Risk Return Relationship

The entire scenario of security analysis is built on two concepts of security: return and risk. The risk and return constitute the framework for taking investment decision. Return from equity comprises dividend and capital appreciation. To earn return on investment, that is, to earn dividend and to get capital appreciation, investment has to be made for some period which in turn implies passage of time. Dealing with the return to be achieved requires estimate of the return on investment over the time period. Risk denotes deviation of actual return from the estimated return. This deviation of actual return from expected return may be on either side -both above and below the expected return. However, investors are more concerned with the downside risk.  The risk in holding security deviation of return deviation of dividend and capital appreciation from the expected return may arise due to internal and external forces. That part of the risk which is internal that is unique and related to the firm and industry is called ‘unsystematic risk’. That part of the risk which is external and which affects all securities and is broad in its effect is called ‘systematic risk’. The fact that investors do not hold a single security which they consider most profitable is enough to say that they are not only, interested in the maximization of return, but also minimization risk. The unsystematic risk is eliminated through holding more diversified securities. Systematic risk is also known as non- diversifiable risk as this cannot be eliminated through holding more securities and is also called ‘market risk’ Therefore, diversification leads to risk reduction but only to the minimum level of market risk. The investors increase their required return as perceived uncertainty increases. The rate of return differs substantially among alternative investments, and because the required return on specific investments change over time, the factors that influence the required rate of return must be considered.

The following figure represents the relationship between risk and return. The slope of the Market line indicates the return per unit of risk required by all investors Highly risk-averse investors would have a steeper line, and vice versa.

Given the composite market line prevailing at a point of time, investors would select investments that act! Consistent with their risk preferences. Some will consider low risk investments, while others prefer high; risk investments.