RISK AND RETURN
FIGURE 15.1 2)3+ Expected Return
Risk High Low High Derivatives Common Shares Preferred Shares Debentures Bonds Treasury Bills ./-).!,
So far we have looked only at a simple rate of return (i.e., the nominal rate of return). For example, if a one-year GIC reports a 6% return, this 6% represents the nominal return on the investment. However, investors are more concerned with the real rate of return – the return adjusted for the effects of inflation.
Example: !
INmATION INVESTMENT
The approximate real rate of return is calculated as: 2EAL
The client in the above example earned a real rate of return of 8% on the investment, calculated as:
2EAL
This calculation, however, does not take tax into account. If you assume that the return is 100% taxable, an investor with a return of 10%, having a tax rate of 30%, would have an after- tax return of 7%, calculated as 10% X (100% – 30%). Taking inflation into account (at 2%), the investor’s approximate real return would be 5% (7% – 2%).
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A study of historical returns reveals that treasury bills usually keep pace with inflation and therefore provide a positive return. Since T-bills are considered essentially risk-free, all other securities must at least pay the T-bill rate plus a risk premium in order to entice clients into investing.
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T-bills often represent the risk-free rate of return as there is essentially zero risk associated with this type of investment. The yield paid on a T-bill is roughly determined by estimating the short- term inflation and adding a real return.
Risk
As has already been pointed out, there is no universal definition of risk. In a statistical sense, it is defined as the likelihood that the actual return will be different from expected return. The greater the variability or number of possible outcomes, the greater the risk.
This can be illustrated in a simple fashion. If an investor purchases a $500 Canada Savings Bond (CSB) and cashes the bond one year later, the investor will receive exactly $500 (plus any accrued interest). However, suppose the same investor purchased $500 worth of common stock at $25 per share in the expectation that the price would rise from $25 per share to $40 in one year’s time. The investor may receive much more than $40 per share or much less than the original $25 per share. Common stocks would be defined as riskier than Canada Savings Bonds since the future outcomes are much less certain.
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There are many types of risk in the market, these include:
Inflation rate risk: As explained previously, inflation reduces future purchasing power and the
return on investments.
Business risk: This risk is associated with the variability of a company’s earnings due to such things
as the possibility of a labour strike, introduction of new products, the state of the economy, and the performance of competing firms, among others. The uncertainty regarding a company’s future performance is its basic business risk.
Political risk: This is the risk associated with unfavourable changes in government policies. For
example, a government may decide to raise taxes on foreign investing, making it less attractive to invest in the country. Political risk also refers to the general instability associated with investing in a particular country. Investing in a war-torn country, for example, brings with it the added risk of losing one’s investment.
Liquidity risk: A liquid asset is one that can be bought or sold at a fair price and converted to cash
on short notice. A security that is difficult to sell suffers from liquidity risk, which is the risk that an investor will not be able to buy or sell a security at a fair price quickly enough due to limited buying or selling opportunities.
Interest rate risk: When an investor purchases a fixed-income security, for example, he or she
expects to earn a certain return or yield on the investment. As we learned in the chapter on fixed-income securities, there is an inverse relationship between interest rates and bond prices. If interest rates rise, the investment will fall in value; on the other hand, it will rise in value if rates fall. Interest rate risk is the risk that investors are exposed to because of changing interest rates.
Foreign exchange risk: Foreign exchange risk is the risk of incurring losses resulting from an
unfavourable change in exchange rates. Investors who invest abroad or businesses that buy and sell products in foreign markets run the risk of a loss whenever the exchange rate changes against foreign currencies.
Default risk: When a company issues more debt to finance its operations, servicing the debt
through interest payments creates a further burden on the company. The more debt the company acquires, the greater the risk that it may have difficulty servicing its debt load through its current operations. Default risk is the risk associated with a company being unable to make timely interest payments or repay the principal amount of a loan when due.
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Certain risks can be reduced by diversification. The risks known as systematic risks cannot be eliminated, as these risks affect all assets within certain classes. Systematic risk is always present and cannot be eliminated through diversification. This type of risk stems from such things as inflation, the business cycle and high interest rates.
Systematic (or market risk) is the risk associated with investing in each capital market: When stock market averages fall, most individual stocks in the market fall. When interest rates rise, nearly all individual bonds and preferred shares fall in value. Systematic risk cannot be diversified away; in fact, the more a portfolio becomes diversified within a certain asset class, the more it ends up mirroring that market.
Non-systematic risk, or specific risk, is the risk that the price of a specific security or a specific group of securities will change in price to a different degree or in a different direction from the market as a whole. Stelco may rise in price, for example, when the S&P/TSX Composite Index falls, or Stelco, Dofasco and Co-Steel (all steel companies) as a group may fall more than the Index.
Specific risk can be reduced by diversifying among a number of securities. This type of risk theoretically could be eliminated completely by buying a portfolio of shares that consisted of all S&P/TSX Composite Index stocks, using index funds or buying ETFs based on the Index. The fund manager could also be asked to create a fund that mirrors an index.
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Investors may expect a given return on an investment, but the actual results may be higher or lower. To get a better feel for the possible outcomes and their probability of occurrence, several measures of risk have been developed. The three common measures of risk are variance, standard deviation and beta.
Variance measures the extent to which the possible realized returns differ from the expected return or the mean. The more likely it is that the return will not be the same as the expected return, the more risky the security. When an investor purchases a T-bill, the return is predictable. The return cannot change as long as the investor holds the T-bill until maturity. With other securities (e.g., equities), the outcomes are more varied. The price could increase, stay the same or decrease. The greater the number of possible outcomes, the greater the risk that the outcome will not be favourable. The greater the distance estimated between the expected return and the possible returns, the greater the variance. The risk of a portfolio is determined by the risk of the various securities within that portfolio.
Standard deviation is the measure of risk commonly applied to portfolios and to individual securities within that portfolio. Standard deviation is the square root of the variance. The past performance or historical returns of securities is used to determine a range of possible future outcomes. The more volatile the price of a security has been in the past, the larger the range of possible future outcomes. The standard deviation, expressed as a percentage, gives the investor
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an indication of the risk associated with an individual security or a portfolio. The greater the standard deviation, the greater the risk.
Beta is another statistical measure that links the risk of individual equity securities to the market as a whole. As we saw earlier, the risk that remains after diversifying is market risk. Beta is important because it measures the degree to which individual stocks tend to move up and down with the market. Once again, the higher the beta, the greater the risk.