Risk and Return on Assets

Individual security is judged on its contributions to both the expected returns and the risk of the
entire portfolio.

RISK

Investors invest for anticipated future returns, but these returns can be rarely predicted. The difference
between the expected return and the realized return may deviate. This deviation is defined as risk. All
investors generally prefer investment with higher returns, they have to pay the price in terms of
accepting higher risk too. Investors usually prefer less risky investments than riskier investments. The
government bonds are known as risk-free investments, while other investments are risky investments.

Types of risk

● Systematic Risk OR Uncontrollable

● Unsystematic Risk or controllable

SYSTEMATIC RISK

It affects the entire market. It indicates that the entire market is moving in particular direction. It
affects the economic, political, sociological changes. This risk is further subdivided into:

1. Market risk

2. Interest rate risk

3. Purchasing power risk

Market risk:

It is a “portion of total variability in return caused by the alternating forces of bull and bear
markets. When the security index moves upward for a significant period of time, it is bull market
and if the index declines from the peak to market low point is called troughs i.e. bearish for
significant period of time. The forces that affect the stock market are tangible and intangible
events. The tangible events such as earthquake, war, political uncertainty and fall in the value of
currency. Intangible events are related to market psychology.

2. Interest rate risk:

It is the variation in single period rates of return caused by the fluctuations in the market interest
rate. Mostly it affects the price of the bonds, debentures and stocks. The fluctuations in the
interest rates are caused by the changes in the government monetary policy and changes in
treasury bills and the government bonds. Interest rates not only affect the security traders but also
the corporate bodies who carry their business with borrowed funds. The cost of borrowing would
increase and a heavy outflow of profit would take place in the form of interest to the capital
borrowed. This would lead to reduction in earnings per share and consequent fall in price of
shares.

3. Purchasing power risk:

Variations in returns are due to loss of purchasing power of currency. Inflation is the reason
behind the loss of purchasing power. The inflation may be, “demand-pull or cost-push “.
Demand pull inflation, the demand for goods and services are in excess of their supply. The
supply cannot be increased unless there is an expansion of labour force or machinery for
production. The equilibrium between demand and supply is attained at a higher price level.
Cost-push inflation, the rise in price is caused by the increase in the cost. The increase in cost of
raw material, labour, etc makes the cost of production high and ends in high price level. The
working force tries to make the corporate to share the increase in the cost of living by demanding
higher wages. Hence, Cost-push inflation has a spiraling effect on price level.

UNSYSTEMATIC RISK

Unsystematic risk stems from managerial inefficiency, technological change in production

process, availability of raw materials, change in consumer preference and labour problems. They
have to be analysed by each and every firm separately. All these factors form Unsystematic risk.
They are

1. Business risk

2. Financial risk

BUSINESS RISK: It is caused by the operating environment of the business. It arises from the
inability of a firm to maintain its competitive edge and the growth or stability of the earnings.
The variation in the expected operating income indicates the business risk. It is concerned with
difference between revenue and earnings before interest and tax.

. 2. FINANCIAL RISK: It is the variability of the income to the equity capital due to the debt
capital. Financial risk is associated with the capital structure of the firm. Capital structure of firm
consists of equity bonds and borrowed funds. The interest payment affects the payments that are
due to the equity investors. The use of debt with the owned funds to increase the return to the
shareholders is known as financial leverage. The financial risk considers the difference between
EBIT and EBT. The business risk causes the variation between revenue and EBIT. The financial
risk is an avoidable risk because it is the management which has to decide how much has to be
funded with equity capital and borrowed capital.

RETURN:

A key measure of an investor’s success is the rate at which his funds have grown during the
investment period. The total “Holding-period Return” HPR of a share of common stock depends
on the increase (or decrease) in the price of the share over the investment period. The rate of
return is defined as Ksh. earned over the investment period (price appreciation as well as
dividends) per Ksh. Invested.

Investors expect a good rate of return from their investments. Return from investment may be in
terms of revenue return or income (interest or dividend) and/or in terms of capital return (capital
gain i.e. difference between the selling price and the purchasing price).

The net return is the sum of revenue return and capital return. For example, an investor purchases
a share (Face Value FV Ksh.10) for Ksh.130. After one year, he receives a dividend of Ksh..3
(i.e. 30% on FV of Ksh.10) from the company and sells it for Ksh.138. His total return is Ksh.11,
i.e., Ksh.3 + Ksh.8. The normal rate of return is Ksh.11 divided by Ksh.130 i.e., 8.46%.

The expected return refers to the anticipated return for some future period. The expected return is
estimated on the basis of actual returns in the past periods.

Realised Returns: The realized return is the net actual return earned by the investor over the
holding period. It refers to the actual return over some past period

Risk Premiums and Risk Aversion

Every investment involves some degree of uncertainty about future holding period returns, and in
most cases that uncertainty is significant. Sources of investment risk range from microeconomic
fluctuations, to the changing fortunes of various industries, to asset-specific unexpected
developments.

Each investor must ask how much of an expected reward is offered to compensate for the risk
involved in investing money in the stocks. That is the reward as the difference between the
expected excepted return on the stock and the risk free rate, that is, the rate you can earn from
Treasury bills. This difference is called, the risk premium on common stocks. For example, if the
risk-free rate of return is 6% per year, and the expected return from the common stock is 14%,
then the risk premium on stocks is 8% per annum.

The degree to which investors are willing to commit funds to stocks depends on risk aversion. It
seems obvious that investors are risk averse in the sense that, if the risk premium were zero,
people would not be willing to invest any money in stocks. In theory then, there must always be
a positive risk premium on stocks in order to induce risk-averse investors to hold the existing
supply of stocks instead if placing all their money in risk-free assets

PORTFOLIO MANAGEMENT

The art of selecting the right investment policy for the individuals in terms of minimum risk and
maximum return is known as portfolio management.

Portfolio management refers to managing an individual’s investments in the form of bonds,

shares, cash, mutual funds etc so that he earns the maximum profits within the stipulated time
frame.

Also, it refers to managing money of an individual under the expert guidance of portfolio
managers.

In a layman’s language, the art of managing an individual’s investment is called portfolio

management.Construction of an optimal portfolio is an important objective for an investor. In
this chapter, we will explore the process of examining the risk and return characteristics of
individual assets, creating all possible portfolios, selecting the most efficient portfolios, and
ultimately choosing the optimal portfolio tailored to the individual in question.
During the process of constructing the optimal portfolio, several factors and investment
characteristics are considered. The most important of those factors are risk and return of the
individual assets under consideration. Correlations among individual assets along with risk and
return are important determinants of portfolio risk

Need for Portfolio Management

Portfolio management presents the best investment plan to the individuals as per their income,
budget, age and ability to undertake risks.

Portfolio management minimizes the risks involved in investing and also increases the chance
of making profits.

Portfolio managers understand the client’s financial needs and suggest the best and unique
investment policy for them with minimum risks involved.

Portfolio management enables the portfolio managers to provide customized investment

solutions to clients as per their needs and requirements.

Steps of the portfolio management process and the components of those steps

The three steps in the portfolio management process;

1)The planning step (objectives and constraint determination, investment policy statement
creation, capital market expectation formation, and strategic asset allocation creation);

2. The execution step (portfolio selection/composition and portfolio implementation);

3. The feedback step (performance evaluation and portfolio monitoring and rebalancing)

Individual investments should be judged in the context of how much risk they add to a portfolio
rather than on how risky they are on a stand-alone basis.

Investors, analysts, portfolio managers should analyze the risk return trade-off of the portfolio as
a whole, not the risk return trade-off of the individual investments in the portfolio, because
unsystematic risk can be diversified away by combining the investments into a portfolio. The
systematic risk that remains in the portfolio is the result of the economic fundamentals that have
a general influence on the security returns, such as GDP growth, unexpected inflation, consumer
confidence, unanticipated changes in credit spreads, and business cycle.

PORTFOLIO DIVERSIFICATION
It is one way to balance risk and reward in your investment portfolio by diversifying your assets.
Diversification is the practice of spreading your investments around so that your exposure to any
one type of asset is limited. This practice is designed to help reduce the volatility of your
portfolio over time.

Diversification helps in reducing the risk of investing. Total risk of one investment is the sum of
the impact of all the factors that might affect the return from that investment. However, investors
need not suffer risk inherent with individual investments as it could be reduced by holding a
diversity of investments. For example, return from a single investment in a cold drink company
is subject to weather conditions. This investment is a risky investment. However, if a second
investment can be made in an umbrella company, which is also subject to weather changes, but
in an opposite way, the return from the portfolio of two investments will have a reduced
risk-level. This process is known as diversification. Portfolio is the combination of securities or
diversified investment in securities. Diversification may be Random or Efficient diversification.
In Random diversification, an investor may randomly select the portfolio without analyzing the
risk and return of the securities. In Efficient diversification, an investor may construct a portfolio
by carefully studying and analyzing the risk and return of individual securities and also of its
portfolio. APPROACHES IN PORTFOLIO CONSTRUCTION:

● Traditional Approach
● Modern Approach

STEPS IN TRADITIONAL APPROACH:

Analysis of constraints: Analysing the constraints like, income needs, liquidity, time horizon,
safety, tax consideration and risk temperament of an investor.

Determination of objectives: The objective of the portfolio range from income to capital
appreciation. Investor has to decide upon the return which he gets from the portfolio like, current
income, growth in income, capital appreciation and so on.

Selection of Portfolio: a) Selecting the type of securities for investment i.e. Shares and Bonds or
Bonds or Shares, b) Calculating the risk and return of the securities and c) Diversifying the
investment by selecting the securities combination and its proportion of investment in that
securities.

MODERN APPROACH: The traditional approach is a comprehensive job for the individual. In
modern approach, gives more attention on selecting the portfolio i.e. Markowitz Model as well
as CAPM. ).

The development of Portfolio theory is given by Harry Markowitz (HM) in1952 .He has
provided a conceptual framework and analytical tool for selection of an optimal portfolio. As the
HM Model is based on the expected returns (mean) and standard deviation (variance) of different
portfolios, this model is also called as Mean-Variance Model.

ASSUMPTIONS:

1. The investor should invest only in risky securities; this means no investment should be made
in risk-free securities.

2. The investor should use his own funds. Borrowed funds are not allowed for investments.

3. The decision of the investor regarding selection of the portfolio is made on the basis of
expected returns and risk of the portfolio: