The Concept of Return
• Return
– The level of profit from an investment, or
– The reward for investing
• Components of Return
– Current income: cash or near-cash that is received as a result of owning an investment
– Capital gains (or losses): the difference between the proceeds from the sale of an investment and its original purchase price
• Total Return: the sum of the current income and the capital gain (or loss) earned on an investment over a specified period of time
Why Return is Important
• Allows comparison of actual or expected gains with the levels of gain needed
• Allows us to “keep score” on how our investments are doing compared to our expectations
• Historical Performance
– Provides a basis for future expectations
– Does not guarantee future performance
• Expected Return
– Return an investor thinks an investment will earn in the future
– Determines what an investor is willing to pay for an investment or if they are willing to make an investment
The Time Value of Money and Returns
• The sooner you receive a return on a given investment, the better
• A dollar received today is worth more than a dollar received in the future
• The sooner your money can begin earning interest, the faster it will grow
Determining a Satisfactory Investment
• Satisfactory Investment: one for which the present value of benefits equals or exceeds the present value of its costs
Holding Period Return (HPR)
• Holding Period: the period of time over which an investor wishes to measure the return on an investment vehicle
-The total return earned from holding an investment for a specified holding period (usually 1 year or less)
• Realized Return: current return actually received by an investor during the given return period
• Paper Return: return that has been achieved but not yet realized (no sale has taken place)
Sources of Risk
• Risk-Return Tradeoff is the relationship between risk and return, in which investments with more risk should provide higher returns, and vice versa
• Risk is the chance that the actual return from an investment may differ from what
is expected
is expected
• Currency Exchange Risk is the risk caused by the varying exchange rates between the currencies of two countries. (Discussed in
Chapter 2)
Chapter 2)
-Types of Investments Affected
• International stocks or ADRs
• International bonds
-Examples of Currency Exchange Risk
• U.S. dollar gets “stronger” against foreign currency, reducing value of foreign investment
• Business Risk is the degree of uncertainty associated with an investment’s earnings and the investment’s ability to pay the returns owed to investors.
-Types of Investments Affected
– Common stocks
– Preferred stocks
-Examples of Business Risk
– Decline in company profits or market share
– Bad management decisions
–
• Financial Risk is the degree of uncertainty of payment resulting from a firm’s mix of debt and equity; the larger the proportion of debt financing, the greater this risk.
-Types of Investments Affected
– Common stocks
– Corporate bonds
-Examples of Financial Risk
– Company can’t get additional loans for growth or to fund operations
– Company defaults on bonds
• Purchasing Power Risk is the chance that changing price levels (inflation or deflation) will adversely affect investment returns.
-Types of Investments Affected
– Bonds (fixed income)
– Certificates of deposit
-Examples of Purchasing Power Risk
– Movie that was $8.00 last year is $9.00 this year
• Interest Rate Risk is the chance that changes in interest rates will adversely affect a security’s value.
-Types of Investments Affected
– Bonds (fixed income)
– Preferred stocks
-Examples of Interest Rate Risk
– Market values of existing bonds decrease as market interest rates increase
– Income from an investment is reinvested at a lower interest rate than the original rate
–
• Liquidity Risk is the risk of not being able to liquidate an investment conveniently and at a reasonable price.
-Types of Investments Affected
– Some small company stocks
– Real estate
-Examples of Liquidity Risk
– The price of a house has to be lowered for a quick sale
• Tax Risk is the chance that Congress will make unfavorable changes in tax laws, driving down the after-tax returns and market values of certain investments.
-Types of Investments Affected
– Municipal bonds
– Real estate
-Examples of Tax Risk
– Lower tax rates reduce the tax benefit of municipal bond interest
– Limits on deductions from real estate losses
• Market Risk is the risk of decline in investment returns because of market factors independent of the given investment.
-Types of Investments Affected
– All types of investments
-Examples of Market Risk
– Stock market decline on bad news
– Political upheaval
– Changes in economic conditions
• Event Risk comes from an unexpected event that has a significant and unusually immediate effect on the underlying value of an investment.
-Types of Investments Affected
– All types of investments
-Examples of Event Risk
– Decrease in value of insurance company stock after
a major hurricane
a major hurricane
– Decrease in value of real estate after a major earthquake
Figure 4.2 Risk-Return Tradeoffs for Various Investment Vehicles
Steps in the Decision Process:
Combining Return and Risk
Combining Return and Risk
• Estimate the expected return using present value methods and historical/projected return rates
• Assess the risk of the investment by looking at historical/projected returns using standard deviation or coefficient of variation of returns
• Evaluate the risk-return of each investment alternative to make sure the return is reasonable given the level of risk
• Select the investment vehicles that offer the highest expected returns associated with the level of risk you are willing to accept
Referance:
1) Gitman, Joehnk; Fundamentals Investing 10th Edition; 2008
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