Risk and Return in Portfolio Investments

Risk in Portfolio Investments

The Webster’s New Collegiate Dictionary definition of risk includes the following meanings: “……. Possibility of loss or injury ….. the degree or probability of such loss”. This conforms to the connotations put on the term by most investors. Professional often speaks of “downside risk” and “upside potential”. The idea is straightforward enough: Risk has to do with bad outcomes, potential with good ones.

In considering economic and political factors, investors commonly identify five kinds of hazards to which their investments are exposed. The following are different components of risks associated with portfolio investments:

A. Systematic Risk

Systematic risk refers to the portion of total variability in return caused by factors affecting the prices of all securities. Economic, Political and Sociological changes are sources of systematic risk. Their effect is to cause prices of nearly all individual common stocks or security to move together in the same manner. For example; if the Economy is moving toward a recession and corporate profits shift downward, stock prices may decline across a broad front. Nearly all stocks listed on the BSE / NSE move in the same direction as the BSE / NSE index.

Systematic risk is also called non-diversified risk. If is unavoidable. In short, the variability in a securities total return in directly associated with the overall movements in the general market or Economy is called systematic risk. Systematic risk covers market risk, Interest rate risk and Purchasing power risk

1. Market Risk

Market risk is referred to as stock/security variability due to changes in investor’s reaction towards tangible and intangible events is the chief cause affecting market risk. The first set that is the tangible events, has a real basis but the intangible events are based on psychological basis.

Here, real events, comprising of political, social or economic reason. Intangible events are related to psychology of investors or say emotional intangibility of investors. The initial decline or rise in market price will create an emotional instability of investors and cause a fear of loss or create an undue confidence, relating possibility of profit. The reaction to loss will reduce selling & purchasing prices down & the reaction to gain will bring in the activity of active buying of securities.

2. Interest Rate Risk

The price of all securities rise or fall depending on the change in interest rate, Interest rate risk is the difference between the expected interest rates & the current market interest rate. The markets will have different interest rate fluctuations, according to market situation, supply and demand position of cash or credit. The degree of interest rate risk is related to the length of time to maturity of the security. If the maturity period is long, the market value of the security may fluctuate widely. Further, the market activity & investor perceptions change with the change in the interest rates & interest rates also depend upon the nature of instruments such as bonds, debentures, loans and maturity period, credit worthiness of the security issues.

3. Purchasing Power Risk

Purchasing power risk is also known as inflation risk. This risks arises out of change in the prices of goods & services and technically it covers both inflation and  deflation period. Purchasing power risk is more relevant in case of fixed income securities; shares are regarded as hedge against inflation. There is always a chance that the purchasing power of invested money will decline or the real return will decline due to inflation.

The behavior of purchasing power risk can in some way be compared to interest rate risk. They have a systematic influence on the prices of both stocks & bonds. If the consumer price index in a country shows a constant increase of 4% & suddenly jump to 5% in the next. Year, the required rate of return will have to be adjusted with upward revision. Such a change in process will affect government securities, corporate bonds & common stocks.

B. Unsystematic Risk

The risk arises out of the uncertainty surrounding a particular firm or industry due to factors like labor strike, consumer preference & management policies are called Unsystematic risk. These uncertainties directly affect the financing & operating environment of the firm. Unsystematic risk is also called “Diversifiable risk”. It is avoidable. Unsystematic risk can be minimized or eliminated through diversification of security holding. Unsystematic risk covers Business risk and Financial risk

1. Business Risk

Business risk arises due to the uncertainty of return  which depend upon the nature of business. It relates to the variability of the business, sales, income, expenses & profits. It depends upon the market conditions for the product mix, input supplies, strength of the competitor etc. The business risk may be classified into two kind viz. internal risk and External risk.

  • Internal risk is related to the operating efficiency of the firm. This is manageable by the firm. Interest Business risk loads to fall in revenue & profit of the companies.
  • External risk refers to the policies of government or strategic of competitors or unforeseen situation in market. This risk may not be controlled & corrected by the firm.

2. Financial Risk

Financial risk is associated with the way in which a company finances its activities. Generally, financial risk is related to capital structure of a firm. The presence of borrowed money or debt in capital structure creates fixed payments in the form of interest that must be sustained by the firm. The presence of these interest commitments – fixed interest payments due to debt or fixed dividend payments on preference share – causes the amount of retained earning availability for equity share dividends to be more variable than if no interest payments were required. Financial risk is avoidable risk to the extent that management has the freedom to decline to borrow or not to borrow funds. A firm with no debt financing has no financial risk. One positive point for using debt instruments is that it provides a low cost source of funds to a company at the same time providing financial leverage for the equity shareholders & as long as the earning of company are higher than cost of borrowed funds, the earning per share of equity share are increased.

Risk and Return in Portfolio Investments

Return in Portfolio Investments

The typical objective of investment is to make current income from the investment in the form of dividends and interest income. Suitable securities are those whose prices are relatively stable but still pay reasonable dividends or interest, such as blue chip companies. The investment should earn reasonable and expected return on the investments. Before the selection of investment the investor should keep in mind that certain investment like, Bank deposits, Public deposits, Debenture, Bonds, etc. will carry fixed rate of return payable periodically. On investments made in shares of companies, the periodical payments are not assured but it may ensure higher returns from fixed income securities. But these instruments carry higher risk than fixed income instruments.

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