INVESTMENT MANAGEMENT 5th Sem B.
Com
MODULE-3
RISK AND RETURN
INTRODUCTION
The portion of the variability of return of a security that is caused by external factors
is called systematic risk. It is also known as market risk or non-diversifiable risk.
Economic recession, macro policy of the government etc. Affect the price of all shares
systematically. Thus the variation of return in shares, which is caused by these factors,
is called systematic risk.
The return from a security sometimes varies because of certain factors affecting only
the company issuing such security. Examples are raw material scarcity, labour strike,
management efficiency etc. When variability of returns occurs because of such firm-
specific factors, it is known as unsystematic risk.
RISK AND RETURN CONCEPTS:
The interplay between risk and return is a foundational concept in finance,
dictating investment strategies and portfolio management. Understanding this
relationship is crucial for both individual and institutional investors as it guides
decision-making in the pursuit of financial goals.
Risk is an unavoidable component of the investment landscape, inherently
linked to the potential for return. Understanding and managing risk through strategies
like diversification and appropriate asset allocation based on one's risk tolerance and
investment horizon are vital for achieving financial objectives. While the pursuit of
high returns is enticing, it is essential to assess the accompanying risk, acknowledging
that the quest for higher profits comes with the possibility of greater losses. In
essence, a well- informed investor not only seeks to maximize returns but also
understands and manages the risks involved, aligning investment choices with
personal financial goals and risk appetite.
CONCEPT OF RISK
Risk, in its broadest sense, refers to the uncertainty associated with the future
outcomes of an investment. It embodies the possibility that an investment's actual
returns will deviate from its expected returns, which can occur in either direction-
positive or negative. However, in the financial context, risk is often perceived
negatively, focusing on the potential for losing part or all of the original investment.
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TYPES OF RISK
The landscape of investment risk is diverse, encompassing several types that
can affect an investment's performance. These risks can be broadly categorized into
systematic and unsystematic risks.
Systematic Risk (Non-Diversifiable Risk):
This type of risk is inherent to the entire market or market segment and cannot be
eliminated through diversification. Examples include interest rate risk, inflation risk,
and market risk. Systematic risk is influenced by external factors like changes in
government policy, natural disasters, or global economic shifts.
Systematic risk is caused by the changes in government policy, the act of
nature such as natural disaster, changes in the nation's economy, international
economic components, etc. The risk may result in the fall of the value of investments
over a period. It is divided into three categories that are explained as under:
Interest risk: Risk caused by the fluctuation in the rate or interest from time to time
and affects interest-bearing securities like bonds and debentures.
Inflation risk: Alternatively known as purchasing power risk as it adversely affects
the purchasing power of an individual. Such risk arises due to a rise in the cost of
production, the rise in wages, etc
Market risk: The risk influences the prices of a share, i.e. the prices will rise or fall
consistently over a period along with other shares of the market.
Unsystematic Risk (Diversifiable Risk):
In contrast, unsystematic risk is specific to a particular company or industry. It can be
mitigated or eliminated through diversification across different sectors or asset
classes. Examples include business risk, financial risk, and sector risk.
Unsystematic risk is the risk that is unique to a specific company or industry. It's also
known as non systematic risk, specific risk, diversifiable risk, or residual risk. In the
context of an investment portfolio, unsystematic risk can be reduced through
diversification while systematic risk is the risk that's inherent in the market.
The risk can be avoided by the organization if necessary actions are taken in this
regard. It has been divided into two category business risk and financial risk,
explained as under
Business risk: Risk inherent to the securities, is the company may or may not perform
well. The risk when a company performs below average is known as a business risk.
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There are some factors that cause business risks like changes in government policies,
the rise in competition, change in consumer taste and preferences, development of
substitute products, technological changes, etc.
Financial risk: Alternatively known as leveraged risk. When there is a change in the
capital structure of the company, it amounts to a financial risk. The debt-equity ratio is
the expression of such risk.
Systematic Risk Unsystematic Risk
Meaning Risk/Threat associated with the Hazard associated with
market or the segment as a specific security, firm, or
whole. industry.
Controllability Cannot be controlled Controllable
Hedging Allocation of the assets Diversification of the
Portfolio
Responsible Factors External Internal
Avoidance Cannot be avoided It can be avoided or
resolved at a quicker pace.
Types Interest Risk and Market Risk Financial and Business risk
Impact A large number of securities in Restricted to the specific
the market company or industry
Protection Asset allocation Portfolio diversification
Portfolio Risk and Return:
Portfolio risk and return are central concepts in the field of investment
management, focusing on how to maximize returns for a given level of risk through
diversification and strategic asset allocation.
Expected Returns of a Portfolio
The expected return of a portfolio is the weighted average of the expected
returns of its individual assets, where the weights are the proportion of each asset's
value relative to the total value of the portfolio. This metric provides investors with an
estimate of the average return that the portfolio is expected to generate over a future
period.
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