Personal Financial Management and Investment Strategies Notes

UNIT – 2: Managing Investment Risk

• Objectives

• Introduction

• Meaning of Risk

• Types of Risks in Investment

  • Systematic Risk

  • Unsystematic Risk

• Measurement of Risk

  • Standard Deviation

  • Beta

• Risk and Return trade off

• Check your progress

• Notes

• Summary

• Key Words

• Questions for self-study

• References

2.0 OBJECTIVES

• Describe the concept of risk.

• Identify different sources of risk.

• Understand the different methods of measuring investment risk.

• Explain the trade-off between risk and return.

2.1 INTRODUCTION

• Investment involves the commitment of funds to generate future income.

• Returns from investments are not guaranteed and subject to risk.

• Uncertainty about expected return is referred to as investment risk.

• It is essential to understand the nature and types of risks to make informed investment decisions.

2.2 MEANING OF RISK

• Risk: probability that actual return differs from expected return.

• Represents uncertainty about investment's future outcome.

• In personal finance: chance of financial loss; affects investment selection.

• Lower risk tolerance impacts financial decisions, as risk is inevitable in financial goals.

2.3 TYPES OF RISKS IN INVESTMENT

• Investment risks affect potential returns; understanding them aids investment decisions.

2.3.1 Systematic Risk

• Systematic Risks: market-wide, non-diversifiable factors affecting all assets; interest rates, inflation, recession, etc.

1. Market Risk

   • Market Risk: fluctuations from investor sentiment, economic changes, social/political events.

   • Affects stock prices; difficult to predict, impacting investor returns.

   • Beta measures market risk sensitivity; > 1 = aggressive; < 1 = defensive.

2. Interest Rate Risk

   • Interest Rate Risk: fixed-income value changes due to interest rate variations.

   • Increased rates lower bond values; longer maturities have higher risk.

3. Purchasing Power Risk

   • Purchasing Power Risk: inflation reduces real investment return.

   • Inflation erodes returns; unexpected inflation impacts investments negatively.

2.3.2 Unsystematic Risk

• Unsystematic Risk: Specific to a company or industry; can be reduced via diversification.

1. Business Risk

   • Business Risk: Company's operational efficiency impacts shareholder earnings.

   • Influenced by competition, management, technology, product obsolescence.

2. Financial Risk

   • Financial Risk: Capital structure (debt/equity) impacts earnings per share.

   • Debt increases financial risk; high ratio may lead to bankruptcy.

2.4 MEASUREMENT OF RISK

• Risk measurement and evaluation are essential in investment decisions. $σ$ and beta are most common measures.

2.4.1 Standard Deviation

• $σ$: dispersion around average; quantifies investment return volatility.

• Higher $σ$ signifies greater volatility; useful for comparing investments.

• Indicates spread of data set.

• Useful in investment; measures volatility of Investment Returns.

• $σ$ near zero = less volatile and comparatively steady returns.

• To Calculate $σ$: Calculate each return’s deviation from average return.

  • Square each deviation to remove (-) sign.

  • Total all squared figures.

  • Divide by number of returns.

  • Obtain by square root of the variance.

2.4.2 Beta

• Beta: Volatility relative to market; measures systematic risk.

• Beta > 1: more volatile than market; < 1: less volatile.

• Beta = 1: price moves with market.

• Negative beta: moves inversely to market.

• Calculate beta through regression of asset returns vs. market returns.

2.5 RISK AND RETURN TRADE OFF

• Risk-return tradeoff: higher potential returns accompany higher risk.

- Investors expect compensation for additional risk.