MGT201 Module 7 Topics 127-144 Preparation

Topic 127: Risk & Return Analysis

Return

• Additional amount on investment · • Dividend · • Interest

Risk

• Uncertainty

• Expected Return/Mean

• Deviation for Mean/Std. Dev.

• Risk & Return are Proportional

Risk and Return are two concepts which go together and in hand. It means that Risk and Return are two such concepts which are difficult to understand separately but we need to understand them with each other’s reference.

Return:

When we define Return, it is simply the additional amount that we get on our investment. When we use the term Return, the other term that is very obvious and that should be discussed along with Return is Investment.

Investment means that if we forgo or give our money to someone or invest anywhere for some time against which we get some additional amount or additional return after some time. And this is what we say is the concept of Return.

So, when we say that we are earning some Return, it means we have made some investment and the rate of return or the amount of return is certainly that every investor would consider. The investor receives this return in which form and for this we need to know the two basic kinds of investment.

One investment may be in equity meaning that we purchase shares of any business organization or company and become owner of that company as we know that the shareholders are the owners of a company. And the other possibility is that we give a loan or debt to the company and we become as debt holder. A shareholder is an investor and a debt holder is also an investor.

How can an Individual be a lender to a corporation or a business organization?

Individuals purchase bonds of the companies or debt certificates or debt securities of a company to become lenders and investors in the form of debt to the company.

The people or investors who purchase shares or stocks of any company then the return that they get are profit. And the profit when distributed among these shareholders then it is called Dividend. So, the Dividend is such return that is given to the shareholders on their investment.

Likewise, the lenders, the bond holders, the debt security holders; the return that they get is generically called Interest. So, Return is that additional amount which will be given to the investor and will be in the form of dividend or interest.

Risk:

Risk actually is the name of Uncertainty. Risk means that when we are investing our money how unsure we are that what will be the return that we will get. If we are sure that the rate of return or the amount of return that we will get on our investment will be exactly the same as we have anticipated then there is no Risk.

But this is not the case whenever we are making investments. Particularly, when we are talking about the Stock market, Security market, Capital market and other types of markets where most of the investors put their money. So, Risk is Uncertainty of Return.

When we talk about Risk with reference to the investment in shares and in bonds, actually initially there is an Expectation of Return from our Investment. When any investor invests his money anywhere then he has some expectation of return that he wants to get from this investment. He sees the past returns of that business or company and by calculating percentage of an average return to develop or make it his expectation. Meaning that Expected Return on an investment is actually the average or mean return on that investment of the past few years or month or weeks or days even.

And when we talk about Risk, it is the Deviation from that Expected Return. It means that Risk is that our Expectation which we have to get return then our actual return can be how much more or less than that Expectation. Because in reality, we cannot be sure that our Expected Return or our Actual return both will be the same.

So, the Deviation or possible Deviation or probable Deviation from our Expected Return which is the Mean, is actually the Risk.

Now, the last thing that we need to understand and remember about these two concepts of Risk and Return that these are Directly Proportional to each other.

What is meant by Directly Proportional?

It means that if one thing will increase then other will also increase and similarly if one thing will decrease then other thing will also decrease. It means that if we want that our Return increase then we have to take more Risk. And if we decrease our Risk level then our Return will also be decreased.

So, the securities where the Risk Level is high, provide higher Return and the securities where the Risk Level is low also provide low of Return.

To conclude our discussion on these concepts of Return & Risk analysis, we would say that Return is what we get on our investment. But the question that we need to remember that this Return can be positive as well as negative and that is something which is related to Risk and will discuss in detail in upcoming lectures.