15.2 Risk And Return

Introduction

Investing always involves a certain level of risk. Understanding various types of risk and how they relate to potential returns is essential for making informed investment decisions. This chapter explores different kinds of risks, methods to measure them, and strategies to manage them effectively within a portfolio.

Types and Measures of Risk

1. Systematic vs. Non-Systematic Risk

• Systematic Risk: Also known as market risk, it affects the entire market and is unavoidable through diversification. Examples include interest rate risk, inflation rate risk, and political risk.

• Non-Systematic Risk: Specific to a company or industry, this type of risk can be mitigated through diversification. Examples include business risk and liquidity risk.

2. Key Risk Measures

• Beta: Measures a security’s volatility relative to the market. A higher beta indicates greater risk.
• Alpha: Represents a security’s return exceeding the market return; used to assess performance.
• Standard Deviation: Indicates the extent to which the returns of a portfolio or security deviate from the expected return, showing the level of risk involved.

The Role of Risk in Asset Selection

Risk plays a crucial role in asset selection as investors seek to balance potential returns with acceptable risk levels. Higher potential returns typically come with higher risk.

    graph LR
	    A[Risk] -->|Increases| B[Potential Return]
	    A -->|Diversification| C[Reduced Non-Systematic Risk]
	    C -->|Portfolio Optimization| D[Balanced Risk & Return]

Calculating and Interpreting Expected Return

Expected return is an important concept to estimate the profitability of an investment. The formula used to calculate the expected return of a portfolio is:

$$ E(R) = \sum_{i=1}^{n} (w_i \cdot R_i) $$

Where:

• $E(R)$ is the expected return of the portfolio
• $w_i$ is the weight of each security in the portfolio
• $R_i$ is the expected return of each security

Calculating the expected return involves determining the weighted average of the potential returns of all assets in the portfolio.

Benefits and Challenges of Combining Securities in a Portfolio

Benefits

• Diversification: Reducing non-systematic risk by investing in various asset categories.
• Risk Management: Hedging against potential market declines.

Challenges

• Correlation: Highly correlated assets can inadvertently increase risk rather than reduce it.
• Complexity: Managing a diversified portfolio requires ongoing analysis and adjustment.

Portfolio Management Styles

Active Investment Strategy

• Objectives: Achieve returns higher than those of benchmark indices by exploiting pricing inefficiencies.
• Methods: Frequent trading, using market analysis, and targeting under/overvalued securities.

Passive Investment Strategy

• Objectives: Match the returns of benchmark indices with minimal trading.
• Methods: Investing in index funds, ‘buy and hold’ strategy.

Bottom-Up Analysis

• Focus on individual companies rather than the overall industry or market.
• Geared towards selecting companies with good fundamentals regardless of market conditions.

Key Terms

• Active Investment Strategy: A method seeking to outperform market benchmarks by identifying market inefficiencies.
• Inflation Rate Risk: The potential for loss due to the decreasing purchasing power of currency.
• Alpha: An indication of a security’s performance compared to the market return.
• Interest Rate Risk: The risk of investment value changes due to emerging interest rates.
• Beta: A measure of a security’s risk in relation to the market.
• Liquidity Risk: The difficulty of selling an asset without significant price concession.
• Bottom-Up Analysis: Individual company focus rather than broad economic factors.
• Non-Systematic Risk: Company or industry-specific risk that can be diversified away.
• Business Risk: Risk associated with the operational aspects of a company.
• Passive Investment Strategy: A strategy that aims to match indices performances with minimal trading.
• Political Risk: Potential losses from political instability or changes in government policies.
• Capital Gain: Profit from selling an asset for more than its purchase price.

Key Takeaways

• Understanding different risks and their measurements can significantly impact investment decisions.
• Systematic risks affect the whole market, while non-systematic risks focus on specific entities and can be reduced through diversification.
• Combining securities can offer diversification benefits but bring complexities that require careful management.
• Different portfolio management styles cater to diverse investor objectives and risk tolerance levels.

Frequently Asked Questions (FAQs)

1. What is the main difference between systematic and non-systematic risk?

Systematic risk impacts the entire market and cannot be mitigated through diversification, while non-systematic risk is specific to individual companies or industries and can be reduced through diversification.

2. How can an investor minimize non-systematic risk?

Non-systematic risk can be minimized through diversification by combining different assets, industries, or countries in a portfolio.

3. What is the importance of beta in assessing a security?

Beta quantifies a security’s volatility in comparison to the overall market risk; a higher beta means more risk and potential return.

4. What are the main strategies of active portfolio management?

Active portfolio management aims to surpass market benchmarks through detailed analysis, buying undervalued and selling overvalued securities frequently.

5. What is a ‘buy and hold’ strategy?

The ‘buy and hold’ strategy is a passive investment approach where investors purchase securities to hold long-term, minimizing trading activities.

In this section

• 15.2.1 Rate Of Return
  Learn the in-depth analysis of the rate of return and its importance in the context of Canadian Securities Course. Understand various related concepts such as capital loss, real rate of return, cash flow, and risk-free rate of return.
• 15.2.2 Types Of Risks
  Learn about the various types of risks involved in investing, including inflation rate risk, business risk, political risk, liquidity risk, interest rate risk, and foreign investment risk. Understanding these risks can help investors make more informed decisions.