There are different motives for investment. The most prominent among all is to earn a return on investment. However, selecting investments on the basis of return in not enough. The fact is that most investors invest their funds in more than one security suggest that there are other factors, besides return, and they must be considered. The investors not only like return but also dislike risk. So, what is required is:
- Clear understanding of what risk and return are,
- What creates them, and
- How can they be measured?
Return: The return is the basic motivating force and the principal reward in the investment process. The return may be defined in terms of (i) realized return, i.e., the return which has been earned, and (ii) expected return, i.e., the return which the investor anticipates to earn over some future investment period. The expected return is a predicted or estimated return and may or may not occur. The realized returns in the past allow an investor to estimate cash inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the investment. The return can be measured as the total gain or loss to the holder over a given period of time and may be defined as a percentage return on the initial amount invested. With reference to investment in equity shares, return is consisting of the dividends and the capital gain or loss at the time of sale of these shares.
Risk: Risk in investment analysis means that future returns from an investment are unpredictable. The concept of risk may be defined as the possibility that the actual return may not be same as expected. In other words, risk refers to the chance that the actual outcome (return) from an investment will differ from an expected outcome. With reference to a firm, risk may be defined as the possibility that the actual outcome of a financial decision may not be same as estimated. The risk may be considered as a chance of variation in return. Investments having greater chances of variations are considered more risky than those with lesser chances of variations. Between equity shares and corporate bonds, the former is riskier than latter. If the corporate bonds are held till maturity, then the annual interest inflows and maturity repayment are fixed. However, in case of equity investment, neither the dividend inflow nor the terminal price is fixed.
Risk should be differentiated with uncertainty: Risk is defined as a situation where the possibility of happening or non happening of an event can be quantified and measured: while uncertainty is defined as a situation where this possibility cannot be measured. Thus, risk is a situation when probabilities can be assigned to an event on the basis of facts and figures available regarding the decision. Uncertainty, on the other hand, is a situation where either the facts and figures are not available, or the probabilities cannot be assigned.
Types of Risk
It refers to that portion of variability in return which is caused by the factors affecting all the firms. It refers to fluctuation in return due to general factors in the market such as money supply, inflation, economic recessions, interest rate policy of the government, political factors, credit policy, tax reforms, etc. these are the factors which affect almost all firms. The effect of these factors is to cause the prices of all securities to move together. This part of risk arises because every security has a built in tendency to move in line with fluctuations in the market. No investor can avoid or eliminate this risk, whatever precautions or diversification may be resorted to. The systematic risk is also called the non-diversifiable risk or general risk.
Types of Systematic Risk
- Market Risk: Market prices of investments, particularly equity shares may fluctuate widely within a short span of time even though the earnings of the company are not changing. The reasons for this change in prices may be varied. Due to one factor or the other, investors’ attitude may change towards equities resulting in the change in market price. Change in market price causes the return from investment to very. This is known as market risk. The market risk refers to variability in return due to change in market price of investment. Market risk appears because of reaction of investors to different events. There are different social, economic, political and firm specific events which affect the market price of equity shares. Market psychology is another factor affecting market prices. In bull phases, market prices of all shares tend to increase while in bear phases, the prices tend to decline. In such situations, the market prices are pushed beyond far out of line with the fundamental value.
- Interest-rate Risk: Interest rates on risk free securities and general interest rate level are related to each other. If the risk free rate of interest rises or falls, the rate of interest on the other bond securities also rises or falls. The interest rate risk refers to the variability in return caused by the change in level of interest rates. Such interest rate risk usually appears through the change in market price of fixed income securities, i.e., bonds and debentures. Security (bond and debentures) prices have an inverse relationship with the level of interest rates. When the interest rate rises, the prices of existing securities fall and vice-versa.
- Purchasing power or Inflation Risk: The inflation risk refers to the uncertainty of purchasing power of cash flows to be received out of investment. It shows the impact of inflation or deflation on the investment. The inflation risk is related to interest rate risk because as inflation increases, the interest rates also tend to increase. The reason being that the investor wants an additional premium for inflation risk (resulting from decrease in purchasing power). Thus, there is an increase in interest rate. Investment involves a postponement in present consumption. If an investor makes an investment, he forgoes the opportunity to buy some goods or services during the investment period. If, during this period, the prices of goods and services go up, the investor losses in terms of purchasing power. The inflation risk arises because of uncertainty of purchasing power of the amount to be received from investment in future.
The unsystematic risk represents the fluctuation in return from an investment due to factors which are specific to the particular firm and not the market as a whole. These factors are largely independent of the factors affecting market in general. Since these factors are unique to a particular firm, these must be examined separately for each firm and for each industry. These factors may also be called firm-specific as these affect one firm without affecting the other firms. For example, a fluctuation in price of crude oil will affect the fortune of petroleum companies but not the textile manufacturing companies. As the unsystematic risk results from random events that tend to be unique to an industry or a firm, this risk is random in nature. Unsystematic risk is also called specific risk or diversifiable risk.
Types of Unsystematic Risk
- Business Risk: Business risk refers to the variability in incomes of the firms and expected dividend there from, resulting from the operating condition in which the firms have to operate. For example, if the earning or dividends from a company are expected to increase say, by 6%, however, the actual increase is 10% or 12 %. The variation in actual earnings than the expected earnings refers to business risk. Some industries have higher business risk than others. So, the securities of higher business risk firms are more risky than the securities of other firms which have lesser business risk.
- Financial Risk: It refers to the degree of leverage or degree of debt financing used by a firm in the capital structure. Higher the degree of debt financing, the greater is the degree of financial risk. The presence of interest payment brings more variability in the earning available for equity shares. This is also known as financial leverage. A firm having lesser or no risk financing has lesser or no financial risk.