Concept of Risk and Return in Financial Management

Principles of Finance and Financial Transactions

our last group of principles emerges from observing financial transactions.

Concept of Risk and Return in Financial Management

The Principle of Risk Return Trade Off, There is a Trade Off Between Risk and Return

The Principle of Risk Return Trade Off or concept of risk and return in financial management is another way of saying that if you want to have a chance at some really great outcomes, you have to take a chance on having a really bad out come. Even without providing a formal definition of risk, we can agree on some of the effects of risk. One important dimension of risk is that higher risk brings with it either a greater chance of a bad outcome or worse possible outcomes. You simply cannot expect to get high returns without simultaneously exposing yourself to the chance of low returns.

When we discussed ;the Principle of Self Interested Behavior, we did not talk about how to operationalize it. We'll don that now. In a financial transaction, we assume that when all else is equal, people prefer higher return and lower risk. To appreciate the justification for this assumption simply ask yourself this question. If you are faced with two alternatives that are identical (including their riskiness), except that alternative A provides a higher return than B, which alternative will you chose? We predict you'll choose A.

Similarly, if you are offered two alternatives that are identical (including their return), except that A is riskier than B, which alternative will you choose? If you are like most people, you'll choose B. This behavior is called risk aversion, avoiding risk when all else is equal. In other words, investors are not indifferent to risk but require compensation for bearing it. 

People generally behave as though they are averse to risk. Almost any decision or choice you make involves risk. For example, decisions to make an investment, take a job or lend money involve varying degrees of risk. Personal decisions also involve risk and your personal choices will generally reflect your attitude toward risk.

If people prefer higher return and lower risk and they act in their own financial self interest, competition then creates the Principle of Risk Return Trade Off. Competition forces people to make a trade off between the return and the risk of their investment. You just can not get high returns and low risk simultaneously because that's what everyone wants. Therefore, to get a higher expected return, you'll have to take more risk.

A corollary to the Principle of Risk Return Trade Off is that most people are willing to take less return in exchange for less risk. When an asset is purchased., its expected future return can be adjusted by altering its purchase price. A lower (higher) purchase price increases (decreases) the buyer's expected future return. Capital markets, such as the stock market. Offer such opportunities and each participant makes his risk return trade off.

The Principle of Diversification, Diversification is Beneficial

The Principle of Diversification is really quite straightforward and requires little explanation. A prudent investor won't invest her entire wealth in a single company. That would expose her entire wealth to the risk that the company might fail. But if the investment is divided among many companies, the entire investment won't be lost unless all of those companies fail. This is much less likely than that one of them will fail. Spreading investments around, instead of concentrating them, is called diversification. We will explain in next post how investors can lower their risk by investing in a group of securities called a portfolio, rather than by investing exclusively in one security.

The Principle of Capital Market Efficiency, The Capital Markets Reflect all Information Quickly

Buying and selling securities is referred to as trading. Probably the best known capital markets are in New York, London and Tokyo. The New York and American Stock Exchanges and especially because of recent television advertising, the NASDAQ (National Association of Securities Dealers Automated Quotation) stock markets are the most widely known in the United States. Together with other stock exchanges around the world and smaller ones around the country, they are collectively referred to as the stock market. There are many other capital markets as well.

Formally, the Principle of Capital Market Efficiency says, Market prices of financial assets that are traded regularly in the capital markets reflect all available information and adjust fully and quickly to "new" information.

How do share prices react to new information? We'll use the stock market for illustrative purposes at this point, because it is probably familiar to you.

Capital market efficiency depends on how quickly new information is reflected in share prices. For a machine, perfect efficiency means there's no wasted energy no loss to friction. This is certainly one aspect of capital market efficiency. The capital markets are well organized. The cost of making a transaction (buying or selling) is very low, especially when compared to transaction costs in the real asset markets (such as machines, real estate and raw materials). It's generally much easier, cheaper and faster to buy and sell financial assets than to buy and sell real assets.

For example, companies such as Merril Lynch charge a sales commission of about 1% of the sales value to execute an order to trade 1000 shares of stock selling for $60 per share, a $60,000 transaction. There are somewhat lower (higher) rates to handle larger (smaller) transactions. In contrast, companies such as Century 21 charge about 6% of the sale value to sell a $60,000 house. In the concept of risk and return in financial management we'll have more to say about why this difference exists , but for now let's just note the difference.
In addition to offering convenience, low cost and high speed, the capital markets are unimaginably large. The New York Stock Exchange alone averages more than $10 billion worth of stock traded each day. There are numerous participants and competition is intense. When new information arrives, there are plenty of people paying close attention because there is a lot of money at stake. Those people can buy or sell their financial assets in minutes or even seconds. This explains why transaction costs and operational efficiencies play an important roll in the speed and accuracy with which prices fully reflect the new information.
In an efficient market that had no impediments to trading, the price of each asset would be the same everywhere in the market, except for temporary differences during periods of disequilibrium. In such a market environment, if price differentials existed, traders would take immediate actions to benefit from those differences through arbitrage. Arbitrage is the act of buying and selling an asset simultaneously, where the sale price is greater than the purchase buying and selling an asset simultaneously, where the sale price is greater than the purchase price, so that the difference provides a riskless profit. As long as selling prices exceed buying prices, traders can earn a riskless arbitrage profit and they can continue to do so until the price differential no longer exists.
Arbitrage opportunities enforce the economic principle called the law of one price. This law states that equivalent securities must trade at the same price. The law of one price may not hold strictly when there are transaction costs or other impediments to trading, but it is a good approximation of reality. Arbitrage activity ensures that whatever price differentials exist are smaller than the cost of arbitraging them away. For example, you might see small differences in price between the New York and London prices of gold, despite intense competition. This is due to the cost of shipping gold from one place to another. In the capital markets, with the same kind of intense competition but with essentially zero "shipping costs", differences in the prices of any particular security tend to be virtually zero.
It's easy to accept the Principle of Capital Market Efficiency. yet it is probably the hard est to "internalize" of all of the principles of finance. We all know there are people who win the lottery and people who occasionally amass vast fortunes trading in the stock market. How can we become winners? How can we start with a small sum and amass a great fortune trading in stocks? (The answer to both questions is the same, only with luck or illegal activity!) If there were a reliable way to amass such a fortune, everyone would do it, of course and then, instead of one great fortune, there would be a multitude of smaller "fortunes". Yet hope springs eternal!
Competition, Size and the similarity of assets combine to make the capital markets extremely efficient. Frequently, we assume that the capital markets are perfect (100% efficient no losses due to friction) in order to build a decision model. In fact, a perfect market is the best approximation we have of the capital markets. The assumption of perfect capital markets is like the assumption of risk aversion. Though not always correct, it is widely accepted and useful.

Reconciling Capital Market Efficiency with Valuable New Ideas

You may find it difficult to reconcile the Principle of Valuable Ideas with the Principle of Capital Market Efficiency. Together, they state that the capital markets are efficient, but that even in the capital markets, with all the competition that exists, a new market, product, or service can be created that provides an extraordinary return.
Here is the critical difference between the two principles. The Principle of Valuable Ideas applies to the return associated with being part of the creation of the opportunity. The Principle of Capital Market Efficiency involves the return associated with simply purchasing part of an opportunity that has become known to everyone. The founders of Apple Computer earned a tremendous rate of return on their investment as a result of their innovations. But what happened as other people became aware of the unique advantages that Apple's computer offered? Those advantages became fully reflected in Apple Computer's share price. So once the stock became actively traded, a purchaser of Apple Computer common stock could expect, because of capital market efficiency, to earn only a rate of return commensurate with the risk of investment. Because of the very nature of risk, the outcome could be quite different from what was expected.

The Time Value of Money Principle, Money has a Time Value

If you own some money, you can "rent" it to someone else. The borrower must pay you interest for the use of your money (or you own not make the loan). Simply stated, the time value of money is how much it costs to rent money.

You can think of the time value of money as the opportunity to earn interest on a bank savings account. A sizable amount of money kept in cash at home creates an opportunity cost, the cost of missing the opportunity to earn interest on the money. For this reason, we think of the interest rate as a measure of the opportunity cost. in fact, because of capital market efficiency, we can use our capital market alternatives as benchmarks against which to measure other investment opportunities. Do not make the investment unless it is at least as good as comparable capital market investments.