Page 84 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 4: Risk and Return

The slope of the Market Line points to the return per unit of risk required by all investors. Notes
Highly risk-averse investors would have a steeper line, and the other way around. Yields on
apparently alike stocks may differ. Differences in price, and thus yield, reflect the market’s
assessment of the issuing company’s standing and of the risk elements in the specific stocks. A
high yield in relation to the market in general demonstrates an above average risk element.
This is shown in the figure below.

Figure 4.2: Risk Return Relationship of Different Stocks
Rate of
Return Risk Market Line E(r)
Premium
Ordinary shares
Preference shares
Subordinate loan stock
Unsecured loan
Debenture with floating charge
Mortage loan
Mortgage loan
Government stock (risk-free)
O Degree of Risk

Given the composite market line existing at a point of time, investors would select investments
that are reliable with their risk preferences. Some will consider low-risk investments, whereas
others prefer high-risk investments.
The risk/return trade-off tells us that the higher risk gives us the possibility of higher returns.
But there are no guarantees or assurance. Just as risk means higher potential returns, it also
means higher potential losses.

Notes A common misconception is that higher risk equals greater return.

On the lower end of the scale, the risk-free rate of return is represented by the return on Treasury
Bills of government securities, for the reason that their chance of default is next to nil. If the risk-
free rate is at present 8 to 10 %, this means, with nearly no risk, we can earn 8 to 10 % per year on
our money.
The common question arises; who wants to earn 6% when index funds average 12% per year
over the long run? The answer to this is that even the full market (represented by the index fund)
carries risk. The return on index funds is not 12% every year, but rather -5% one year, 25% the
next year, and so on. An investor still faces considerably greater risk and volatility to receive an
overall return that is higher than a predictable government security. We call this additional
return the risk premium, which in this case is 8% (12%–8%).
Deciding what risk level is most proper for you isn’t an easy question to answer. Risk tolerance
differs from person to person. Your decision will depend on your goals, income and personal
situation, among other factors.

Self Assessment

State whether the following statements are true or false:
7. A common misconception is that higher risk equals smaller return.

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