Components of Risk and Return
Portfolio management is the process of managing a collection of investments or assets to achieve a specific financial goal. One of the primary objectives of portfolio management is to balance risk and return to optimize the performance of the portfolio. To do this, portfolio managers consider various components of risk and return.
The components of risk include systematic risk and unsystematic risk. Systematic risk is the risk that cannot be diversified away, such as economic or political risks that affect the entire market. Unsystematic risk is the risk that can be diversified away, such as company-specific risks like management changes or product recalls. Portfolio managers aim to diversify their portfolios to reduce unsystematic risk and manage systematic risk through asset allocation.
The components of return include expected return and unexpected return. Expected return is the return that an investor anticipates based on historical data and market trends. Unexpected return is the return that results from unforeseen events, such as changes in interest rates, global pandemics, or natural disasters. Portfolio managers aim to maximize the expected return of a portfolio while minimizing the unexpected return by investing in a diversified mix of assets and regularly monitoring the portfolio’s performance.
Expected Return and Risks
The investor return is a measure of the growth in wealth resulting from that investment. This growth measure is expressed in percentage terms to make it comparable across large and small investors. People often express the percent return over a specific time interval, say, one year.
The objective of any investor is to maximize expected returns from his investments, subject to various constraints, primarily risk. Return is the feature that motivates investors in the form of rewards for undertaking the investment. There are 2 types of returns: Realized Return and Expected Return.
- Realized Return: This is the return that was or could have been earned. For instance, if a deposit is made for Rs. 1000 in a bank on January 1 and a stated annual interest rate of 10% will be worth Rs. 1,100 exactly a year later. The historical or realized return in this case is 10%.
- Expected Return: This is the return from an asset that investors anticipate or expect to earn over some future period. The expected return is subject to uncertainty and investors compensate for this uncertainty in returns and the timing of those returns by requiring an expected return that is sufficiently high to offset the risk. It is calculated as
Expected Rate of Return = (Probability of Outcome x Rate of Outcome) + (Probability of Outcome x Rate of Outcome)
Risk can be defined as the chance that the actual outcome of from an investment will differ from the expected outcome. The more variable the possible outcomes that can be, the greater the risk. The sources of risk are below.
- Interest Rate Risk: It is the variability in a security’s return resulting from changes in the level of interest rates. Other factors being equal, security prices move inversely to interest rates. This risk affects bondholders more directly than directly than equity investors.
- Market Risk: This refers to the variability of returns due to fluctuations in the security’s market. All securities, especially equities, are exposed to market risk as they are subjected to being impacted by depressions, wars, politics, etc.
- Inflation Risk: A rise in inflation leads to a reduction of purchasing power and affects all securities. This risk is tied to interest rate risk because interest rate goes up with a rise in inflation.
- Business Risk: This is the risk associated with a particular industry or environment. It further impacts the investors who have invested in a business in that sector or company.
- Financial Risk: When a company resorts to financial leverage or the use of debt financing, financial risk occurs. This increases when the company resorts to debt financing.
- Liquidity Risk: Liquidity risk is mostly associated with the secondary markets in which the security is traded. A security is considered liquid when it can be bought or sold quickly without concessions on the price. Liquidity risk increases with the rise in the uncertainty of time and price concession.
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