Risk-Return

Analysis
 WHAT IS RETURN?

Return is measured by taking the income plus price

change. Income is dividend and price change is the
capital gain.

Rate of Return
= (Income received + Price change)/Purchase
Price of Asset

= {D + (P1 - P0)} / P0
 MEANING OF RISK
Variability of return
• ELEMENTS OF RISK
• The essence of risk in an investment is the variation in
return. This variation in return is caused by a number of
factors that are called the elements of risk.
• The elements of risk may be broadly classified into two
groups as follows:
 Elements of risk
(Risk factor)

Group I Group II
External factors Internal factors
which are which are
noncontrollable controllable

Produces Produces
Systematic Risk Unsystematic Risk
 TOTAL RISK
• The total variability in returns of a security
represents the total risk of that security.
• Systematic risk and unsystematic risk are
the two components of total risk. Thus

• Total risk = Systematic risk + Unsystematic risk

 SYSTEMATIC RISK

• The portion of the variability of return of a

security that is caused by external factors, is
called systematic risk.
• Economic and political instability,
• Economic recession,
• Macro policy of the government, etc.
• affect the price of all shares systematically.
• Thus the variation of return in shares, which is
caused by these factors, is called systematic
risk.
 UNSYSTEMATIC RISK

• The security return sometimes varies because of

certain factors affecting only the company
issuing such security.
• Examples are
• Raw material scarcity,
• Labour strike,
• Management efficiency etc.
• When variability of returns occurs because of
such firm-specific factors, it is known as
unsystematic risk.
• EXPECTED RETURN
• The expected return of the investment is the weighted average of all
possible returns. If the possible returns are 10, 15, 20, 25 and 30%
with equal profitability, the expected return is
1 n
• X= n 
i 1
Xi
• = 1/5( 10+15+20+25+30) = 20%
 RISK
The most popular measure of risk is the variance or standard deviation
of the possible returns. The S.D. of the above return series is
calculated as follows.

xi xi -x (xi –x)2
10 -10 100
15 -5 25
20 0 0
25 5 25
30 10 100
n n

 Xi =100
i 1
 (Xi-X)2 = 250
i 1
 n
1
• S.D.= σ = [ n  (Xi –X)2] =
i 1
[(1/5)250] = 7.12

• The σ measure is the total risk of the security

which comprises two components: systematic
variation and unsystematic variation.
• Total Risk
• = Systematic risk + Unsystematic risk
• DIVERSIFICATION OF RISK
• We have seen that total risk of an individual
security is measured by the standard deviation
(σ ), which can be divided into two parts i.e.,
systematic risk and unsystematic risk
• Total Risk (σ)
• = Systematic Risk + Unsystematic risk
• σ

• Un systematic risk

• Systematic risk
•
• Number of shares
• Figure 1: Reduction of Risk through Diversification
• Only to increase the number of securities in the portfolio will not
diversify the risk. Securities are to be selected carefully. If two
security returns are less than perfectly correlated, an investor
gains through diversification.
• If two securities M and N are perfectly negatively correlated, total
risk will reduce to zero.
• Suppose return are as follows:
t1 t2 t3 t4
M 10% 20% 10% 20%

N 20% 10% 20% 10%

Mean 15% 15% 15% 15%

Return
• 20% M

• 10% N

• Figure 2
• If r = -1 (perfectly negatively correlated), risk is completely
eliminated (σ = 0)
• If r = 1, risk can not be diversified away
• If r < 1 risk will be diversified away to some extent.
TWO IMPORTANT FINDINGS:
• More number of securities will reduce
portfolio risk.
• Securities should not be perfectly
correlated.