Risk Involved In Investment And Portfolio Management - Essay Example

Introduction Investment in financial assets and liabilities undoubtedly provides great returns to the investors for short as well as long-term. However these returns do not to come to investors without risks. There are various factors that decrease the chances of expected returns for the investors. This paper provides an introduction to risk and various elements that add to the risk associated with a certain type of investment. This paper also illuminates the effectiveness of portfolio management to eliminate the risks that are confronted by investors while maximising the returns on investment. Risk Involved In Investment And Portfolio Management Risk happens to be the most crucial and inevitable factor involved in financial investment. Investors at all stages are vulnerable to various types of risks associated with different types of investments. Gibson (2000, p118) defines risk as, "in investment management, risk is often equated with the uncertainty (variability or standard deviation) of possible returns around the expected return". Risk is the capability of pointing out possible outcomes and their probabilities without being sure as to which will happen. It is the extent and possibility to which expected returns vary in response to several factors. Jorion (2000, p35) propounds that, "risk can be defined as the volatility of unexpected outcomes, generally the value of assets or liabilities of interest". Investors confront with risk as an unavoidable element that bears the capability to decrease the returns the investors expect to obtain from the investment asset. Investors block their money in certain assets such as stock and securities as well as liabilities such as bonds in anticipation of certain return with less exposure to risk factors. Different types of investments contain different levels of risk that also correspond to the return expected by investors. Investments such as government bonds and securities bear no risk to the investors therefore provides less return to the investors. Other most common investments such as stocks and bonds bear higher levels of risks, therefore provide the investors with a risk-premium i.e., much high level of return. Blake (1996, p1191) says that, "investors are reluctant to hold equities unless they are compensated with a sufficiently high risk premium". It is natural because investors perceive much risk to be involved in investments such as bonds and stocks they are willing to expect more return on them. Stocks and bonds are considered more risky because they involve several elements that may change with time due to uncontrollable factors such as price, interest rates, inflation etc. The most important thing with respect to any investment is the level of certainty with respect to the recovery of principal amount invested. Stocks and bonds are different with regard to risks that are confronted by investors from time to time. Stocks or bonds are both issued by corporations at different times to raise long-term finance for their business but their treatment is different. Stock is regarded as equity capital whereas bonds are considered as borrowed capital or external funds. Stock investors become owners of the company and bondholders become creditors. Owners i.e., stockholders therefore perceive more risks pertaining to the recovery of their principal amount because in case if company defaults they would be given less priority over bondholders on the company's assets. Gibson (2000, p58) elaborates that, "because the bondholders and other creditors of a corporation have a prior claim to the corporation's revenues and assets, common stock shareholders are said to have a residual ownership interest". Also the returns to stockholders are not guaranteed but bondholders are entitled to receive a fixed rate of guaranteed return. Therefore, in this view, investment in stock is riskier than bonds. There are various aspects that determine the risks involved in investing into corporate bonds and securities. Bodie (1995, p21) says that, "with real bonds, the investor knows that regardless of what happens to the price of the bond prior to its maturity date, at maturity it will pay its holder a known number of units of purchasing power". Bonds come with a price that the corporation is liable to pay at the end of the maturity period along with periodic interests payments that the bondholder is entitled to receive as per the contract. Therefore bondholders are more assured of recovery of their principal amount invested than the shareholders. Investment in stock is riskier because the company bears no legal liability to pay off the principal amount to them. Bodie (1995, p21) mentions this point as, "stocks carry no certainty of value-real or nominal-at any date in the future". Stocks have no certain value with respect to their price i.e., if the share price falls in the market below the invested amount, the shareholders are not legally entitled to recover their principal amounts. Besides the issues related to corporation, there are other uncontrollable factors that enhance the risk associated with these investments i.e., price fluctuations, interests rates and inflation. The most significant issue is that the investors whether shareholders or bondholders are never able to expect the price fluctuations that occur in the market. Gibson (2000, p44) illustrates that, "the fluctuation in bond prices, due to changes in interest rates, is referred to as interest rate risk". Because returns associated with bonds is mostly in the form of interest, bond prices fluctuate mostly because of interest rates. Thau (2000, p49) elaborates that, "interest rate risk, also known as market risk, refers to the propensity bonds have of fluctuating in price as a result of changes in interest rates". Because most investors are willing to gain quick return by selling off their bonds before maturity, fluctuations in price due to interest rates remain as the greatest risk involved. As the interest rates increase in the market the bond prices fall down leading to a decline in the return for the bondholders willing to sell the bonds before maturity. Bondholders not only confront with the risk of volatility in the interest rates but also with the inflation. As Bodie (1995, p21) says that, "investing in bonds exposes the investor to inflation risk- the risk of depreciation in the purchasing power of the currency in which the bond payments are denominated". Because bonds are mostly long-term investments, their remains a long span of time to reach the maturity date. During that time inflation may rise that renders investors to receive less purchasing power than that the one available to them at the time of investment. This is also an important type of risk because investors are looking to enhance their returns by means of investing in long-term bonds rather than bearing any unanticipated losses. Inflation does not only affect bonds but also involves significant risks for shareholders. Gibson (2000, p62) points out that, "it is the unanticipated inflation that is especially harmful to common stock performance, particularly in the short run". As all financial investments generally possess several risks, rational investors make a portfolio of their investment. Investors make portfolio by investing in different types of investments such as risk-free government bonds, corporate bonds, stocks etc. Jansen et al. (2000, p247) illuminates that, "the portfolio choice of a safety-first investor is to maximise expected return subject to a downside risk constraint". Because different investments bear different levels of risks and returns, an investor strives to eliminate the risk associated with all these investments through portfolio. An investor who wants to lessen the impact of risks on his overall invested funds can greatly do so by adding only riskless or less risky investments to its portfolio, as Wachter (2003, p325) says that, "A highly risk-averse investor holds a portfolio consisting almost entirely of the riskless asset". Managing a portfolio of investment also protects an investor from the risk of inflation even in riskier investments. Gibson (2000, p317) illuminates that "as the portfolio maintains its purchasing power by growing at a rate sufficient to offset inflation, the cash withdrawals from the portfolio can also be increased over time to keep pace with inflation". Because portfolio also contains different types of investments less affected by inflation and others with high returns it keeps the average rate of return at a higher level and risk at the lowest. This serves as a great protection to the investors from various risks associated with financial investments. However this should also be understood that investors with huge resources are more able to build up a sufficient portfolio to minimise risks as compared to small investors with limited funds. Conclusion This paper discusses various factors that make the investment in bonds and shares as risky for the investors. Because these factors are mostly external and uncontrollable they are inevitably involved in the investment. Shares are by nature riskier than bonds because they do not bear any legal guarantee for the investors to recover their principal amount in case if the company defaults. Bonds however are categorised as liabilities and therefore bear a legal guarantee for investors to receive their invested amount even if the company goes bankrupt. There are other factors also that make investment in bonds and shares risky such as interests rates and inflation. An investor can greatly minimise the risks associated with investments by means of portfolio management. References Blake, D. (1996), "Efficiency, Risk Aversion And Portfolio Insurance: An Analysis Of Financial Asset Portfolios Held By Investors In The United Kingdom", The Economic Journal, 106, September, pp. 1175-1192 Bodie, Z. (1995), "On the Risk of Stocks in the Long Run", Financial Analysts Journal, May-June, 52(3), pp. 18-22 Gibson, R. (2000), Asset Allocation: Balancing Financial Risk, Blacklick, OH, USA: McGraw-Hill Professional Book Group. Jansen, D.W., Koedijk K.G. and Vries, C.G. (2000), "Portfolio Selection With Limited Downside Risk, Journal of Empirical Finance, 7, pp. 247-269 Jorion, P. (2000), "Value at Risk: The Benchmark for Controlling Market Risk", Blacklick, OH, USA: McGraw-Hill Professional Book Group Thau, A. (2000), Bond Book, Blacklick, OH, USA: McGraw-Hill Professional Book Group Wachter, A.J. (2003), "Risk Aversion And Allocation To Long-Term Bonds", Journal of Economic Theory, 112, pp. 325-333 Read More