You cannot talk about investment returns without talking about risk because investment decisions invariably involve a trade off between the two.
Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome. More specifically most investors are concerned about the actual outcome being less than the expected outcome. The wider the range of possible outcome the greater is the risk.
Sources of risk:
Risk emanates from several sources. The three major ones are: business risk, interest rate risk, and market risk. While a detailed treatment of these sources of risk is woven throughout the book, a brief discussion may be given here.
Business Risk: As a holder of corporate securities (equity shares or debentures), you are exposed it the risk of poor business performance. This may be caused by a variety of factors like heightened competition, emergence of new technologies development of substitute products, shifts in consumer preferences in adequate supply of essential inputs changes in governmental policies, and so on. Often, of course the principal factor may be inept and incompetent management. The poor business performance definitely affects the interest of equity shareholders, who have a residual claim on the income and wealth of the firm. It can also affect the interest of debenture holders if the ability of the firm to meet its interest and principal payment obligation is impaired. In such a case, debentures holders face the prospects of default risk.
Interest Rate Risk: The changes in interest rate have a bearing on the welfare of investors. As the interest rate goes up, the market price of existing fixed income securities falls, and vice versa. This happens because the buyer of a fixed income security would not buy it at is par value or face value if its fixed interest rate is lower than the prevailing interest rate on a similar security. For example, a debentures that has a face value of Rs 100 and fixed rate of 12 percent will sell at a discount if the interest rate moves up from, say, 12 percent to 14 percent . While the changes in interest rate have a direct bearing on the prices of fixed income securities, they affect equity prices too, albeit somewhat indirectly. The change in the relative yields of debentures and equity shares influence equity prices.
Market Risk: Even if the earnings power of the corporate sector and the interest rate structure remain more or less unchanged, prices of securities, equity shares in particular tend to fluctuate. While there can be several reasons for this fluctuations a major cause appears to be the changing psychology of the investors. There are periods when investors become bullish and their investment horizons lengthen. Investor optimism which may border on euphoria during such a period drives share prices to great heights. The buoyancy created in the wake of this development is pervasive, affecting almost all the shares. On the other hand, when a wave of pessimism (which often is an exaggerated response to some unfavorable political or economic development) sweeps the market, investors turn bearish and myopic. Prices of almost all equity shares register decline as fear and uncertainty pervade the market.
One would expect large scale participation of institutions to dampen the price fluctuation in the market. After all institutional investors have core professional expertise to do fundamental analysis and greater financial resources to act on fundamental analysis. However, nothing of this has happened. On the contrary, price fluctuations seem to have become wider after the arrival of institutional investors in larger numbers.
Types of risk:
Modern portfolio looks at risk from a different perspective. It divides total risk as follows:
Total Risk = Unique risk + Market risk
The unique risk of security represents that portion of its total risk which stems from firm specific actors like the development of a new product, a labor strike or the emergence of a new competitor. Events of this nature primarily affect the specific firm and not all forms in general. Hence the unique risk of a stock can be washed away by combining it with other stocks. In a diversified portfolio, unique risk of different stocks end to cancel each other — a favorable development in one firm may offset an adverse happening in another and vice versa, Hence, unique risk is also referred to as diversified risk or unsystematic risk.
The market risk of a stock represents that portion of its risk which is attributable to economy wide factors like the growth rate of GDP, the level of government spending money supply, interest rate structure and inflation rate. Since these factors affect all firms to a greater or leer degree, investors cannot avoid the risk arising from them, however diversified their portfolios may be. Hence, it is also referred to as systematic risk (as it affects all securities) or non-diversifiable.