Chapter 3

26

Investment Planning

PDP

Measurement of Risk

e invest in various investment vehicles expecting some amount of return from these avenues. The investment risk refers to the probability of actually not earning the desired or expected return and may be a lower or negative return. A particular investment is considered riskier if the chances of lower than expected returns or negative returns are higher. Standard deviation (si) measures total, or stand-alone, risk. The larger the si, the lower the probability that actual returns will be close to the expected return.

Standard Deviation
When an investor goes in for an investment option, he may do so expecting to get a return of say 15% in one year. This is only a one-point estimate of the entire range of possibilities. Given that an investor must deal with the uncertain future, a number of possible returns can and will occur. In the case of a Treasury bill, of say 90 days, paying a fixed rate of interest, the interest payment will be made with 100 per cent certainty barring a financial collapse of the economy. The probability of occurrence is 1.0, because no other outcome is possible. With the possibility of two or more outcomes, which is the norm for stock market investment, each possible likely outcome must be considered and a probability of its occurrence assessed. The result of considering these outcomes and their probabilities together is a probability distribution consisting of the specification of the likely returns that may occur and the probabilities associated with these likely returns. Probabilities represent the likelihood of various outcomes and are typically expressed as a decimal (sometimes fractions are used.) The sum of the probabilities of all possible outcomes must be 1.0, because they must completely describe all the (perceived) likely occurrences. How are these probabilities and associated outcomes obtained? The probabilities are obtained on the basis of past occurrences with suitable modifications for any changes expected in the future. In the final analysis, investing for some future period involves uncertainty and, therefore, subjective estimates. Investors and analysts should be at least somewhat familiar with the study of probability distributions. Since the return which an investor earns from investing is not known, it must be estimated. An investor may expect the TR (total return) on a particular security to be 10 per cent for the coming year, but in truth, this is only a point estimate. Probability distributions can be either discrete or continuous. With a discrete probability distribution, a probability is assigned to each possible outcome. With a continuous probability distribution an infinite number of possible outcomes exist. The most familiar continuous distribution is the normal distribution depicted by the well-known bell-shaped curve often used in statistics. It is a two-parameter distribution in which the mean and the variance fully describe it. To describe the single most likely outcome from a particular probability distribution, it is necessary to calculate its expected value. The expected value is the average of all possible return outcomes, where each outcome is weighted by its respective probability of occurrence. For investors, this can be described

PDP

Investment Planning

27

as the expected return. Expected Return In the case of a fixed income security like a Government of India Bond or a bank fixed deposit, normally the expected return is the same as the coupon rate or rate of interest. Hence there, are no uncertainties about being able to get the expected return. In the case of investments where the returns are market dependant, for example a stock, one will have to estimate the possible returns and the probability of getting the same, as given here below:

In this case, the expected return is calculated as under: Expected return = Sum (returns*probability) = = = (0.04*0.1+0.08*0.2+0.12*0.4+0.16*0.2+0.2*0.1) .004+.016+.048+.032+.02 0.12 or 12%

It is a normal distribution curve as pictorially depicted below:

28

Investment Planning

PDP

Standard Deviation We have mentioned that its important for investors to be able to quantify and measure risk. To calculate the total risk associated with the expected return, the variance or standard deviation is used. This is a measure of the spread or dispersion in the probability distribution; that is, a measurement of the dispersion of a random variable around its mean. Without going into further details, just be aware that the larger this dispersion, the larger the variance or standard deviation. Since variance, volatility and risk can in this context be used synonymously, remember that the larger the standard deviation, the more uncertain the outcome. Calculating Standard Deviation Lets use the same table that we did for calculating the expected returns and find out the standard deviation of the same:

Standard deviation is square root of variance. Variance = Sum of {Probabilities*(actual return expected return)2} Variance = Probability * (actual return expected return)2

So, based on the figures in the table we can work out the variance as under; Expected return already calculated to be 12%

Variance = sum of last column = (6.4+3.2+0+3.2+6.4) = 19.2 Standard deviation = Square root of variance = 4.3817 Lets quickly work out another example to understand how to arrive at expected returns and calculate standard deviation.

PDP

Investment Planning

29

Expected return = [-6*.15+0*.2+6*.3+12*.2+18*15) = [-0.9+0+1.8+2.4+2.7] = 6% Standard deviation can be worked out as follows:

Variance = (21.6+7.2+0+7.2+21.6) = 57.6 Standard deviation = 7.5895 Calculating a standard deviation using probability distributions involves making subjective estimates of the probabilities and the likely returns. However, we cannot avoid such estimates because future returns are uncertain. The prices of securities are based on investors expectations about the future. The relevant standard deviation in this situation is the ex ante (estimated before the event) standard deviation and not the ex post (calculated after the events/historic) based on realized returns. Although standard deviations based on realized returns are often used as proxies for projecting standard deviations, investors should be careful to remember that the past cannot always be extrapolated into the future without modifications. Historic (ex post) standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviation is the distinction between individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the future. Moving from well- diversified portfolios to individual securities, however, makes historical calculations less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable. Something very important to remember about standard deviation is that it is a measure of the total risk of an asset or a portfolio, including both systematic and unsystematic risk. It captures the total variability in the assets or portfolios return, whatever the sources of that variability. In summary, the standard deviation of return measures the total risk of one security or the total risk of a portfolio of securities. The

30

Investment Planning

PDP

historical standard deviation can be calculated for individual securities or portfolios of securities using total returns for some specified period of time. This ex post value is useful in evaluating the total risk for a particular historical period and in estimating the total risk that is expected to prevail over some future period. The standard deviation, combined with the normal distribution, can provide some useful information about the dispersion or variation in returns. In a normal distribution, the probability that a particular outcome will be above (or below) a specified value can be determined. With one standard deviation on either side of the arithmetic mean of the distribution, 68.3 percent of the outcomes will be encompassed; that is, there is a 68.3 percent probability that the actual outcome will be within one (plus or minus) standard deviation of the arithmetic mean. The probabilities are 95 and 99 percent that the actual outcome will be within two or three standard deviations, respectively, of the arithmetic mean.

In a bell shaped normal distribution the probabilities for values lying within certain bands are as follows: 1 S.D. 2 S.D. 3 S.D. 68.3% 95.4% 99.7%

What Standard Deviation Means Say a fund has a standard deviation of 4% and an average return of 10% per year. Most of the time (or, more precisely, 68% of the time), the funds future returns will range between 6% and 14% (or its 10% average plus or minus its 4% standard deviation). Almost all of the time (95% of the time), its returns will fall between 2% and 18%, or within two standard deviations i.e. [10-(2*4) or 10 + (2*4)] Limitations of Standard Deviation Using standard deviation as a measure of risk can have its drawbacks. For starters, its possible to own a fund with a low standard deviation and still lose money. In reality, thats rare. Funds with modest standard deviations tend to lose less money over short time frames than those with high standard deviations.

PDP

Investment Planning

31

The bigger flaw with standard deviation is that it isnt intuitive. Certainly, a standard deviation of 7% is higher than a standard deviation of 5%, but these are absolute figures and one can not reach a conclusion as to whether these are high or low figures. Because a funds standard deviation is not a relative measure, which means its not compared to other funds or to a benchmark, it is not very useful to the investor without some context.

Case
Let us consider two stocks: stock X and stock Y whose returns and probability are given as follow: Stock X

Expected return on stock X is sum of the last column which is 12% Stock Y

Expected return on stock Y is the sum of the last column which is 12%. In this example, we find that the expected returns of both stocks are the same. If the expected returns on two stocks are the same, obviously one should prefer that stock where the risk is less. In other words, we shall go ahead and measure the standard deviation of both the stocks to find out which stock is more likely to give us the expected returns of 12%.

32

Investment Planning

PDP

Variance which is the sum of the last column = 2.1 Standard deviation for stock X = 1.449 Lets work out for stock Y

Variance of stock Y which is the sum of last column = 0.6 Standard deviation of stock Y = 0.77 Thus, after the calculation of total risk (standard deviation), it is obvious that stock Y is more likely to deliver the expected returns of 12% compared to stock X. This case has been discussed basically to understand that while deciding on which stock to invest in, it is important to consider the expected return as well as the total risk of not getting the desired return stock wise and reach decision accordingly. All the same, it may be pertinent to point out here that standard deviation is more seriously considered and is useful in portfolio of stocks rather than individual stocks. We shall consider the portfolio scenario in the subsequent topics.

Beta
Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. Beta measures non-diversifiable risk. Beta shows the price of an individual stock which performs with changes in the market. In effect, the more responsive the price of a stock to the changes in the market, the higher is its Beta. Beta is a relative measure of risk the risk of an individual stock relative to the market portfolio of all stocks. If the securitys returns move more (or less) than the markets returns as the latter changes, the securitys returns have more (or less) volatility (fluctuations in price) than those of the market. It is important to note that beta measures a securitys volatility, or fluctuations in price, relative to a benchmark, the market portfolio of all stocks.

PDP

Investment Planning

33

Securities with different slopes have different sensitivities to the returns of the market index. If the slope of this relationship for a particular security is a 45-degree angle, the beta is one (1). This means that for every one percent change in the markets return, on average, this securitys returns change one (1) per cent. The market portfolio has a beta of one (1). A security with a beta of 1.5 indicates that, on average, security returns are 1.5 times as volatile as market returns, both up and down. This would be considered an aggressive security because when the overall market return rises or falls 10 per cent, this security, on average, would rise or fall 15 per cent. Stocks having a beta of less than 1.0 would be considered a more conservative investment than the overall market. Betas can be negative or positive. But generally, betas have been found to be positive which means that the direction of the movement of individual stock generally tends to be in line with the market: falling when the market is falling and rising when the market is rising. Beta is useful for comparing the relative systematic risk of different stocks and, in practice, is used by investors to judge a stocks risk. Stocks can be ranked by their betas. Because the variance of the market is a constant across all securities for a particular period, ranking stocks by beta is the same as ranking them by their absolute systematic risk. Stocks with high betas are said to be high-risk securities. Given below are different scenario showing how the portfolio return moves relative to market for Beta equal to 1, 0.5, and 2.

34

Investment Planning

PDP

The beta of a security is a historical measure and it is arrived at by plotting the actual returns on the security over long periods of time with market returns as shown in the earlier charts. A line is drawn which depicts beta of the security. To determine the beta of any security, youll need to know the returns of the security and those of the benchmark index you are using for the same period. Using a graph, plot market returns on the X-axis and the returns for the stock over the same period on the Y-axis. Upon plotting all of the monthly returns for the selected time period (usually one year), we draw a bestfit line that comes the closest to all of the points. This line is called the regression line. Beta is the slope of this regression line. The steeper the slope, the more the systematic risk, the shallower the slope, the less exposed the company is to the market factor. In fact, the coefficient (Beta) quantifies

PDP

Investment Planning

35

the expected return for the stock, depending upon the actual return of the market. Calculating Beta Rs = a + BsRm Where, Rs = estimated return on the stock a = estimated return when the market return is zero Bs = measure of the stocks sensitivity to the market index Rm = return on the market index Allowing for random errors, some times beta is calculated as under: Rs = a + BsRm+ e Where, e is the random error term embodying all of the factors that together make up the unsystematic return. If we want to compare the return on the security related to the risk free avenues, then the formula is: Rs = Rf + Bs (Rm - Rf) Where the concept of Rf is the risk free return return that can be obtained by investing in risk free securities like treasury bills.

Case
For example, suppose you are considering a private equity investment in a company with a new job work. The process is inherently risky, i.e. the standard deviation of the project is 75% per year. The beta of the project is 0.5. The Rf = 5% and the E[Rm] = 14.5%. What is the required rate of return on the project? Theory tells us that the answer does not depend upon the volatility associated with the returns. Instead we use the beta of the project. E[Rjob] = 5% + (.5)(14.5% - 5%) = 9.5% This is the required rate of return on the project. The answer would not change if the range of outcome next year broadened or narrowed. (beta) is the only relevant piece of information now all that remains is to estimate it!

36

Investment Planning

PDP

Review Questions: 1. Mr. Joshi has analysed a stock for a one-year holding period. The stock is currently quoting at Rs 100 and is paying no dividends. There is a 50-50 chance that the stock may quote Rs 100 or Rs 120 by year-end. What is the expected return on the stock? a. 12% b. 10% c. 15% d. 20% 2. A stock is quoting at Rs. 100 and is paying no dividends. The possible year end price and the probabilities are given below: Year end price 110 115 120 125 130 a. 10% b. 15% c. 8% d. 20% 3. What is the standard deviation of the stock based on the figures in question 2? a. 14.45 b. 5.79 c. 16.30 d. 33.60 4. Stocks A and B are not paying any dividends. Stock A is quoting at Rs. 100 while B is quoting at Rs 50. There is a 50-50 chance that stock A will quote at Rs 120 and Rs 140 while there is a 5050 chance that the stock B will quote at Rs 60 and Rs 70 at the end of the year. Which stock will you buy considering the return and the risk? a. I shall buy B because it is cheaper b. I will buy Stock B because the risk is less c. I will buy Stock A because the risk is less d. The risk and the return in both are same; I shall buy any one 5. Compute the expected return for the stock when the risk free return is 8% and the expected return from the market is 12% for a stock with Beta of 1.2. a. 15.6% b. 12.8% c. 16.4% d. 22.2% Probabiltiy 0.1 0.2 0.3 0.2 0.1

What is the expected return on the stock?

PDP

Investment Planning

37

6.

Beta of stock A is 1.5 while that of stock B is 1. If the market is expected to rise then an aggressive investor would buy: a. Either A or B; because in a rising market all stocks will rise b. Stock A because it may deliver superior returns compared to B c. Stock B because the risk will be less compared to A while the returns would be the same d. Stock B because it may deliver superior returns compared to A

Answers: 1. 2. 3. 4. 5. 6. b c b d - (while deciding you calculate the risk also besides the returns) b - use the formula Rs = Rf + Bs (Rf -Rm) b - higher beta means higher risk and also higher returns compared to market.

38

Investment Planning

PDP