rate.

(ii) Buy treasury bills and bonds of short maturity.

(iii) Invest in bonds with different maturities.

Protection Against Business and Financial Risk

(i) Analyze the strengths and weaknesses of the industry to which the company belongs.

Risk and Return Analysis

(ii) Analyze the profitability trend of the company.

(iii) Analyze the capital structure of the company.

Return

The objective of investment is to get return or return on funds invested in various financial assets. Attribution can take many forms. Investor gets interest on bonds, gets dividend on equity shares. The investor can generate capital gains from certain investments and get income in the form of rent from the house property.

Measurement of Returns

The techniques of measuring return or income can be classified as follows:

  • 1. Traditional Techniques.
  • 2. Modern Techniques.

Traditional Techniques

Under this technique, the income (yield) is calculated to measure the return of financial assets. The following formula is used to calculate the income-

Estimated Yield - Expected Cash Income/Current Price Of Assets

Actual Yield - Cash Income/Amount Invested

Earnings can be calculated for both bonds and stocks and shares.

Bonds

Bonds usually have a maturity period. Earnings on these can be calculated for the current period or the maturity period.

i) Current Yield

Example 1

An investor buys a 20 year bond at ? 100 and it carries a 120 annual return and its par value is  1,000. What is the current yield?

Solution:

Current Yield - Annual Return 120/Purchase Price 100 =1.20 or 12%

Example 2-An investor buys a ? 100 bond of 10 year maturity with  80 annual return. The par value is  1,000. Calculate current yield.

Solution:

Current Yield =80/1,000 = 0.08 or 8%

Note- Investor has bought the bond at par value

(ii) Yield to Maturity (YTM)

Example 1

An investor buys a bond in 2005 having a maturity in 2015, at  900. It has a maturity value of 10 years and par value of 1,000. Annual return is  90. Calculate current yield and yield to maturity?

(i) Current Yield = 90/900 = 0.10 = 10%

(ii) YTM= Average Annual Return/Average Investment

1+(RV- Bo)/ n   /   (RV - Bo)/2

where:

1 = Annual Interest

Rv = Redeemable value of the bond 

Bo = Price of the bond

N = Number of years to maturity

YTM = 90+(1,000 -900) /10  /  (1,000 +900)/2   = 100/950 =10.5%

Stocks and Shares

Return on equity is measured to calculate dividend income. Dividend can be estimated on the basis of expected income as well as actual income and earned income.

Estimated Yield - Expected Dividend/Current Share Price

Actual Yield - Dividend Received/Price Of Share In The Beginning Of The Period

Earning Price Ratio-E/P Ratio

These ratios are very important and sometimes they are also called capitalization rate. The E/P ratio is expressed as a percentage and represents the difference between the return on shares and their selling price.

 P/E Ratio

This method is used when the analyst wants to estimate the future price to know the fairness of the price.

Modern Techniques

Holding Period Yield (HPY) is a new technique for measuring returns. HPY can be used for any asset. For example, income from savings account, income from stocks, real estate and bonds etc. can be calculated with this technique. Its formula is as follows:- 

HPY = Income Payments Received + Capital Change for the Period / Original Investment at the Beginning of Period

HPY For Bonds

HPY = Income Payment during Period (T) + Change Price during Period (T) / Price at the beginning of Period (t)

OR

HPY = 1 (t)+P / P(t)

where:

  1. 1(t) = Bond's coupon interest during period t.
  2. t = Holding Period (time)
  3. P(t) =Bond's price at the beginning of the holding period.
  4. P = Change in bond price over the period.

Example 1

A company's bonds are bought at 1,000. Its coupon interest rate is 9% p.a. It is retained for a holding period of one year and sold for  1,100. Find out HPY.

Solution:

HPY = 90+100 / 1,000 = 190/1000 - 0.19

Return & Statistical Methods

Return can be measured either through Central Tendency or Dispersion

Central Tendency

There are many methods of central tendency such as mean, median and mode. The mean is used to measure the average return. The median is useful for finding the middle value while the bhuyishthaka is the number that occurs maximum number of times. Each of these methods can be used to find the average value. The most appropriate method for the HPY distribution is the mean (Cenri per Centra Ten)

The Holding Period Yield (HPY) is an important method to calculate the return. It is usually determined by means of central tendency or dispersion from probability distribution. goes. For example, a typical HPY distribution for 10 years shows the following:

Frequency Distribution of HPY

0.10

0.00

0.10

0.20

0.30

0.10

0.50

0.40

0.10

0.00

-------

1.80

-------

x = 1.80

Mean = Ex / n = 1.8/10 =18

Median =  20

Mode = 10

Mean of any probability distribution is called its "expected value". The mean of HPY probability distribution is usually called is "expected return." To summarise, "mean" is the best measure to calculate returns.

Measure of Dispersion

Dispersion method helps in estimation of risk and return on investment. The greater the potential dispersion, the greater the risk. The simplest way to calculate the dispersion is the range. Although the range is of limited importance. It is suitable in case the samples are small. The best and most effective method is the standard deviation.

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