Fundamentals of Risk and Return – NISM Series XV Short Notes (Part 11)
This is Part 11 of the NISM Research Analyst Short Notes series on PassNISM.in. Understanding risk and return is fundamental to every investment decision. This chapter covers return calculation methods (simple return, CAGR, XIRR), types of investment risk, risk measurement (beta, standard deviation), risk-adjusted return metrics (Sharpe, Treynor, Jensen's Alpha), and liquidity measurement of equity shares.
Concept of Return on Investment
When you invest, you commit capital today hoping to receive more back in the future. The return on investment (ROI) measures how much you earned relative to what you invested.
ROI = Net Profit / Investment × 100
Investors expect two things from any investment:
- A return on their capital (income + price appreciation)
- Return of their capital (getting the original investment back)
Methods of Calculating Returns Simple Return (Absolute Return)
Simple return is the most basic measure. It tells you how much your investment grew in percentage terms from the original investment, without considering the time taken.
Formula: Simple Return = (Ending Value − Beginning Value) / Beginning Value × 100
Limitation: Does not account for the time period over which the return was earned. A 50% return over 10 years is very different from 50% in 1 year.
Annualised Return
Converts the simple return into an annual rate to enable comparison across different time periods. However, annualised return does not account for the time value of money or compounding.
CAGR (Compounded Annual Growth Rate)
CAGR assumes that returns are compounded — i.e., returns earned in earlier periods are reinvested and also earn returns in subsequent periods. It gives the equivalent annual growth rate that would take an investment from its beginning value to its ending value.
Formula: CAGR = (Ending Value / Beginning Value)^(1/n) − 1
Where n = number of years
Example: ₹1,000 growing to ₹2,000 in 5 years: CAGR = (2000/1000)^(1/5) − 1 = 14.87%
CAGR is the most commonly used return metric for mutual funds, stocks, and long-term investments.
XIRR (Extended Internal Rate of Return)
When investments are made at multiple irregular intervals (like SIPs), CAGR cannot be used directly. XIRR calculates the underlying CAGR for multiple cash flows occurring at different dates.
XIRR is calculated using Excel's XIRR function. It requires two columns — dates of cash flows and corresponding cash flow amounts (investments as negative, withdrawals as positive).
Types of Investment Risk 1. Inflation Risk (Purchasing Power Risk)
The risk that returns earned on an investment may be worth less in real terms after adjusting for inflation. Example: If a bond earns 5% annually but inflation is 6%, the investor loses 1% in real purchasing power each year.
Equity shares are relatively less exposed to inflation risk — as prices rise, company revenues and profits tend to rise in nominal terms too, reflecting as higher stock prices.
2. Interest Rate Risk
The risk that rising interest rates will cause bond prices to fall. Bond prices and interest rates move in opposite directions. Longer-duration bonds have higher interest rate risk. Equity valuations (especially high-PE growth stocks) also face interest rate risk as higher rates increase the discount rate in DCF models.
3. Business Risk (Operating Risk)
Risk arising from the inherent uncertainty in a company's operations. Factors include: competitive intensity, cost structure, demand volatility, management quality, and technological disruption. Business risk is company-specific and cannot be diversified away entirely.
4. Market Risk (Systematic Risk)
Risk of loss due to adverse broad market movements. Market risk affects all investments simultaneously and cannot be eliminated through diversification. This is also called systematic risk and is measured by Beta.
5. Credit Risk (Default Risk)
The risk that a bond issuer will fail to make the expected interest or principal payments. Debt instruments are subject to credit risk as they have pre-committed cash flows. Credit ratings help assess this risk. The higher the credit risk, the higher the yield demanded by investors.
6. Liquidity Risk
The risk that you may not be able to sell an investment when you want to, or that you may have to sell it at a significantly lower price due to lack of buyers in the market. Small-cap stocks and certain bonds face high liquidity risk.
7. Call Risk
Specific to bonds with a call option — the risk that the issuer will redeem the bond before its maturity date, usually when interest rates fall. The investor receives back the principal but must reinvest at lower prevailing rates.
8. Reinvestment Risk
The risk that periodic income received from an investment (coupons, dividends) may need to be reinvested at lower rates than the original investment's return, reducing the overall compound return.
9. Political Risk
Risk from adverse government actions — nationalisation of assets, sudden changes in tax policy, withdrawal of licences, or political instability. Political risk is especially relevant for investments in emerging and frontier markets.
10. Country Risk
Risk related to a country's overall ability to meet its financial and commercial obligations. Encompasses political risk, economic risk, and the risk of sovereign default. Investors in foreign securities must assess country risk.
Measuring Risk
Risk can be defined and measured in three ways:
- Measure of uncertainty — Standard deviation (volatility of returns around the mean)
- Measure of sensitivity — Beta (sensitivity of returns relative to the market)
- Measure of loss — Value at Risk (VaR), maximum drawdown
Beta — Systematic Risk Measure
Beta measures the systematic (non-diversifiable) risk of a security by comparing its volatility to the benchmark market index.
| Beta Value | Interpretation |
|---|---|
| Beta = 1 | Stock moves exactly in line with the market |
| Beta < 1 (e.g., 0.6) | Stock is less volatile than the market (defensive stock) |
| Beta > 1 (e.g., 1.4) | Stock is more volatile than the market (aggressive stock) |
| Beta = 0 | No correlation with market (e.g., cash) |
| Beta < 0 (negative) | Moves opposite to market (very rare; gold may sometimes exhibit this) |
Beta measures systematic risk — the risk that cannot be eliminated through diversification. Non-systematic (company-specific) risk can be reduced through a well-diversified portfolio.
Risk-Adjusted Return Metrics
Comparing absolute returns across portfolios with different risk levels is misleading. Risk-adjusted metrics normalize returns for the amount of risk taken.
Jensen's Alpha
Alpha measures the excess return earned by a portfolio beyond what CAPM predicts for its level of systematic risk.
Jensen's Alpha = Portfolio Return − [Rf + β × (Rm − Rf)]
- Positive alpha = Portfolio outperformed its expected risk-adjusted return (skill)
- Negative alpha = Portfolio underperformed its expected risk-adjusted return
- Alpha = 0 = Portfolio performed exactly in line with CAPM expectations
Sharpe Ratio
The Sharpe Ratio measures the return earned per unit of total risk (standard deviation). It is the most widely used risk-adjusted performance metric.
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Standard Deviation
- Higher Sharpe Ratio = Better risk-adjusted performance
- A Sharpe Ratio above 1 is generally considered good
- Useful for comparing portfolios with different absolute risk levels
Treynor Ratio
The Treynor Ratio measures the return earned per unit of systematic risk (Beta). Unlike the Sharpe Ratio (which uses total risk), the Treynor Ratio focuses only on market risk.
Treynor Ratio = (Portfolio Return − Risk-Free Rate) / Beta
- Higher Treynor Ratio = Better return per unit of market risk
- Most useful for well-diversified portfolios where unsystematic risk is already minimised
Comparison: Sharpe vs Treynor vs Jensen's Alpha
| Metric | Risk Measure Used | Best Used When |
|---|---|---|
| Sharpe Ratio | Standard Deviation (total risk) | Comparing total-return portfolios |
| Treynor Ratio | Beta (systematic risk only) | Comparing well-diversified portfolios |
| Jensen's Alpha | Beta (systematic risk, via CAPM) | Measuring portfolio manager's skill |
Concept of Margin of Safety (Recap)
Popularised by Benjamin Graham and Warren Buffett, margin of safety is the difference between a stock's intrinsic value and its purchase price. Buying well below intrinsic value provides a buffer against:
- Errors in the valuation model or assumptions
- Unexpected negative events in the business
- General market downturns
There is no universal margin of safety threshold — it varies by investor, investment style, and the certainty of the business model.
Measuring Liquidity of Equity Shares
Liquidity measures how easily a share can be bought or sold without significantly affecting its price. Stock exchanges exist to provide liquidity, but all shares are not equally liquid.
Stock Turnover Ratio
Stock Turnover Ratio = Number of Shares Traded in a Period / Number of Free Float Shares Outstanding
Free float shares = shares held by non-promoter shareholders (publicly tradeable shares). A higher turnover ratio indicates greater liquidity.
Traded Value Turnover Ratio
Traded Value Turnover Ratio = Total Traded Value in a Period / Market Capitalisation
Similar to the stock turnover ratio but uses monetary value instead of share count. Higher ratio = more liquid stock.
Quick Revision Points — Risk and Return
- ROI = Net Profit / Investment × 100
- Simple return ignores time period; CAGR accounts for compounding; XIRR is for irregular multiple cash flows
- CAGR = (Ending Value / Beginning Value)^(1/n) − 1
- 10 types of risk: Inflation, Interest Rate, Business, Market (Systematic), Credit, Liquidity, Call, Reinvestment, Political, Country
- Beta = systematic risk measure; Beta < 1 = defensive; Beta > 1 = aggressive
- Standard deviation measures total risk (systematic + unsystematic)
- Jensen's Alpha = excess return vs CAPM benchmark (higher = better)
- Sharpe Ratio = excess return / standard deviation (higher = better)
- Treynor Ratio = excess return / Beta (higher = better)
- Sharpe uses total risk; Treynor uses only systematic risk (Beta)
- Margin of safety = gap between intrinsic value and purchase price
- Stock liquidity measured by: Stock Turnover Ratio and Traded Value Turnover Ratio
- Free float = shares held by non-promoters (publicly tradeable)
Final Post Coming Up
Part 12 — the final post in our NISM Research Analyst Short Notes series — covers Research Report Writing, Rating Conventions, Legal and Regulatory Environment (SEBI, RBI, IRDAI, PFRDA), Key Regulations, Insider Trading Rules, Code of Conduct, and Surveillance Mechanisms.
Strengthen your preparation with free practice tests at Research Analyst Free Mock Test.