In business ventures or investment planning, two things are always calculated by the capital holder: risk of the return and return on investment. The relationship between risk and return is inevitable. Let us define the two.
What are Returns?
Returns are usually quoted in percentage terms. They represent the gains or losses of a security in a particular time period. The basic premise is that an investor has a higher potential for larger gains or losses if he undertakes more risk on an investment. In finance, returns can be a Return on:
- Equity, or
We arrive at a Return on Investment in percentage terms by first calculating what the gain was and then divide it by the initial investment amount (or cost) of the investment. As an example, if you pay $50,000 for a number of stocks and then sell them later for $60,000, you receive a gain (or capital appreciation) of $10,000. Now, you divide the gain of $10,000 by the initial principal investment of $50,000. Therefore:
- $10,000 / $50,000 = 0.2 = 20%
In this scenario, the return after selling your stocks is 20%.
On the other hand, when we compute the Return on Equity to analyze a company’s performance, we take into account its net income and equity. So let’s say, Company A makes a profit of $20,000 this year and its equity capital is $200,000. We divide $20,000 by $200,000, and we arrive at a ROE of 10%.
As for Return on Assets which is relevant in analyzing financial stocks, the gain (or loss) that we consider in the computation is also the company’s net income. However, we divide the net income by the total company assets. If its net income for the year is $20,000 and total assets in the same year is $300,000, then we divide $20,000 by $300,000 and get an ROA of 6.67%.
What is considered a good ROI?
By now, you may be asking, if I am to start or am currently investing in the stock market, what’s a good return on investment? Is it 4%? How about 10%? Is 15% more than enough?
There are three things you must remember:
- Times and markets change. Wars start and end. Markets crash and recover. A government’s policy change also affects the economy and equity markets. There really is no one single figure that any investor will be satisfied with. It is all a matter of understanding your financial goals, objectives, constraints, as well as willingness and ability to take risk. You really don’t have to be overwhelmed by all the various market figures.
- Rates of return are dependent on market conditions. However, most experts suggest that you keep updated with the current performance figures of key stock market indexes. For example, if the S&P 500 index is up 7% for the one year period, then you might have to make sure that your portfolio of securities with similar exposure and risks are performing similarly.
- Be realistic in terms of your expectations. Expecting a 20% rate of return without research or plainly depending on what other investors say (or “hearsay”) will only disappoint you. Again, we go back to your financial goals. How long do you intend to keep your investment before enjoying the benefits? Do you intend to sell them straight away as soon as you enjoy a 30 to 50% gain? Are you aware of the fees of your pension funds, bonds, stocks and other types of money market instruments? By analyzing these things, among others, you will have a more clear understanding of what to expect regarding your investments.
Next, we’ll discuss another very important factor in stock investing; Risk.
Risk is simply the possibility of losing some or all of your original investment in any form of security. The more an asset fluctuates in value in a shorter period of time, the more volatile it is, and the more risky it’s considered to be. Again, in most cases the higher the risk of an investment, the higher the potential return. The lower the risk of an investment, the lower your potential returns.
Basic example: bonds have lower risks than equities (or stocks) because they’re generally less volatile, very often have periodic coupon payments, and get paid out first in case of company bankruptcy. Thus, bonds generally have lower potential for returns, while equities have higher potential for returns.
There are two main categories of risk: systematic and unsystematic.
Systematic risk affects the overall market instead of a specific industry or stock. It’s also referred to as “market risk”, “undiversifiable risk”, and “aggregate risk”. It pertains to an entire market or entire market segment’s vulnerability to events that affect a security’s price fluctuations. Some of these market events include:
- central bank’s decision to increase or decrease interest rates,
- aggregate income and GDP,
- worsening business production and customer orders in an industry,
- debt crisis, and
- many others.
Systematic risk is measured in terms of Beta in the capital asset pricing model (CAPM). Beta is the sensitivity of a security to market fluctuations. And CAPM computes the estimated return of an asset based on its beta and expected market returns.
While systematic risk pertains to the market as a segment or as a whole, unsystematic risk comes with a company or an industry that you invest in. It is also known as “specific risk”, “diversifiable risk” and “residual risk”. Some events that pertain to unsystematic risk are:
- employee strike,
- entrepreneurial error,
- unfavorable litigation,
- political and legal policy changes that affect the business,
- bad management,
- changes in business location or succession, and
- other company or industry specific events.
At this point, you should be aware that investment risk can either be inherent to an entire market, or is company or industry specific. Below, we’ll take a look at four types of risks that derive from the two categories discussed above. You need to be mindful of these risks in order to protect your investment portfolio.
- Business Risk – The value of a company’s stock is dependent on internal operational activities and external threats (competitors’ activities). Strategies, expansions, bankruptcies, mergers, regulatory environment changes and many other factors pose risks to investor portfolios.
- Liquidity Risk – Liquidity refers to how easy it is to buy or sell a security. The more liquid a security is, the more fair the price will be when trying to buy or sell it and the easier it is to get in and out of a trade. Illiquid securities have high bid-ask spreads. For instance, some illiquid securities may be trading at a premium (referred to as liquidity premium) from its fair market value. Therefore, if you’d want to buy that security, you’d have to pay more for it. Whereas, if you wanted to sell an illiquid security you may have to accept a lower price than its fair market value.
- Economic Risk – This refers to anything related to economic events and indicators. Some examples include production PMI, GDP, employment, inflation, monetary policy, currency valuations, etc. For example, at the end of 2015, the Federal Reserve increased interest rates. What did it mean to investors and regular consumers? It meant that borrowing money became more expensive. Companies received lower valuations (because of higher discount rates), bond prices declined (because of increased yields), and the US dollar surged.
- Concentration Risk – We have discussed so many areas relating to investment risks that by now you should have realized the importance of diversifying your investments. This fourth type of risk becomes present when you put all your investments in, say, only one type of security, such as equities. It is also not advisable to put all of your capital in only one type of market sector or industry. You will have a safer and more balanced portfolio if you diversify into different types of equities, bonds, commodities, and various other asset classes.
As discussed previously, higher levels of risk mean higher potential returns. Lower levels of risk will result in smaller potential returns. This is basically what the risk/reward (or return) trade-off is and what every investor needs to face when making their investment decisions.
Now that we have defined both returns and risks, why do we look into return on risk rather than return on investment? Why do we put more emphasis on the return on risk when considering how to develop your portfolio for wealth management?
Remember how we calculated return on investment? It was a simplistic calculation based on invested values without any risks taken into account. There is no point in focusing your attention to the return on investment only without looking at the risk. This is because the increase or decrease in the value of your investment depend largely on what is going on in the entire market, a market segment, a company, or industry.
How Risks Instead of Returns Affects an Investor’s Behavior
Below, we’ll look at some examples of risks and how these affect investor decisions.
Interest Rates – Let us take a look at how interest rates affect the stock market and investment decisions.
Before 2015 ended the Fed increased interest rates due to the belief that the US is on a good path to recovery after the financial crisis in 2008. How does that decision impact the stock market?
Simple: when the Fed increases interest rates it simply means that financial institutions have to borrow money from the Fed at higher costs (or rates), and when a consumer borrows from the bank, interest rates are consequently high as well. It becomes more expensive for a business to borrow money to expand. People have to pay higher rates for home mortgages, credit cards, auto loans and more.
Naturally, an increase in the federal funds rate (interest rate risk) will affect decision-making among businesses and individuals. Furthermore, as an investor, you will take into account, for example, the future cash flows of the company you will be investing in. If you see that Company A might have an undesirable outcome on their future cash flows as a result of increased interest rates due to their high debt, you will opt out from investing in their shares.
Now, if the market declines and there is a large possibility for Company A’s stock prices or remain stagnant or decline further, then of course you wouldn’t buy its stocks today. Not too many people will be interested in stocks ownership in a company that’s expected to lose value.
Here you can see how a major market event (increase in interest rates) triggered risk in a certain investment, which in turn affected an investor’s decisions. This just shows how closely investors look at risk in the market and very often base their decisions from that perspective.
Currency Fluctuations – Do currency exchange rates also affect behavior of investors? Of course! Otherwise, we wouldn’t even see those figures at banking institutions or when opening the business section of a newspaper.
Foreign exchange risk (also called FX risk or currency risk) is simply the risk of currency exchange rate movements. For example, exchange rates matter for companies who deal with more than one currency. If a company exports and imports goods and services to and from other countries it will exchange currencies. There are pros and cons for a US company with suppliers outside the country if dollar either strengthens or weakens. A company’s cash flow and earnings will depend on exchange rates, which will ultimately affects the company’s stock price. This then affects investor decisions.
Credit Risk – Credit risk is another example of an area of consideration in investments. When a company raises money by selling bonds, they are simply asking bond buyers for a loan. One way for investors to check the financial stability of the company they invest in is by looking at its bond ratings. If their credit risk is low and the bonds are rated as single, double or triple A’s, then they are in good standing. A company’s credit risk is calculated by checking into its collateral assets, their ability to generate revenues and their taxing authority, among other factors. If the overall ability of the borrower to repay is good, then chances are you would be more willing to invest part of your hard-earned money in this company’s corporate bonds.
Political Risk – What makes every election period exciting? The confidence by the people in the new government will affect market returns. Political risk is the risk that the returns on your investments may either be good or bad depending on current political changes and other governmental events. If part of your portfolio is invested in countries with instability threats and reforms, there is a higher risk that you will lose money in that exposure. Local labor laws, tax regulations, trade policies, legal and regulatory constraints, and other federal, state and local laws are just some of the events associated with political risks.
Here again, we see that as new political events occur, risks may rise or fall and investors act accordingly.
Key Difference between Return on Investment and Return on Risk
Again, for a given level of risk, you should be investing in the highest returning asset possible. For example, if a risk-free asset is offering 5% annual return, whereas an equity investment is also expected to generate 5% but at a higher risk, it’s much better to accept the risk free asset.
If you were to just see the 5% return on investment in a year’s time without knowing what risks were taken, would that be considered a good return or a poor one? The answer is unknown because if it was invested in a stock that fluctuates 10% every day that return is extremely poor due to how unsafe an investment like that is. But if it was invested in a risk-free asset such as treasuries, then the investment may very well be a good one (especially given the extremely low interest rate environment over the last several years).
Return on risk (ROR) takes this into account and provides an annual return figure that provides more than just a simple return on investment (ROI). ROI doesn’t tell you anything relating to the asset’s risk, whereas ROR (return on risk) does. Return on risk tells you how much you will earn for a given level of volatility or other risk measures.
As you can see, investing in securities comes with many risks. Your expected gains or losses will depend on your risk appetite. First, you need to know whether you are a conservative, moderate or aggressive investor, as well as your financial goals, in order to decide on the level of risk you are willing to take in order to arrive at your stated objectives.
You might be putting so much of your attention on what you should be doing to increase the value your capital through bonds, stocks, and other forms of securities. However, this kind of behavior will prove to be futile if you don’t have more than ample knowledge about the risks that come with your investment portfolio.
Are the companies you are planning to invest in affected by currency changes? Does the company perform many transactions outside the country? If so, how is the political situation there? Does this company have a double A bond rating? How do the prices of this company’s stocks perform in the last week? These are just some of the questions you need to ask in order to better understand the risks associated with the securities you choose for your portfolio. This is obviously more important than just knowing how much you expect to earn in a specified number of years. Our measure of return on risk is more helpful and can assist in understanding returns in the context of risk.
That is what we call understanding your investment’s high earning potential while still considering the possibility of incurring losses. And that, my friends, is the application of knowledge, which then leads to power.