INVESTORS AND MARKETS : Risk and return
There are various risks involved in financial securities. There are economic risks (political, inflation, etc.) which threaten cash flows from financial securities and which come from the “real economy”, and there are financial risks (liquidity, currency, interest rate and other risks) which do not directly affect cash flow and come under the financial sphere.
All risks, regardless of their nature, lead to fluctuations in the value of a financial security.
In a market economy, a security's risk is measured in terms of the volatility of its price (or of its rate of return). The greater the volatility, the greater the risk, and vice versa.
We can break down the total risk of a financial security into the market-related risk (market or systematic risk) and a specific risk that is independent of the market (intrinsic or diversifiable risk). These two risks are totally independent.
The market risk of a security is dependent on its β coefficient, which measures the correlation between the return on the security and the market return. Mathematically, this is the regression line of the security's return vs. that of the market.
The β coefficient depends on:
- the sensitivity of the company's business sector to the wider market;
- the economic situation;
- the company's operating cost structure (the higher the fixed costs, the higher the β );
- the financial structure (the greater the group's debts, the higher the β );
- the quality and quantity of information provided to the market (the greater visibility there is over future results, the lower the β ); and
- earnings growth rates (the higher the growth rate, the higher the β ).
Although the return on a portfolio of shares is equal to the average return on the shares within the portfolio, the risk of a portfolio is lower than the average risk of the shares making up that portfolio. This happens because returns on shares do not all vary to exactly the same degree, since correlation coefficients are rarely equal to 1.
As a result, some portfolios will deliver better returns than others. Those portfolios that are located on the portion of the curve known as the efficient frontier will deliver better returns than those portfolios which are not. However, given portfolios located on the efficient frontier curve, it is impossible to choose an optimal portfolio objectively from among them. The choice then becomes an individual one, and every investor chooses the portfolio according to his personal appetite for (or aversion to) risk.
By including risk-free assets, i.e. assets on which the return is guaranteed such as government bonds, it is possible to obtain portfolios that are even more efficient.
The inclusion of a risk-free asset in a portfolio leads to the creation of a new efficient frontier which is the line linking the risk-free asset to the market portfolio in the risk/returns space. This new line is called the capital market line. Investors are well advised to own shares in this market portfolio and to choose the level of risk that suits them by investing in risk-free assets or by going into debt. On this line, no portfolio could perform better, i.e. no portfolio could offer a better return for a given level of risk, or a lower risk for a given return.
Portfolio theory is generally applied in varying degrees, as demonstrated by the existence of investment strategies that favour certain securities rather than market portfolios.