The Risk–Return Relationship
Objective 17-4 Describe the risk–return relationship and discuss the use of diversification and asset allocation for investments.
Individual investors have different motivations and personal preferences for safety versus risk. That is why, for example, some individuals and firms invest in stocks while others invest only in bonds. Although all investors anticipate receiving future cash flows, some cash flows are more certain than others. Investors generally expect to receive higher returns for higher uncertainty. They do not generally expect large returns for secure, stable investments such as government-insured bonds. The investment’s time commitment, too, contains an element of risk. While short-term investments are generally considered to be less risky, longer-term investments are subject to future uncertainties in the economy and financial markets. As of mid-2017, the average rate of return on a 1-year U.S. Treasury bill was 0.25 percent, versus 1.51 percent on a 5-year bill, and 2.10 percent on a 10-year bill. Each type of investment, then, has a risk–return (risk–reward) relationship: Safer investments tend to offer lower returns, riskier investments tend to offer higher returns (rewards).
Figure 17.3 shows the general risk–return relationship for various financial instruments, along with the types of investors they attract. Thus, conservative investors, who have a low tolerance for risk, will opt for no-risk U.S. Treasury Bills (fully insured by the U.S. government), or even intermediate-term high-grade corporate bonds that rate low in terms of risk on future returns, but also low on the size of expected returns. The reverse is true of aggressive investors who prefer the higher risks and potential returns from long-term junk bonds and common stocks.14
Figure 17.3
Potential Financial Returns Rise with Riskier Investments.
Investment Dividends (or Interest), Appreciation, and Total Return
In evaluating potential investments, investors look at returns from dividends (or from interest), returns from price appreciation, and total return.
Dividends
The rate of return from dividends paid to shareholders is commonly referred to as the current dividend yield (or, in the case of interest from a loan, the current interest yield) and is calculated by dividing the yearly dollar amount of dividend income by the investment’s current market value. For example, during one recent time period, each share of AT&T stock was receiving annual dividend payments of $1.80. Now, if the share price was $35.67 on a particular day, the current yield would be 5.05 percent or ($1.80/$35.67 × 100). This dividend can then be compared against current yields from other investments. Larger dividend yields, of course, are preferred to smaller returns.
Price Appreciation
Another source of returns depends on whether the investment is increasing or decreasing in dollar value. Price appreciation is an increase in the dollar value of an investment. Suppose, for example, you purchased a share of AT&T stock for $35.67 and then sold it one year later for $37.45. The price appreciation is $1.78 or ($37.45 − 35.67). This profit, realized from the increased market value of an investment, is known as a capital gain.
Total Return
The sum of an investment’s current dividend (interest) yield and capital gain is referred to as its total return. Total return cannot be accurately evaluated until it is compared to the investment that was required to get that return. Total return as a percentage of investment is calculated as follows:
To complete our AT&T example, the total return as a percentage of our one-year investment would be 10.04 percent or [($1.80 + $1.78)/$35.67 × 100]. Again, obviously, larger total returns are preferred to smaller ones.
Fantasy Stock Markets
Enthusiasts of fantasy baseball, football, hockey, and other “hypothetical” games aren’t the only people who enjoy competing in fantasy realms. Fantasy stock markets are also popular venues for learning how securities markets work, for trying your hand at various investment strategies, and earning a fantasy fortune (or going broke!). Online games, including free ones such as Wall Street Survivor and How the Market Works, provide an investment experience that is educational, challenging, and entertaining. Starting with an initial sum of virtual cash with which to manage their own fantasy portfolio of real companies, participants must live with real market results. It’s a learn-by-doing experience—using online symbol lookups to enter stock ticker symbols, searching various information sources for research on companies of interest, making buy and sell decisions, and then discovering the financial results as real market prices change for the portfolio holdings. Many students and business practitioners are finding these “games” to be a valuable resource for learning the “how to” of online investing.
Managing Risk with Diversification and Asset Allocation
Investors seldom take an extreme approach—total risk or total risk avoidance—in selecting their investments. Extreme positions tend to lead to extreme results. Instead, most investors select a mixed portfolio of investments—some riskier and some more conservative—that, collectively, provides the overall level of risk and financial returns that feels comfortable. After determining the desired risk–return balance, they then achieve it in two ways: through (1) diversification and (2) asset allocation.
Diversification
Diversification means buying several different kinds of investments rather than just one. For example, diversification as applied to common stocks means that you invest in stocks of several different companies, companies in different industries, and companies in various countries. The risk of loss is reduced by spreading the total investment across different kinds of stocks because although any one stock price may decline the chances are less that all of them will decline at the same time. For instance, when oil and gas prices drop as they did in 2016, stock prices for oil and gas companies like Shell and Chevron also decline (all else equal) because their revenues go down. However, stock prices for firms that use a lot of oil and gas fuel, such as UPS, FedEx, and Delta Airlines, might go up (all else equal) because these firms see a drop in their operating expenses.
Even more diversification is gained when assets are spread across a variety of investment alternatives—stocks, bonds, mutual funds, precious metals, real estate, and so on. On the other hand, though, employees who do not have diversified investments and instead have all their retirement funds invested in their firm’s stock can lose everything if their company goes bankrupt or invests poorly. The collapse of Enron Corporation in 2001, one of the 10 largest U.S. firms at the time, was a financial disaster for its thousands of its employees because Enron’s retirement program was invested solely in Enron common stock. Enron’s stock price dropped from near $90 per share to nearly $5, effectively wiping out employees’ retirement savings. Putting all their eggs in one basket was an extremely risky position, as they learned the hard way. When their firm’s stock took a free fall as a result of a market collapse and resulting scandal, the retirement funds disappeared.
Asset Allocation
Asset allocation is the proportion (the relative amounts) of funds invested in (or allocated to) each of the investment alternatives. You may decide for example, to allocate 50 percent of your funds to common stocks, 25 percent to a money market mutual fund, and 25 percent to a U.S. Treasury bond mutual fund. Ten years later, with more concern for financial safety as you get closer to retirement, you may decide on a less risky asset allocation of 20 percent, 40 percent, and 40 percent in the same investment categories, respectively. In this example, the portfolio has been changed from moderate-risk to lower-risk investments for the purpose of preserving the investor’s accumulated capital. That is, the asset allocation was changed accordingly.
Performance Differences for Different Portfolios
Once an investor has chosen an investment objective with an acceptable risk level, he or she can put the tools of diversification and asset allocation to use in their investor’s portfolio. A portfolio is the combined holdings of all the financial investments—stocks, bonds, mutual funds, real estate—of any company or individual.
Just like investors, investment funds have different investment objectives—ranging from aggressive growth/high risk to stable income/low volatility—and their holdings are diversified accordingly among hundreds of company stocks, corporate bonds, or government bonds that provide the desired orientation. The money in a diversified portfolio is allocated in different proportions among a variety of funds. If all goes according to plan, most of these funds will meet their desired investment objectives and the overall portfolio will increase in value.
A risk–return relationship is inherent in every business investment. Whereas safer investments tend to offer lower returns, riskier investments tend to offer higher returns (rewards). Different types of investments vary along the risk–reward continuum, and most firms strive for a mixture of investments that, overall, provide that firm’s desired risk–return posture. Each investment’s total financial return is the sum of its capital gain and dividend (interest) yield. After determining the desired risk–return balance, investors use two methods for achieving it: (1) diversification and (2) asset allocation. Diversification means buying several different kinds of investments rather than just one. Asset allocation is the proportion of funds invested in each of the investment alternatives. Diversification and asset allocation, together, are essential to protect against the uncertainties (risks) inherent in any single investment.