7.4 Risk and Return Analysis - 7.4 Risk and Return Analysis Explained
Key Concepts
- Risk and Return Relationship
- Expected Return
- Standard Deviation
- Beta
- Sharpe Ratio
- Capital Asset Pricing Model (CAPM)
Risk and Return Relationship
The risk and return relationship is a fundamental concept in finance, stating that higher potential returns come with higher risk. Investors must balance their desire for high returns with the willingness to accept greater uncertainty.
For example, investing in a high-growth tech stock may offer higher returns but comes with the risk of significant price volatility.
Expected Return
Expected return is the anticipated gain or loss on an investment, calculated based on historical data and future projections. It is a key factor in determining whether an investment is worthwhile.
Imagine you are considering two stocks. Stock A has an expected return of 8%, while Stock B has an expected return of 12%. The higher expected return of Stock B makes it more attractive, assuming the risk is acceptable.
Standard Deviation
Standard deviation measures the dispersion of returns around the expected return. A higher standard deviation indicates greater volatility and, therefore, higher risk. It helps investors understand the potential variability of their investments.
For instance, if Stock A has a standard deviation of 5% and Stock B has a standard deviation of 15%, Stock B is considered riskier due to its higher volatility.
Beta
Beta measures the sensitivity of an investment's returns to changes in the overall market. A beta of 1 indicates that the investment moves in line with the market, while a beta greater than 1 suggests higher volatility, and a beta less than 1 indicates lower volatility.
Consider a stock with a beta of 1.5. This means that for every 1% change in the market, the stock is expected to move by 1.5%. A higher beta implies higher risk relative to the market.
Sharpe Ratio
The Sharpe Ratio is a measure of risk-adjusted return, calculated by dividing the excess return of an investment over the risk-free rate by its standard deviation. It helps investors evaluate the performance of an investment relative to its risk.
Suppose Stock A has a Sharpe Ratio of 0.5 and Stock B has a Sharpe Ratio of 0.8. Stock B is considered more efficient in terms of risk-adjusted return, as it offers a higher return per unit of risk.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk. It is used to determine the required rate of return on an investment, given its beta and the market risk premium.
Using CAPM, the expected return of an investment can be calculated as: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). For example, if the risk-free rate is 2%, the market return is 8%, and the beta is 1.2, the expected return would be 9.2%.