Wealth Management | Expected Return & Risks

Expected Return & 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.

Return

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 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

Risk can be defined as the chance that the actual outcome from an investment will differ from the expected outcome. The more variable the possible outcomes, the greater is the risk.

Following are some of the sources of risk.

• 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 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 that sector or industry.
• Financial Risk: When a company resorts to financial leverage or the use of debt financing, financial risk occurs. This risk 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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