Risk vs Uncertainty: Risk and uncertainty seem to be one and the same thing. Both ‘risk and uncertainty’ talk about future losses or hazards. But the key differences between these two are: i) While risk can be quantified and measured, there is no known way of ascertaining uncertainty. For example, if you are taking a risk on a particular number in a game of dice, the probability of that number finally appearing is 1/6, while uncertainty is reflected when you are not sure of the outcome as in the case of putting money on a horse in a horse race. ii) Risk is closely associated with probability but uncertainty has no relation with probability. iii) Risk can be transferred/minimized/diversified through specific mechanisms but uncertainty cannot be removed.
Investors Risk Attitude
When analyzing human behavior, we make assumptions about investors’ attitudes towards risk. Theoretically, there are three different attitudes: 1. Risk Aversion: Individuals seek to avoid or minimize risk. Risk averter chooses the projects with less risk. A risk averse investor is one who requires a higher average return in order to take on a higher level of risk 2. Risk Neutrality: Individuals focus on expected returns and disregard the dispersion of returns (risk). Risk neutral is indifferent for the choice of projects involving high and low risk. 3. Risk Seeking: Individuals prefer risk. Risk seeker chooses the projects with high risk
Business managers and investors are mostly risk averters. Some individuals prefer risk when small amounts of money are involved (entrepreneurs, innovators, inventors, speculators, lottery ticket buyers).
Risk Measurement (Systematic and Unsystematic risk)
Total risk of a security can be split into the proportion that may be diversified away, and the proportion that will remain after diversification. Increasing the number of securities in a portfolio reduces the risk. 1. Systematic risk: is the portion of a security's risk that cannot be eliminated through efficient diversification. The systematic risk indicates how including a particular security in a diversified portfolio will contribute to the riskiness of the portfolio. This risk is also called market risk or non-diversifiable risk. The relevant risk of an individual security is its systematic risk and it is on this basis that investments should be judged. 2. Unsystematic risk: is the portion of a security's total risk that can be eliminated by including the security as part of a diversifiable portfolio. This is also called firm-specific or diversifiable risk. Since unsystematic risk can be eliminated fully, it has no consequence to the well-diversified investor.
Measuring Systematic Risk through Capital Asset Pricing Model (CAPM)
Systematic risk of investment and the required rate of return can be measured using Capital Asset Pricing Model (CAPM). The method adopted by CAPM is to measure systematic risk as an index, normally referred to as beta (β). CAPM may be represented on the following graph:
1 Md. Iqbal Hossain, FCA, FCMA The line of the above graph is often referred to in the form of the following CAPM equation: Rj = Rf +βj (Rm – Rf) Where, Rj = required rate of return on investment j; when applied to shares, Rj is the same as the cost of equity capital Ke. This required rate of return is also called Risk Adjusted Discount Rate (RADR) due to considering systematic risk. Rf = risk-free rate of interest, which carries no systematic risk i.e. risk-free security has a beta of zero. Rm = return on the market portfolio covering all risky investments available in the market. This represents the ultimate in diversification and therefore contains only systematic risk. CAPM sets beta to 1.00 for the market portfolio and this will represent the average systematic risk for the market. βj = index of systematic risk for security j
Explanation of CAPM equation:
There is a basic risk-free return (Rf) which reflects the rational nature of investors i.e. they require a return to reflect the time value of money. On top of this, investors require a premium for systematic risk. The average market premium for such risk is (Rm – Rf) which the βj flexes, i.e. if the investment has more systematic risk than the market average, βj is > 1.00 and the premium (βj (Rm – Rf) is therefore greater than the market average.
Assumptions used by CAPM:
CAPM uses the following operational assumptions: i) Capital markets are efficient which implies that share prices reflect all available information immediately. ii) Investors are risk averse i.e. they prefer highest return at any given level of risk. iii) All investors have the same expectations about the expected return and risk of the securities. iv) All investors can lend or borrow at a risk-free rate of interest when they want for. v) All investors’ decisions are based on a single period.
Weaknesses/Limitations of CAPM: i) CAPM is based on a number of unrealistic assumptions that are far from reality as follows: a) Risk free security is not always freely available to all investors whenever they want. Also the risk free rate for lending and borrowing may not be always the same. b) Investors may not always hold highly diversified portfolios, or the market indices may not be always well-diversified. c) Capital market may not be always perfectly efficient. ii) Beta as a measure of systematic risk does not remain constant over different time periods.
Diversification of Unsystematic Risk through Portfolio Effect
Investors seldom hold securities in isolation, rather they usually attempt to reduce their risks by 'not putting all their eggs into one basket' and therefore, hold portfolios of securities. A portfolio is simply a combination of investments. If an investor puts half of his funds into an engineering company and half into a retail shops firm, it is possible that any misfortunes in the engineering company (e.g. a strike) may be to some extent offset by the performance of the retail investment. It would be unlikely that both would suffer a strike in the same period.
This effect can be demonstrated more formally in the following graphs. Assume two companies, A and B, whose fortunes are inversely correlated (i.e. when A does well B does badly and vice versa).
2 Md. Iqbal Hossain, FCA, FCMA Both investment A and investment B show fluctuating returns over time. They both have about the same amount of variability. When A does well, B does badly, and vice versa. If both investments are held, the resulting portfolio will show the same average return but a greatly reduced risk, because the 'ups' of A cancel with the 'downs' of B and vice versa.
Expected values and expected NPV under uncertainty
The simplest way to work with a spread of possible outcomes is to use expected values or averages. The expected value is an average (arithmetic mean) of possible outcomes, weighted by the probability of each outcome occurring. Example: A firm has to choose between two projects, outcomes of which depend on the economy being recession or boom: Probability Project A NPV (CU m) Project B NPV (CU m) Recession 0.6 – 100 – 50 Boom 0.4 + 250 + 200 Using expected values which project should be chosen? Solution: Project A expected NPV = (0.6 x – CU100m) + (0.4 x CU250m) = CU40m Project B expected NPV = (0.6 x – CU50m) + (0.4 x CU200m) = CU50m Based on expected values, project B is the better project.
Advantages of expected values
i) The information is reduced to a single number for each choice ii) The idea of an average is readily understood
Limitations of expected values
i) The probabilities of the different possible outcomes may be difficult to estimate It is possible to use: – Objective probabilities based on past experience of similar projects; or – Subjective probabilities, e.g. from the results of market research, where the project is very different ii) The average may not correspond to any of the possible outcomes. iii) Unless the same decision has to be made many times, average will not be achieved. So it is not a valid way of making a decision in 'one-off' situations unless the firm has a number of independent projects and there is a portfolio effect. iv) The average gives no indication of the spread of possible results, i.e. it ignores risk.
Methods of dealing with decision making under uncertainty
(a) Setting a minimum payback period for projects (b) Using Risk adjusted discount rate (RADR): Increasing the discount rate considering the risk premium using CAPM to apply a higher 'hurdle' rate in investment appraisal of the project; (c) Making prudent estimates of outcomes (Applying Certainty equivalent co-efficient to the cashflows): Simply multiplying the relevant cashflows with a certainty equivalent factor to remove the forecast bias; (d) Assessing the best, the worst and most likely possible situations to obtain a range of outcomes (Scenario Analysis); (e) Using sensitivity analysis to measure the 'margin of safety' on input data: Analyzing every driver affecting NPV one by one at a time to assess how far each driver could change to arrive at zero NPV; 3 Md. Iqbal Hossain, FCA, FCMA Sensitivity Analysis: Sensitivity analysis is a formalized approach to incorporating alternative forecasts in the project evaluation. The technique is to take each uncertain forecast one by one, and calculate the change necessary for the NPV to fall to zero, i.e. this is essentially breakeven analysis in NPV terms. If sensitivity analysis is to be carried out, it is often useful to calculate net present values in such a way that PVs are found of individual elements of costs and revenues over the life of the project. This means that the tabular approach with headings 'Time', 'Cash flow', 'Discount factor', 'Present value ' may be preferred, unless it becomes very cumbersome.
Strengths of Sensitivity Analysis
i) Information will be presented to management in a form which facilitates subjective judgment to decide the likelihood of the various possible outcomes considered. ii) Identification and highlighting the critical issues that may limit the possibility of success. iii) Straight forward and simple to understand. Weaknesses of Sensitivity Analysis i) Independent variable assumption: It assumes that changes to variables can be made independently, e.g. material prices will change independently of other variables, which is unlikely. If material prices were to rise, the firm would probably increase selling price at the same time and there would be little effect on NPV. ii) Ignores probability. iii) No clear answer given.
Simulation analysis One weakness of sensitivity analysis is that only one factor at a time is changed e.g. material price, product life etc. In the real world it is likely that more than one factor will change at the same time. Simulation is a technique which allows the effect of more than one variable changing at the same time to be assessed. Many companies use Monte Carlo simulation as an important tool for decision-making. For example both General Motors and Procter and Gamble use simulation to estimate both the average return and the riskiness of new products.
Advantages of simulation: i) It gives more information about the possible outcomes and their relative probabilities. ii) It is useful for problems which cannot be solved analytically. Limitations of simulation: i) It is not a technique for making a decision, only for obtaining more information about the possible outcomes. ii) It can be very time-consuming without a computer. iii) It can prove expensive in designing and running the simulation on a computer for complex projects. iv) Monte Carlo techniques require assumptions to be made about probability distributions and the relationships between variables that may turn out to be inaccurate.
Aggressive vs Defensive shares
Aggressive Shares: Aggressive shares means investing in shares involving greater risks. The risks take many forms: i) Investing in highly volatile market where the price fluctuations defy all the techniques of analytical and research. There are rises and falls in the prices of stocks that appear contrary to the expectations of investors. ii) Investing in stocks that seem to have gone to "cases" for general calculations. But, they show a high growth and provide rich dividends. Of course, they can also fall further down, since they have already disappeared cases. iii) Investing in some stocks, like Wal-Mart, fully aware that they are expensive and the price cannot rise in the near future. Few people know that the buyer does not invest so high-value stocks in them to make money by a rise in their prices, but these companies will pay rich dividends to their investors each year, so that they become a source of regular income and their livelihood. The dividends paid by such blue-chip companies almost wipe out the high prices for their shares to pay people to buy them. Defensive Shares: A defensive share does not at all mean free from all dangers, but merely means that the risks and the best yields are affordable at the same time to that share. It must be clear that the risks in stock trading are neither higher nor lower than in any other business. Ordinary equity investors especially the ones being beginners should follow a defensive approach and should be careful while trading in shares. A slow, cautious and conservative approach is not high Gains in the early stages. In fact, the gains seem negligible, almost daunting in its infancy, but it can be phenomenal as over time. You will appreciate their value, when you retire. This approach is an example of the truth, the slow and steady wins the race.
