Session 5: Risk and Return

Transport Financial Analysis

Page 34 of 43 pages. Chapter: 11: Fundamental Concept in Financial Management

Session 5: Risk and Return

Learning Objective

Explain to the learner on the concept of risk and return.
Guiding the learners in calculation of an estimated risk and return of portfolios.

Important Terms

Portfolio theory
Risk
Compounding

Introduction

The diversification of portfolios is an important concept in finance management. Both individuals and firms diversify their investments. Individuals have portfolios of shares and firms have portfolio of business operation. Remember the aim of an individual or the firm is to maximize their return at the same time minimizing their risk.

Risk and Return

Because of the volatility of environment, the financial management should consider investments, which offers better return with optional risk level. A key feature of project appraisal is its orientation to the future. There are two types of expectations individuals may have about future: certainty and uncertainty
The risk in an investment, or in a portfolio of investments, is that the actual return will not be the same as the expected return. The actual return may be higher, but it may be lower. A prudent investor will want to avoid too much risk, and will hope the actual returns from his investment are much the same as what he expected them to be. The risk of a security and the risk of a portfolio is the standard deviation of the expected return.
A portfolio is the collection of different investments that make up the investor’s total holding. A portfolio might be the investments in shares or in the capital project of a company.
Portfolio theory which originates from the work of Markowitz is concerned with establishing guidelines for building up a portfolio of share or a portfolio of investments.

Factors in the Choice of an Investment

Security	Maintenance of capital
Liquidity	If made with short-term funds should be convertible into cash with short notice
Return	Obtain highest return compatible with safety
Spreading risks	Spread risks over several investments, so losses on some offset by gains on other
Growth prospects	Investment in steadily growing businesses

The risk of an investment might be high or low, depending on the nature of the investment. Low risk investments usually give low returns. High risk investments might give high returns, but with more risk of disappointing results. So how does holding a portfolio of investments affect expected returns and investment?

Example:

Correlation of Investments

Portfolio theory states that individual investments cannot be viewed simply in the their risk and return. The relationship between the return from one investment and the return from the other investments is just as important. The relationship between investments can be one of the three types:

1. Negative correlation

Investments in a portfolio with direct opposite in risk and return over time i.e. when return on one investment is increasing another investment: return will drop. Thus if you hold shares in one company making umbrellas and another which sells ice cream, the weather will affect the companies differently. The risk will be reduced through this diversification.

2. Positive Correction

Investments in a portfolio having similar trend in rate of return movements. Thus you buy shares in one company which sells umbrellas and another which makes raincoats you would expect both companies to do badly in dryweather.Diversification will not minimise the risk.

3. Independent investments

A third possibility is that rate if the returns on stocks in two firms are completely unrelated. If you hold shares in a mining company and in a leisure company, it is likely that there would be no relationship between the profits and return from each.

Coveriance

Measures the extent to which the returns on two investments ‘co-vary’ or ‘correlate. If the rate of return tends to go up together or go down together then the covariance will be positive and if returns move in opposite direction, the covariance will be negative. A figure close to + 1 indicates high positive correlation, and the figure close to -1 indicates high negative correlation. A figure of 0 indicates no correlation. If the investments show high negative correlation, then by combining them in a portfolio overall risk would be reduced. Risk will also be reduced by combining in portfolio investments which have no significant correlation.

Example 2

Security A and Security B have the following expected returns.

Security B /30% = 8.944%

Security B has high return than security A, but at a great risk.

If an investor holds a portfolio consisting 50% of A and 50% B. The expected return from the portfolio will be 0.5 x 25% + 0.5 x 30% = 27.5%

The combined result should be less risky than security B which alone has the highest risk but as seen above the expected return is also slightly lower than that of B stand alone of 30%

The standard deviation of the portfolio can be calculated as: