Risk & Rates of Return
The relationship between risk and return in complicated, but in general, there is a direct tradeoff. Total risk is defined as variability in returns and can be separated into systematic and unsystematic risk. An investor can reduce unsystematic risk by maintaining a diversified portfolio. This article is devoted to exploring the components of risk and discussing techniques for reducing, measuring and pricing risk and return.
Risk consists of uncertainty and the possible exposure to a negative result. The stock market is fraught with risks as well as rewards. Why would a stock investor be willing to forgo a risk-free investment such as a savings account that reliably earns 1-2 percent interest for a security that could lose all its value? A smart investor understands the tradeoff and how to estimate the return required in order to compensate for risk. Most investors are risk averse and would prefer a low-risk alternative. However, there is a certain return where the investor is willing to take on additional risk. The riskier the investment, the higher the expected return must be. The following diagram illustrates the pattern of the risk-return trade-off.
There are five critical components to understanding risk and return:
- Defining risk;
- Measuring systematic risk and return;
- Measuring unsystematic risk and return;
- Reducing risk; and return;
- Pricing risk and return.
Risk comes in many shapes and sizes. There are countless risks to consider when assessing an investment. The following are examples of some common risks:
- Legal risk is the possibility that a company will be subject to unexpected litigation.
- Industry risk includes such factors as changing technology, foreign competitors, etc.
- Operational risk is the potential for internal processes or systems to fail.
- Currency risk is an issue for companies that do business in other countries. They are subject to exchange rates that could unexpectedly fluctuate and affect profits.
- Liquidity risk is the chance that no one will buy a security that needs to be sold. This is different from the price per share dropping to zero. Generally publicly traded stocks have low liquidity risks. Shares of private companies or assets such as houses can have high liquidity risks.
The proceeding risks are just a few of the myriad risk factors that can affect a security. There are certain risks that are particularly important when discussing the risk of a fixed-income investment such as a bond. Interest rate risk, inflation risk, and credit risk can significantly affect the return on a bond:
- Interest rate risk is the possibility that interest rates will change before you sell a bond;
- Inflation risk refers to unexpected changes in inflation; and
- Credit risk is the potential that the issuer will default on its debt obligation. If a bond is defaulted, an investor can lose interest as well as principle.
As a rule, bond prices fall when interest rates and inflation rise. Bonds are acutely sensitive because they have coupon payments that are fixed into the future and do not adjust for changes in interest rates or inflation. Therefore, when interest rates and inflation rise, the present value of the bond is worth less than its purchase price. In general, short-term bonds carry a lower interest rate and less inflation risk. They have a lower risk premium because the duration of time is brief. Credit risk is another important factor when choosing a bond. Credit ratings, which can help assess risk, are published by companies such as Moody's and Standard and Poor's. Interest coverage ratios (EBIT/interest expense) can also provide insight into credit risk. If a company's earnings do not have enough cushion to cover interest expense, then there is a high risk of default.
Stock prices fluctuate for a variety of reasons, but here we will focus on placing risk into two very distinct categories. Understanding the differences between these two categories is the basis for financial evaluation of risk. Some stock price fluctuations are due to factors that affect many securities in the market. For example, an economic downturn can cause many companies to experience unexpected losses. These kinds of risks are very different from random factors that affect only one firm. For example, a union strike at an automotive firm would only affect that specific company. The financial community has defined two categories of risk: systematic or market risk, and unsystematic or firm-specific risk.
Systematic risk includes economic and market factors that affect almost every company in the market. This risk cannot be eliminated by diversification. Interest rates and inflation are two kinds of risk that would fall into this category. Other examples of systematic risk include the country going to war or tax cuts approved by Congress.
Unsystematic risks are factors that only affect individual securities. Legal risk, industry risk, operational risk, currency risk, and liquidity risk fall into this category. Other examples of unsystematic risk include a fire in the main warehouse of a company, the CEO getting killed in an auto accident or a low-cost competitor entering the market. If you own only one stock, this kind of risk is very important. However, once you diversify your portfolio with several stocks, this unsystematic risk can be virtually eliminated. In financial markets, investors are only rewarded for bearing systematic risk, because this is the only kind of risk that cannot be eliminated through diversification.
In 1952, Harry Markowitz introduced an investment strategy called "portfolio diversification." He demonstrated how an investor can reduce risk and the overall standard deviation, or spread, of returns by creating a portfolio of securities.
If two securities are positively correlated (i.e., move together when the market changes), there is no impact on risk. However, if two securities are negatively correlated (i.e., securities do not move together), the portfolio is considered diversified and risk is reduced. Gains from one security in the portfolio can offset losses from another, lessening the overall exposure to a negative return.
Portfolio diversification can only mitigate risk associated with unsystematic risk. As you increase the number of securities in your portfolio, unsystematic risk can be virtually eliminated. However, you cannot diversify away systematic risk because, by definition, it affects all companies. Investors are only compensated for systematic risk because unsystematic risk is expected to be diversified away.
In portfolios of thirty-plus randomly selected stock, unsystematic risk is virtually eliminated.
Measuring Unsystematic Risk
In order to measure risk, we must first understand rates of return. Suppose...
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