INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification

<< COMMON STOCKS â€“ RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model

RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION >>

Financial Management MGT201

Lesson 19

INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT

Learning Objectives:

After going through this lecture, you would be able to have an understanding of the following

topics

· Introduction to Risk

· Risk and Return for Single Stock Investment

Before discussing this important topic we should go through the area of finance which we have

studied up till now.

Part I (Introduction and Capital budgeting)

FM Markets, Concepts, Definitions

Review of Accounting

Interest Rate Theory & Calculations

Investment Decisions: NPV (Valuation), IRR, Payback

Capital Budgeting: NPV & DCF

Capital Rationing (Budgeting for Real Assets)

Part II (Securities Valuation)

Valuation of Stocks & Bonds (Direct Claim Securities)

The Chapter 4 and 5 of text book cover the topics of risk and return. It is the fundamental concept to

understand the topics of portfolio theory and Capital Asset pricing model (CAPM).In the previous

lectures, we are ignoring the origin of required rate of return.

Risk:

Chinese Definition of Risk:

It is defined as the combination of danger and opportunity. Risk is the combination of both.

When we talk about risk with the reference to the investment we are talking about risk in term of the

uncertainty in outcome of our investment. We are talking about the variability, spread, or volatility that

can take place in the expected future Value (Cash Flows) or Returns. For example, we are asking

ourselves if we invest Rs 1,000 for buying a share today then what will be the price of the share one

year from now. There is no guarantee about the price of the share after one year therefore there is an

uncertainty or risk we are taking because we do not know the final outcome. So, the difference or

variation in the possible outcomes of a particular investment also represents the risky ness of a particular

investment.

As we have studied earlier that there are two major categories of assets

1 Real Physical Assets 2 .Financial Assets (Stock & bonds)

Risk can be understood with reference to the uncertainty of Future Cash Flows produced by

Assets (Physical & Financial Securities). Businesses make forecasts based on certain assumptions which

we have discussed in lecture 5 of your course. These forecasts are not 100% accurate and there is

uncertainty in the possible outcome. The actual cash flows one or five years from now may be very

different from the forecasted and this to represent risk. When we talk about risk in investing in direct

claim securities then we need to keep in mind the distinction between Stand Alone Risk (or Single

Investment Risk) as oppose to market or Portfolio Risk (or Collection of Investments Risk).which is a

risk of particular investment compare to other investments you have made. In Portfolio risk we are

interested in overall risk of entire collection of investments that made by the company. We will study

this topic in the next lectures.

In case of portfolio risk we can further made distinction between Diversifiable Risk and Market

risk

Diversifiable Risk: random risk specific to one company, can be virtually eliminated.

Market Risk: It is defined as uncertainty caused by broad movement in market or economy. More

significant.

Causes of Risk:

These can be Company-Specific or General. It may be because of Cash Losses from operations

or poor financial management of the company. This is one possibility but the real question is that why

these losses occurred. One of the reasons for the losses might be the company's Debt, Inflation,

Economy, Politics, War or Fate. Final analysis of risk is that it is a game of fate or chance.

Financial Management MGT201

Measurement of Risk:

It is important to attach different numbers to the risk so that we can rank different investments.

Risk is measured in terms of the standard deviation or variance. You have studied these terms in the

statistics. Risk is still quite subjective even after the numbers you have calculated after standard

deviation. The reason is that you have to keep in mind what kind of risk you are talking about. Are you

Stand Alone Risk or Portfolio Risk?

Market Risk or Diversifiable Risk?

Stock Price Risk or Earnings Risk?

Another important thing is Time Horizon for which you are measuring the risk. Are you

investing in Stocks over 1 Year or over 30 Years?

The level of risk might change as time period of the investment change.

Fundamental Rule of Risk & Return:

This rule can be summed up in saying that No Pain - No Gain. Investors will not take on

additional Market Risk unless they expect to receive additional Return which is common sense and

quite logical. Most investors are Risk Averse. Another important principle that one should to keep in

mind is Diversification.

Diversification:

It states that don't put all your eggs in one basket. Diversification can reduce risk. By

spreading your money across many different Investments, Markets, Industries, Countries you can avoid

the weakness of each. Make sure that they are Uncorrelated so that they don't suffer from the same bad

news. Due to certain change in the interest rates some of the investments in your portfolio may go up

and the others go downward.

Every Day Examples of Risk-Return Pairs:

Risk Level

Return

· Climbing Mount K2

High

· Gambling on Cricket Matches

High

· Oil drilling in Badin Block

High

· Satta / Speculation in Shares

High

Med-High

· Construction Commercial Plaza

Medium

High

· Investing "Blue Chip" Stocks

Medium

· Crossing Road at Peak Traffic

Medium

· Investing TFC's

Med-Low

Low

· Depositing Money in Bank A/c

Low

· Investing in T-Bills

Low

Before taking about the risk we first see the different possible outcomes of a particular investment

by analyzing the expected return. It is mentioned earlier that once we have an idea of the variation then

we can measure the risk of that investment.

Range of Possible Outcomes, Expected Return:

Overall Return on Stock = Dividend Yield + Capital Gains Yield (Gordon's Formula)

Simply, Return is proportional to Capital Gain which is proportional to Selling Price. We can use

Forecasted Selling Price as measure of Return. The wider the range of Possible Outcomes that can occur,

the greater the Risk

The chance that a future event will actually occur is measured using Probability

Expected ROR = < r > =

pi ri

Where pi represents the Probability of Outcome "i" taking place and ri represents the Rate of Return

(ROR) if Outcome "i" takes place. The Probability gives weight age to the return. The Expected or

Most Likely ROR is the SUM of the weighted returns for ALL possible Outcomes.

Now let us take a look of case of investing in the share of the particular company.

Suppose you are deciding whether to invest in the Stock of Company ABC. You're not sure

because the Future or Forecasted Price of the Stock after 1 year could reach any one of 3 Possible

Values (or Outcomes). Before you can estimate the most likely or Mean or Expected Future Price, you

need to guess the Probability of Each Possible Outcome

Financial Management MGT201

Outcomes (After 1 Yr)

Probability (%)

"Bull Market" (Stock Price P1*=140)

30% or 0.3

"Normal Market" (Stock Price P1*=110)

40% or 0.4

"Bear Market" (Stock Price P1*=80)

30% or 0.3

100%

1.0

Po= Present Market Price Rs100. P1*=Forecasted Price.

The Sum of Probabilities of all Possible Outcomes MUST Add Up to 100% (or 1.0).

Payoff Table & Expected ROR

Payoff Table for Investment in Stock

Outcomes (1 Yr)

Prob (p)

ROR <r> = (P1*-Po)/Po)

Price Rises (P1*=140) 0.3

+ 40 % = (140-100)/100

Price Same (P1*=110) 0.4

+ 10 % = (110-100)/100

Price Falls (P1*=80)

0.3

- 20 % = (80-100)/100

1.0

Expected ROR of Investment in Stock

Most Likely or Weighted Average or Mean ROR Rate of Return < r >

Expected ROR = < r > =

pi ri.

= p1 (r1) + p2 (r2) + p3 (r3)

= 0.3(40%) + 0.4(10%) + 0.3(-20%)

= 12% + 4% - 6% = 10%

Probability Distribution

Forecasted Returns for Single Stock Investment

"BELL"

0.45

Curve

0.4

Proba

0.35

bility

0.3

(p)

Possible

0.25

Outcomes

0.2

0.15

"Expected ROR" or Most

0.1

Likely or Mean ROR = 10%

0.05

-20

Rate of Return after 1 Year < r >

In the diagram, the probability graphed on y axis and the rate of return is graphed on x axis. All

three outcomes are shown in the form of the bars. In this diagram the largest probability takes place at

the value of the expected rate of return which is 10%. If the top of each vertical bar is connected then

the bell curve is formed. It is easy to calculate the risk after calculating the expected rate of return. We

simply use the formula of standard deviation to calculate the risk

Stand Alone Risk of Single Stock Investment:

The wider the range of Possible Outcomes (i.e. the greater the variability in potential returns)

that can occur, the greater the Risk

Risk Measured using Standard Deviation (Note: Variance = Standard Deviation 2)

Risk = Std Dev =

( r i - < r i > )2 p i . =

Summed over each possible outcome " i " with return "r i " and probability of occurrence "p i ." < r i

> is the Expected (or weighted average) Return

This topic will be discussed in detail in the next lecture

Table of Contents: