Unit 1 Introduction to Investment:

Introduction
Investment vs. Speculation
The main difference between speculating and investing is the amount of risk undertaken in the trade.
Typically, high-risk trades that are almost akin to gambling fall under the umbrella of speculation,
whereas lower-risk investments based on fundamentals and analysis fall into the category of investing.

Investors seek to generate a satisfactory return on their capital by taking on an average or below-

average amount of risk. On the other hand, speculators are seeking to make abnormally high returns
from bets that can go one way or the other. It should be noted that speculation is not exactly like
gambling because speculators do try to make an educated decision on the direction of the trade, but the
risk inherent in the trade tends to be significantly above average.

Investment vs. Gambling

Think investing is the same as gambling or scratching off a lottery ticket?

Many people who are nervous about putting their money in the market hesitate because they believe
that investing comes down to the luck of the draw.
In other words, they believe their ability to make money investing comes down to pure chance, like the
flip of a card or roll of the dice.
Investors and gamblers have one thing in common. They both want to put more money in their
pockets. But investing and gambling could not be more different.

Investing Gambling

You control your risk. You can invest according to your

goals and timelines: Conservative, moderate or Risky. The odds are always in
aggressive. favor of the house.

Strategy: Slow and steady. Investors plan to make a Strategy: Fast money. Gamblers bet it all
consistent return on their investments every year. for the chance to make a bundle fast.

Taxes: By putting your money in a retirement account, Taxes: You have to pay taxes on any
you can defer paying taxes on your investment earnings. gambling or lottery winnings over $600

Here’s why investing your money can be a way better option than playing the lottery or betting it all on
a game of cards:
Investment Objectives
An investment is made because it serves some objective for an investor. Depending on the life stage
and risk appetite of the investor, there are three main objectives of investment: safety, growth and
income. Every investor invests with a specific objective in mind, and each investment has its own
unique set of benefits and risks. Let us understand these objectives in detail.

Depending on the life stage and risk appetite of the investor, there are three main objectives of
investment: safety, growth and income.

Safety

While no investment option is completely safe, there are products that are preferred by investors who
are risk averse. Some individuals invest with an objective of keeping their money safe, irrespective of
the rate of return they receive on their capital. Such near-safe products include fixed deposits, savings
accounts, government bonds, etc.

Growth

While safety is an important objective for many investors, a majority of them invest to receive capital
gains, which means that they want the invested amount to grow.There are several options in the market
that offer this benefit. These include stocks, mutual funds, gold, property, commodities, etc. It is
important to note that capital gains attract taxes, the percentage of which varies according to the
number of years of investment.

Income

Some individuals invest with the objective of generating a second source of income. Consequently,
they invest in products that offer returns regularly like bank fixeddeposits, corporate and government
bonds, etc.

Other objectives

While the aforementioned objectives are the most common ones among investors today, some other
objectives include:

 Tax exemption
Some people invest their money in various financial products solely for reducing their tax
liability. Some products offer tax exemptions while many offer tax benefits on long-term
profits.

 Liquidity
Many investment options are not liquid. This means they cannot be sold and converted into
cash instantly. However, some people prefer investing in options that can be used during
emergencies. Such liquid instruments include stock, money market instruments and exchange-
traded funds, to name a few.
Investment Attributes

To enable the evaluation and a reasonable comparison of various investment avenues, the investor
should study the following attributes:

1. Rate of return

2. Risk

3. Marketability

4. Taxes

5. Convenience

Each of these attributes of investment avenues is briefly described and explained below.

1. Rate of return: The rate of return on any investment comprises of 2 parts, namely the annual income
and the capital gain or loss. To simplify it further look below:

Rate of return = Annual income + (Ending price - Beginning price) / Beginning price

The rate of return on various investment avenues would vary widely.

2. Risk: The risk of an investment refers to the variability of the rate of return. To explain further, it is
the deviation of the outcome of an investment from its expected value. A further study can be done
with the help of variance, standard deviation and beta.

3. Marketability: It is desirable that an investment instrument be marketable, the higher the

marketability the better it is for the investor. An investment instrument is considered to be highly
marketable when:

 It can be transacted quickly.

 The transaction cost (including brokerage and other charges) is low.

 The price change between 2 transactions is negligible.

Shares of large, well-established companies in the equity market are highly marketable. While shares
of small and unknown companies have low marketability.

To gauge the marketability of other financial instruments like provident fund (which in itself is non-
marketable). Then we would consider other factors like, can we make a substantial withdrawal without
much penalty, or can we take a loan against the accumulated balance at an interest rate not much
higher than our earning rate of interest on the provident fund account.

4. Taxes: Some of our investments would provide us with tax benefits while other would not. This
would also be kept in mind when choosing the investment avenue. Tax benefits are mainly of 3 types:

Initial tax benefits. This is the tax gain at the time of making the investment, like life insurance.
Continuing tax benefit. Is the tax benefit gained on the periodic return from the investment, such as
dividends.

Terminal tax benefit. This is the tax relief the investor gains when he liquidates the investment. For
example, a withdrawal from a provident fund account is not taxable.

5. Convenience: Here we are talking about the ease with which an investment can be made and
managed. The degree of convenience would vary from one investment instrument to the other.

Investment Process: 
Step # 1. Investment Policy:

The first stage determines and involves personal financial affairs and objectives before making
investments. It may also be called preparation of the investment policy stage.

The investor has to see that he should be able to create an emergency fund, an element of liquidity and
quick convertibility of securities into cash. This stage may, therefore; be considered appropriate for
identifying investment assets and considering the various features of investments.

Investment Process: Step # 2. Investment Analysis:

When a individual has arranged a logical order of the types of investments that he requires on his
portfolio, the next step is to analyse the securities available for investment. He must make a
comparative analysis of the type of industry, kind of security and fixed vs. variable securities. The
primary concerns at this stage would be to form beliefs regarding future behaviour or prices and stocks,
the expected returns and associated risk.

Investment Process: Step # 3. Valuation of Securities:

The third step is perhaps the most important consideration of the valuation of investments. Investment
value, in general, is taken to be the present worth to the owners of future benefits from investments.
The investor has to bear in mind the value of these investments.

An appropriate set of weights have to be applied with the use of forecasted benefits to estimate the
value of the investment assets. Comparison of the value with the current market price of the asset
allows a determination of the relative attractiveness of the asset. Each asset must be valued on its
individual merit. Finally, the portfolio should be constructed.

Investment Process: Step # 4. Portfolio Construction:

Under features of an investment programme, portfolio construction requires a knowledge of the

different aspects of securities. These are briefly recapitulated here, consisting of safety and growth of
principal, liquidity of assets after taking into account the stage involving investment timing, selection
of investment, allocation of savings to different investments and feedback of portfolio
Security Analysis vs. Portfolio Management

What is a Security ?

Assets with some financial value are called securities.

Characteristics of Securities
 Securities are tradable and represent a financial value.
 Securities are fungible.

Classification of Securities
 Debt Securities: Tradable assets which have clearly defined terms and conditions are called
debt securities. Financial instruments sold and purchased between parties with clearly
mentioned interest rate, principal amount, maturity date as well as rate of returns are called debt
securities.
 Equity Securities: Financial instruments signifying the ownership of an individual in an
organization are called equity securities. An individual buying equities has an ownership in the
company’s profits and assets.
 Derivatives: Derivatives are financial instruments with specific conditions under which
payments need to be made between two parties.

What is Security Analysis ?

The analysis of various tradable financial instruments is called security analysis. Security analysis
helps a financial expert or a security analyst to determine the value of assets in a portfolio.

Why Security Analysis ?

Security analysis is a method which helps to calculate the value of various assets and also find out the
effect of various market fluctuations on the value of tradable financial instruments (also called
securities).

Classification of Security Analysis

Security Analysis is broadly classified into three categories:

1. Fundamental Analysis
2. Technical Analysis
3. Quantitative Analysis

What is Fundamental Analysis ?

Fundamental Analysis refers to the evaluation of securities with the help of certain fundamental
business factors such as financial statements, current interest rates as well as competitor’s products and
financial market.
What are Financial Statements ?

Financial statements are nothing but proofs or written records of various financial transactions of an
investor or company.

Financial statements are used by financial experts to study and analyze the profits, liabilities, assets of
an organization or an individual.

What is Technical Analysis ?

Technical analysis refers to the analysis of securities and helps the finance professionals to forecast the
price trends through past price trends and market data.

What is Quantitative Analysis ?

Quantitative analysis refers to the analysis of securities using quantitative data.

Difference between Fundamental Analysis and Quantitative Analysis

Fundamental analysis is done with the help of financial statements, competitor’s market, market data
and other relevant facts and figures whereas technical analysis is more to do with the price trends of
securities.

What is Portfolio Management ?

The stream which deals with managing various securities and creating an investment objective for
individuals is called portfolio management. Portfoilo management refers to the art of selecting the best
investment plans for an individual concerned which guarantees maximum returns with minimum risks
involved.

Portfolio management is generally done with the help of portfolio managers who after understanding
the client’s requirements and his ability to undertake risks design a portfolio with a mix of financial
instruments with maximum returns for a secure future.

Portfolio Theory

Portfolio theory was proposed by Harry M. Markowitz of University of Chicago. According to

Markowitz’s portfolio theory, portfolio managers should carefully select and combine financial
products on behalf of their clients for guaranteed maximum returns with minimum risks.

Portfolio theory helps portfolio managers to calculate the amount of return as well as risk for any
investment portfolio.

Portfolio Management Process

Portfolio management process is an on-going way of managing a client’s portfolio of assets. There are
various components and sub-components of the process that ensure a portfolio is tailored to meet the
client’s investment objectives well within his constraints. Portfolio managers need to chart out specific
strategies for the portfolio management to maintain the risk-return trade-off.
Definition of Portfolio Management Process

The portfolio management process is an integrated compilation of steps implemented in a consistent

way to create and manage a suitable portfolio of assets to achieve client’s specified goals.

Portfolio Perspective

The portfolio perspective is the key fundamental principle of portfolio management. According to this
perspective, portfolio managers, analysts and investors need to analyze risk – return trade-off of the
whole portfolio, and not of the individual assets in the portfolio. The individual investments carry an
unsystematic risk, which is diversified away by bundling the investments into one single portfolio. The
whole portfolio carries only the systematic risk, which is caused by the influence of economic
fundamentals on the returns of a stock. GDP growth, consumer confidence, unexpected inflation,
business cycles, etc. are the examples of such economic fundamentals. The portfolio managers,
analysts and investors should only be concerned with the systematic risk of the whole portfolio. In fact,
all the equity pricing models are based on the fact that only systematic risk is factored.

Steps of The Portfolio Management Process

The portfolio management process has the following steps and the sub-components:

Planning

This is the most crucial step as it lays down the foundation of the entire process. It comprises of these
tasks:

Identification of Objectives and Constraints: The identification of client’s investment objectives and
any constraints is the foremost task in the planning stage. Any desired outcomes that the client has
regarding return and risk are the investment objectives. Any limitations on the investment decisions or
choices are the constraints. Both are specified at this stage.

Investment Policy Statement: Once the objectives and constraints are identified, the next task is to
draft an investment policy statement.

Capital Market Expectations: The third step in the planning stage is to form expectations regarding
capital markets. Risk and return of various asset classes are forecasted over a long term to choose
portfolios that either maximizes the expected return for certain levels of risk or minimize the portfolio
risk for certain levels of expected return.

Asset Allocation Strategy: This is the last task in the planning stage.

Strategic Asset Allocation: The investment policy statement and the capital market expectations are
combined to determine the long term weights of the target asset classes, also known as strategic asset
allocation.
Tactical Asset Allocation: Any short-term change in the portfolio strategy as a result of the change in
circumstances of the investor or the market expectations is a tactical asset allocation. If the changes
become permanent and the policy statement is updated to reflect the changes, there is a chance that the
temporary tactical allocation becomes the new strategic portfolio allocation.

Execution

Once the planning stage is completed, execution of the planned portfolio is the next step. This consists
of these decisions:

Portfolio Selection: The expectation of the capital markets is combined with decided investment
allocation strategy to choose specific assets for the investor’s portfolio. Generally, the portfolio
managers use the portfolio optimization technique while deciding the portfolio composition.

Portfolio Implementation: Once the portfolio composition is finalised, the portfolio is executed.
Portfolio executions are equally important as high transaction costs can reduce the performance of the
portfolio. Transaction costs include both explicit costs like taxes, fees, commissions, etc. and implicit
costs like bid-ask spread, opportunity costs, market price impacts, etc. Hence, the execution of the
portfolio needs to be appropriately timed and well-managed.

Feedback

Any changes required due to the feedback are analyzed carefully to make sure that they are as per the
long-run considerations. The feedback stage has the following two sub-components:

Monitoring and Rebalancing: The portfolio manager needs to monitor and evaluate risk exposures of
the portfolio and compares it with the strategic asset allocation. This is required to ensure that
investment objectives and constraints are being achieved. The manager monitors the investor’s
circumstances, economic fundamentals and market conditions. Portfolio rebalancing should also
consider taxes and transaction costs.

Performance Evaluation: The investment performance of the portfolio must be evaluated regularly to
measure the achievement of objectives and the skill of the portfolio manager. Both absolute returns and
relative returns can be used as a measure of performance while analysing the performance of the
portfolio.

INVESTMENT POLICY STATEMENT

A formal written document created to govern investment decision making after taking into account the
client’s objectives and constraints. This statement is formulated in the planning stage of the process as
mentioned above.

Role: Investment policy statement has the following roles to play:

Endorse long-term discipline in all the portfolio decisions.

Easily implemented by both current as well as future investment advisors.

Protect against short-term portfolio reallocation in case the changing markets or the performance of the
portfolio causes overconfidence or panic.

Elements: An investment policy statement has several of these elements:

A complete client description providing enough background so that any investment advisor can
understand the client’s situation.

A purpose with respect to investment objectives, policies, goals, portfolio limitations and restrictions.

Identification of responsibilities and duties of all the parties involved.

A formal statement depicting objectives and constraints.

A schedule for reviewing the performance of the portfolio and the policy statement.

Ranges of asset allocation and guidelines regarding rigidity and flexibility when devising or modifying
the asset allocation.

Instructions for adjustments in the portfolio and rebalancing.

Types of Investment Strategies

Strategic asset allocation is a part of the asset allocation in the planning stage. The following are the
approaches used to execute the strategic asset allocation:

Passive Investment: These strategies comprise of portfolios that do not respond to any changes in
expectations. Buy and hold and indexing are examples of such passive strategies.

Active Investment: These strategies respond much more to changing expectations. They aim to benefit
from the differences between the beliefs of a portfolio manager concerning the valuations and those of
the marketplace. Making investments according to a particular style of investment and generating
alpha are examples of such active investments.

Hybrids: These include enhanced index, risk-controlled active and semi-active strategies, which are
hybrids of active and passive strategies. Index tilting is one example of a hybrid strategy, where the
portfolio manager tries to match the risk attributes of a benchmark portfolio, but at the same time
deviates from the same benchmark portfolio allocations to earn superior returns.

Conclusion:

The portfolio management process is a set of comprehensive steps that needs to be followed with
complete dedication and understanding to achieve the stated objectives. Investment policy statement is
a crucial component of this process and is a key aspect in creating a portfolio or evaluating the
performance of any portfolio. Both the client and the investment advisor need to share the same
expectations and outlook of the portfolio.

Any discrepancy might defeat the purpose of portfolio management.

Meaning and Types of Returns Holding Period return–– Expected return –
Annualized return
Holding Period Return

The formula for the holding period return is used for calculating the return on an investment over
multiple periods.

The returns on an investment may be shown on an annual, quarterly, or monthly basis. An

individual may be tempted to incorrectly add the percentages of return to find the return over the
multiple periods. By incorrectly adding the periodic returns, the effect of compounding is not
taken into consideration. For example, a return of 10% the first year followed by a return of 10%
the next year does not equate to an aggregate of 20%. By using the holding period return
formula, the amount gained would be 21%. The extra 1% can be attributed to the effect of
compounding through earning 10% in the second year on the 10% that was earned in the first
year. This is sometimes called earning interest on interest.

Example of Holding Period Return Formula

An example of the holding period return formula would be an investment in an asset that has an
annual appreciation of 10%, 5%, and -2% over three years. As stated in the prior section, simply
adding the annual appreciation of each year together would be inaccurate as the 5% earned in
year two would be on the original value plus the 10% earned in the first year. After putting the
annual percentages into the holding period return formula, the correct calculation would be:

After solving this equation, the holding period return would be 13.19% for all three years.
What Does Expected Return Mean?

What is the definition of expected return? The ER is the profit that an investor anticipates on
investment. For instance, it may be the ER on a bond if the bond pays out the maximum return at
maturity. In fact, the ER is a possible return on investment, and the outcomes are continuous, i.e.
between 0 and infinity.
In portfolio analysis, the returns of a portfolio are the sum of each potential return multiplied by the
probability of occurrence or weight. You can also look at it like the ER is the weighted average of
potential returns of the portfolio, weighted by the potential returns of each asset class included in the
portfolio.

Let’s look at an example.

Example
Peter holds a portfolio that consists of equity and fixed income with 50% invested in the S&P 500
stock index, 30% invested in the MSCI Emerging Markets index and 20% invested in bonds. The ER
on the S&P 500 is 11.8%, for the MSCI is 16.35% and for the bonds is 2.23%. Peter wants to see how
this diversification has an impact on his investment strategy and what is the expect return of this
portfolio.

Peter calculates the portfolio expected return by multiplying the expected return of each asset class to
its weight as follows:

Rpf = (11.8% x 0.5) + (16.35% x 0.25) + (2.23% x 0.5) = 0.059 + 0.041 + 0.006 = 10.55%

The return of 10.55% is an assumption that Peter makes based on the weights of each asset class. If the
weights change, i.e. the probability changes, then the return will be different. However, the weights
used in portfolio analysis are estimated based on the historical performance of each asset class.

Annualised Return

When we make investments, we invest our money in different assets and earn returns for different
periods of time. For example, an investment in a short-term Treasury bill will be for 3 months. We may
invest in a stock and exit after a week for a few days. For the purpose of making the returns on these
different investments comparable, we need to annualize the returns. So, all daily, weekly, monthly, or
quarterly returns will be converted to annualized returns. The process for annualizing the returns is as
follows:
The basic idea is to compound the returns to an annual period. So, if we have monthly returns, we
know that there are 12 months in the year, similarly there are 52 weeks, 4 quarters, and 365 days. We
compound our returns by the number of periods in the whole year.

Let’s take a few examples to understand this.

Example 1: Quarterly Returns

Let’s say we have 5% quarterly returns. Since there are four quarters in a year, the annual returns will
be:

Annual returns = (1+0.05)^4 – 1 = 21.55%

Example 2: Monthly Returns

Let’s say we have 2% monthly returns. Since there are 12 months in a year, the annual returns will be:

Annual returns = (1+0.02)^12 – 1 = 26.8%

Example 3: Weekly Returns

Let’s say we have 0.5% weekly returns. Since there are 52 weeks in a year, the annual returns will be:

Annual returns = (1+0.005)^52 – 1 = 29.6%

Example 4: Daily Returns

Let’s say we have 0.1% daily returns. Since there are 365 days in a year, the annual returns will be:

Annual returns = (1+0.001)^365 – 1 = 44.02%

Example 5: 100 Days Returns

We can actually have returns for any number of days and convert them to annualized returns. Let’s say
we have 6% returns over 100 days. The annual returns will be:

Annual returns = (1+0.06)^(365/100) – 1 = 23.69%

Annualized returns however have one limitation – they assume that we will be able to reinvest the
money at the same rate. However this may not always be possible. If we earned 5% in a quarter there is
no guarantee that we will be able to replicate these returns over the next three quarters in the year.

Portfolio Return

Let’s say the returns from the two assets in the portfolio are R 1 and R2. Also, assume the weights of the
two assets in the portfolio are w1 and w2. Note that the sum of the weights of the assets in the portfolio
should be 1. The returns from the portfolio will simply be the weighted average of the returns from the
two assets, as shown below:

RP = w1R1 + w2R2

Let’s take a simple example. You invested $60,000 in asset 1 that produced 20% returns and $40,000
in asset 2 that produced 12% returns. The weights of the two assets are 60% and 40% respectively.

The portfolio returns will be:

RP = 0.60*20% + 0.40*12% = 16.8%

Portfolio Risk

Let’s now look at how to calculate the risk of the portfolio. The risk of a portfolio is measured using
the standard deviation of the portfolio. However, the standard deviation of the portfolio will not be
simply the weighted average of the standard deviation of the two assets. We also need to consider the
covariance/correlation between the assets. The covariance reflects the co-movement of the returns of
the two assets. Unless the two assets are perfectly correlated, the covariance will have the impact of
reduction in the overall risk of the portfolio.

The portfolio standard deviation can be calculated as follows:

In the above example, let’s say the standard deviation of the two assets are 10 and 16, and the
correlation between the two assets is -1. The standard deviation of the portfolio will be calculated as
follows:

σP = Sqrt(0.6^2*10^2 + 0.4^2*16^2 + 2*(-1)*0.6*0.4*10*16) = 0.4

Risk

In broad terms, risk involves exposure to some type of danger and the possibility of loss or injury. In
general, risks can apply to your physical health or job security. In finance and investing, risk often
refers to the chance an outcome or investment's actual gains will differ from an expected outcome or
return. Risk includes the possibility of losing some or all of an original investment.

Quantifiably, risk is usually assessed by considering historical behaviors and outcomes. In finance,
standard deviation is a common metric associated with risk. Standard deviation provides a measure of
the volatility of a value in comparison to its historical average.
Overall, it is possible and prudent to manage investing risks which makes understanding risks very
important. Learning the risks that can apply to different scenarios and some of the ways to manage
them holistically will help all types of investors and business managers to avoid unnecessary and costly
losses.

9 types of investment risk

1. Market risk
The risk of investments declining in value because of economic developments or other events that
affect the entire market. The main types of market risk are equity risk, interest rate risk and currency
risk.
 Equity risk – applies to an investment in shares. The market price of shares varies all the time
depending on demand and supply. Equity risk is the risk of loss because of a drop in the market
price of shares.
 Interest rate risk – applies to debt investments such as bonds. It is the risk of losing money
because of a change in the interest rate. For example, if the interest rate goes up, the market
value of bonds will drop.
 Currency risk – applies when you own foreign investments. It is the risk of losing money
because of a movement in the exchange rate. For example, if the U.S. dollar becomes less valuable
relative to the Canadian dollar, your U.S. stocks will be worth less in Canadian dollars.

2. Liquidity risk
The risk of being unable to sell your investment at a fair price and get your money out when you want
to. To sell the investment, you may need to accept a lower price. In some cases, such as exempt
market investments, it may not be possible to sell the investment at all.

3. Concentration risk
The risk of loss because your money is concentrated in 1 investment or type of investment. When
you diversify your investments, you spread the risk over different types of investments, industries and
geographic locations.

4. Credit risk
The risk that the government entity or company that issued the bond will run into financial difficulties
and won’t be able to pay the interest or repay the principal at maturity. Credit risk applies to debt
investments such as bonds. You can evaluate credit risk by looking at the credit rating of the bond. For
example, long-term Canadian government bonds have a credit rating of AAA, which indicates the
lowest possible credit risk.

5. Reinvestment risk
The risk of loss from reinvesting principal or income at a lower interest rate. Suppose you buy a bond
paying 5%. Reinvestment risk will affect you if interest rates drop and you have to reinvest the regular
interest payments at 4%. Reinvestment risk will also apply if the bond matures and you have to
reinvest the principal at less than 5%. Reinvestment risk will not apply if you intend to spend the
regular interest payments or the principal at maturity.

6. Inflation risk
The risk of a loss in your purchasing power because the value of your investments does not keep up
with inflation. Inflation erodes the purchasing power of money over time – the same amount of money
will buy fewer goods and services. Inflation risk is particularly relevant if you own cash or debt
investments like bonds. Shares offer some protection against inflation because most companies can
increase the prices they charge to their customers. Share prices should therefore rise in line with
inflation. Real estate also offers some protection because landlords can increase rents over time.

7. Horizon risk
The risk that your investment horizon may be shortened because of an unforeseen event, for example,
the loss of your job. This may force you to sell investments that you were expecting to hold for the
long term. If you must sell at a time when the markets are down, you may lose money.

8. Longevity risk
The risk of outliving your savings. This risk is particularly relevant for people who are retired, or are
nearing retirement.

9. Foreign investment risk

The risk of loss when investing in foreign countries. When you buy foreign investments, for example,
the shares of companies in emerging markets, you face risks that do not exist in Canada, for example,
the risk of nationalization.

Measurement of Risk

The risk associated with a single asset is measured from both a behavioral and a statistical
(quantitative) point of view.

The behavioral risk view is measured using:

1. Sensitivity analysis and
2. Probability distribution

The statistical risk view is measured using:

1. Standard deviation and
2. Coefficient of variation.

Behavior Risk views:

1. Sensitivity analysis 

Sensitivity analysis is one of the simplest ways of handling risk. It consists of examining the
magnitude of change in the rate of return for the project, for a small change in each of its
components which are uncertain. The best possible way is to select these variables whose
estimated value may contain significant errors or element of uncertainty and then to calculate
the effect of errors of different sizes on the present value of the project. Some of the key
variables are cost, price, project life, market share etc. Sensitivity analysis takes into
account a number of possible outcome estimates while evaluating an asset risk. In order to
have a sense of the variability among return estimates, a possible approach is to estimate the
worst(pessimistic), the expected(most likely) and the best(optimistic) returns associated with
the asset. The difference between the optimistic and the pessimistic outcomes is the range,
which according to the sensitivity analysis is the basic measure of risk. The greater the range,
the more is the risk and vice versa.
 Example: 

Particulars Asset X Asset Y

Initial investment(t=0) 50 50
Annual return(%)
Pessimistic 13 7
Most likely 15 14
Optimistic 17 21
Range (High – Low) 4 14

Asset Y is more risky than Asset X on the basis of annual returns.

2. Probability distribution 

Probability may be described as the measure of likelihood of an event�s occurrence. The risk
associated with an asset can be assessed more accurately by the use of probability distribution
than sensitivity analysis. For example, if the expectation is that a given outcome or return will
occur six out of ten times, it can be said to have sixty percent chance of happening; if it is
certain to happen, the probability of happening is 100%. An outcome which has a probability of
zero will never occur. So, on the basis of the probability distributed or assigned to the rate of
return, the expected value of the return can be computed. The expected rate of return is the
weighted average of all possible returns multiplied by their respective probabilities and those
probabilities of the various outcomes are used as weights. The expected return(R),

R = ∑ n Ri x Pri  i=1 
Where: 

Ri = Return for the ith possible outcome

Pri = Probability of its outcome / return
n = Number of outcomes considered Example:

Let us calculate the expected return of two assets X & Y, whose probability of
generating pessimistic returns of 13% and 7% is 30%, most likely returns of 15% and
14% is 30% and optimistic returns of 17% and 21% is 40%, respectively.

Expected
Possible outcomes Probability Returns
Returns
ASSET X (P) (R) (P x R)
Pessimistic 0.30 13% 3.9
Most likely 0.30 15% 4.5
Optimistic 0.40 17% 6.8
   Expected return 15.2
ASSET Y
Pessimistic 0.30 7% 2.1
Most likely 0.30 14% 4.2
Optimistic 0.40 21% 8.4
   Expected return 14.7

From the above risk analysis, Asset X seems to have a higher expected return and
would be preferred over Asset Y.

Statistical risk views:

1. Standard Deviation: 

The most common statistical measure of risk of an asset is the standard deviation from
the mean or expected value of return. It represents the square root of the average
squared deviations of the individual returns from the expected returns. The standard
deviation can be represented as thus:

                                         
σ = √∑ n (Ri - R)2 x Pri 
          i=1 

Where: 

Ri = Return for the ith possible outcome

mean of the returns ( Pri and n as
R =
given above)

Example: Let us calculate the standard deviation for the returns of assets X & Y. (data as
given above) 

( Ri - R)2 Pri 
i Ri R Ri - R AXB
A B
1 13% 15% (-2)% 4% 0.30 1.20%
2 15% 15% 0 0 0.30 0
3 17% 15% 2% 4% 0.40 1.60%
Total (x) 2.80%
1 7% 14% (-7)% 49% 0.30 14.7%
2 14% 14% 0 0 0.30 0
3 21% 14% 7% 49% 0.40 19.6%
Total (Y) 34.3%

Standard deviation of Asset X = √2.80 = 1.67% 

Standard deviation of Asset Y = √34.3 = 5.86% 

If the standard deviation is greater, the variability and thus risk is also greater and vice
versa. According to this measure, Asset Y is riskier than Asset X. 

2. Coefficient of variation: 
It is a measure of relative dispersion or a measure of risk per unit of expected return. It
converts standard deviation of expected values into relative units and thus facilitates
comparison of risks associated with assets having different expected values. It is
calculated by dividing the standard deviation of an asset by its expected value.

CV = σr √R 

Example: Let us calculate the coefficient of variations for the assets X and Y(data as
given above). 

CV of asset X => 1.67 / 15 => 0.111 

CV of asset Y => 5.86 / 14 => 0.419 

If the coefficient of variation is greater, the risk is greater and vice versa. According to
this measure, Asset Y is riskier than Asset X. As this measure considers the expected
value of assets, it is considered the best method for comparing risks.