Real Estate Financing and Investing/Understanding Return and Risk
To be successful as an investor, you need an understanding of investment risk and realistic expectations of reward. Also, an understanding of the tradeoff between the return you are expecting from an investment and the degree of risk you must assume to earn it is perhaps the most important key to successful investing. This chapter discusses:
- Return and how it is measured.
- Types of risk and how to reduce risk.
- Investment alternatives and their relationship to risk.
What Is Return?
Return is a key consideration in the investment decision. It is the reward for investing. You must compare the expected return for a given investment with the risk involved. The return on an investment consists of the following sources of income:
- Periodic cash payments, called current income.
- Appreciation (or depreciation) in market value, called capital gains (or losses).
Current income, which is received on a periodic basis, may take the form of interest, dividends, rent, and the like. Capital gains or losses represent changes in market value. A capital gain is the amount by which the proceeds from the sale of an investment exceeds its original purchase price. If the investment is sold for less than its purchase price, then the difference is a capital loss.
The way you measure the return on a given investment depends primarily on how you define the relevant period over which you hold the investment, called the holding period. We use the term holding period return (HPR), which is the total return earned from holding an investment for that period of time. It is computed as follows:
HPR = (Current Income + Capital Gain (or loss)) / Purchase Price
EXAMPLE 1 Consider the investment in stocks A and B over a one period of ownership:
|Purchase price (beginning of year)||$100||$100|
|Cash dividend received (during the year)||$13||$18|
|Sales price (end of year)||$107||$97|
The current income from the investment in stocks A and B over the one year period are $13 and $18, respectively. For stock A, a capital gain of $7 ($107 sales price $100 purchase price) is realized over the period. In the case of stock B, a $3 capital loss ($97 sales price $100 purchase price) results.
Combining the capital gain return (or loss) with the current income, the total return on each investment is summarized below:
|Capital gain (loss)||7||(3)|
Thus, the return on investments A and B are:
HPR (stock A) = ($13 + ($107 - $100)) / $100 = ($13 + $7) / $100 = $20 / $100 = 20%
HPR (stock B) = ($18 + ($97 - $100)) / $100 = ($18 - $3) / $100 = $15 / $100 = 15%
Table 1 shows the rates of return in ranking order by type of investment for the period 1997 - 2006.
Table 1. Rates of Return in Ranking Order 2000-2008
Risk and the Risk-Return Trade Off
Risk refers to the variability of possible returns associated with a given investment. Risk, along with the return, is a major consideration in investment decisions. The investor must compare the expected return from a given investment with the risk associated with it. Higher levels of return are required to compensate for increased levels of risk. In general, there is a wide belief in the risk return trade off. In other words, the higher the risk undertaken, the more ample the return, and conversely, the lower the risk, the more modest the return.
What are the Types Of Risk?
Risk refers to the variation in earnings. It includes the chance of losing money on an investment. There are different types of risk. These risks affect various investment alternatives, such as stocks, bonds, or real estate, differently. All investments are subject to risk.
- Business risk. Business risk is the risk that the company will have general business problems. It depends on changes in demand, input prices, and obsolescence due to technological advances.
- Liquidity risk. It represents the possibility that an asset may not be sold on short notice for its market value. If an investment must be sold at a high discount, then it is said to have a substantial amount of liquidity risk.
- Default risk. It is the risk that the issuing company is unable to make interest payments or principal repayments on debt. For example, there is a great amount of default risk inherent in the bonds of a company experiencing financial difficulty. The marketable securities with the lowest default risk are those issued by the federal government because they are backed by the full faith and credit of the U.S. Agency securities are issued by agencies and corporations created by the federal government, such as the Federal Housing Administration. They are backed by a secondary promise form the government.
- Market risk. Prices of all stocks are correlated to some degree with broad swings in the stock market. Market risk refers to changes in the price of a stock that result from changes in the stock market as a whole, regardless of the fundamental change in a firm`s earnings power. For example, the prices of many stocks are affected by trends such as bull or bear markets.
- Interest rate risk. It refers to the fluctuations in the value of an asset as the interest rates and conditions of the money and capital markets change. Interest rate risk relates to fixed income securities such as bonds and real estate. For example, if interest rates rise (fall), bond prices fall (rise).
- Purchasing power risk. This risk relates to the possibility that you will receive a lesser amount of purchasing power than was originally invested. Bonds are most affected by this risk since the issuer will be paying back in cheaper dollars during an inflationary period.
- Systematic risk. This risk is the relevant risk of a security is its contribution to the portfolio`s risk. It is the risk that cannot be eliminated through diversification. The relevant risk results from factors, such as recession, inflation, and high interest rates that affect all stocks.
Risk and return are two major factors you should consider in making financial and investment decisions. You must compare the expected risks and returns of each investment. Always remember that the higher the return, the higher the risk. In order to reduce the risk, you might want to diversify your investment holdings by constructing a portfolio of different investments.
The chapter covered a wide range of tools and measures associated with return and risk. The need for an understanding of different types of risks was emphasized.