Understanding Risk and Return in Single Stock Investments
Learning Objectives
After completing this lecture, you will understand the following topics:
- Introduction to Risk
- Risk and Return for Single Stock Investments
Before discussing this important topic, let’s review the areas of finance we have studied so far.
Part I: Introduction and Capital Budgeting
- Financial Markets, Concepts, Definitions
- Review of Accounting
- Interest Rate Theory and Calculations
- Investment Decisions: Net Present Value (NPV) (Valuation), Internal Rate of Return (IRR), Payback
- Capital Budgeting: NPV and Discounted Cash Flow (DCF)
- Capital Rationing (Budgeting for Real Assets)
Part II: Securities Valuation
- Valuation of Stocks and Bonds (Direct Claim Securities)
Chapters 4 and 5 of the textbook cover the topics of risk and return. This is a fundamental concept for understanding portfolio theory and the Capital Asset Pricing Model (CAPM). In previous lectures, we have ignored the origin of the required rate of return.
Risk
Chinese Definition of Risk:
Risk is defined as the combination of danger and opportunity.
When we discuss risk in the context of investment, we are referring to the uncertainty in the outcome of our investment. We are talking about the variability, spread, or volatility that can occur in the expected future value (cash flows) or returns. For example, if we invest Rs 1,000 to buy a share today, what will be the price of the share one year from now? There is no guarantee about the share price after one year; therefore, there is uncertainty or risk because we do not know the final outcome. The difference or variation in the possible outcomes of a particular investment also represents the riskiness of that investment.
As we have studied earlier, there are two major categories of assets:
- Real Physical Assets
- Financial Assets (Stocks and Bonds)
Risk can be understood in relation to the uncertainty of future cash flows produced by assets (physical and financial securities). Businesses make forecasts based on certain assumptions, as discussed in lecture 5. These forecasts are not 100% accurate, and there is uncertainty in the possible outcomes. The actual cash flows one or five years from now may differ significantly from the forecast, and this represents risk. When discussing risk in investing in direct claim securities, we must distinguish between Standalone Risk (or Single Investment Risk) and Market or Portfolio Risk (or Collection of Investments Risk). Standalone risk is the risk of a particular investment compared to other investments. In portfolio risk, we are interested in the overall risk of the entire collection of investments made by the company. We will study this topic in the next lectures.
In the case of portfolio risk, we can further distinguish between Diversifiable Risk and Market Risk.
- Diversifiable Risk: Random risk specific to one company, which can be virtually eliminated through diversification.
- Market Risk: Uncertainty caused by broad movements in the market or economy. This is more significant.
Causes of Risk
These can be company-specific or general. Risk may arise from cash losses from operations or poor financial management. However, the real question is why these losses occurred. Possible reasons include the company’s debt, inflation, the economy, politics, war, or fate. Ultimately, the final analysis of risk is that it is a game of fate or chance.