Finance for Managers

Returns

A return, also known as a financial return is the money made or lost on an investment. A return can be expressed nominally as the change in dollar value of an investment over time or as a percentage derived from the ratio of profit to investment. We will cover those ratios below. If we make a profit on our investment or venture, we have a positive return. If we lose money on our investment or venture, we have negative return.

A nominal return is the net profit or loss of an investment expressed in nominal terms (i.e., levels). It can be calculated by figuring the change in value of the investment over a stated time period plus any distributions minus any outlays. Distributions received by an investor depend on the type of investment or venture but may include dividends, interest, rents, rights, benefits, or other cash flows received by an investor. Outlays paid by an investor depend on the type of investment or venture but may include taxes, costs, fees, or expenditures paid by an investor to acquire, maintain, and sell an investment. For example, assume an investor buys $2,000 worth of publicly traded stock, receives no distributions, pays no outlays, and sells the stock two years later for $2,200. The nominal return in dollars is $2,200 - $2,000 = $200.

A percentage return is a return expressed as a percentage. It is known as the return on investment (ROI). ROI is the return per dollar invested and is calculated by dividing the dollar return by the dollar initial investment. This ratio is multiplied by 100 to get a percentage. Assuming a $200 return on a $1,000 investment, the percentage return or ROI = ($200 / $1,000) × 100 = 20 percent.

A holding period return is an investment's return over the time it is owned by a particular investor. Holding period return may be expressed nominally or as a percentage.

Rate of return is the proportion of profit earned from an investment during a periodic interval of time, expressed as a percentage. For example, the return earned during the periodic interval of a month is a monthly return and of a return earned during a year is an annual return.

Returns over periodic internals of different lengths can only be compared when they have been converted to same length intervals. It is customary to compare returns earned during yearlong intervals. Return of capital refers to the recovery of the original investment.

Return Ratios

Companies use different kinds of return ratios to compare one investment option to another one:

· Return on equity (ROE) is a profitability ratio figured as net income divided by average shareholder's equity, which measures how much net income is generated per dollar of stock investment. If a company makes $10,000 in net income for the year and the average equity capital of the company over the same time period is $100,000, the ROE is 10 percent.

· Return on assets (ROA) is a profitability ratio figured as net income divided by average total assets, which measures how much net profit is generated for each dollar invested in assets. It determines financial leverage and whether enough is earned from asset use to cover the cost of capital. Net income divided by average total assets equals ROA. For example, if net income for the year is $10,000, and total average assets for the company over the same time period is equal to $100,000, the ROA is $10,000 divided by $100,000, or 10 percent.

Evaluating Investment Options

The first category of your investment plan is risk and return objectives. This category describes your expectations for returns on your investments. These expectations will, to a large extent, determine your asset allocation decisions. In other words, these expectations will determine how you will distribute your investments among different asset classes. This category also addresses your expectations for risk and outlines how much risk you are willing to accept.

Expected Returns

You should not invest without specific goals in mind. For your first goal, you should decide what return you expect your total portfolio to make over a specific time period. You cannot know with certainty what the actual returns will be before you invest. However, you can estimate an expected return, or a goal that you hope to achieve during a certain period of time (such as a week, a month, or a year). Be aware that your expected return will have a major impact on what your portfolio looks like:

· An expected annual return of 2 to 3 percent will likely be the result of a well-diversified, very low-risk portfolio.

· An expected annual return of 4 to 6 percent will likely be the result of a well-diversified, low-risk portfolio.

· An expected annual return of 7 to 8 percent will likely be the result of a well-diversified, moderate-risk portfolio.

· An expected annual return of 9 to 10 percent will likely be the result of a less-diversified, high-risk portfolio.

· An expected annual return that is greater than 10 percent will likely be the result of an undiversified, very high-risk portfolio that is heavily dependent on high-risk assets.

Note that you will determine your expected returns for two periods of time: before retirement and during retirement.

There are several ways to estimate your expected returns. To give you an idea of how to estimate your expected returns over a period of time longer than one year, it may be helpful to look at the long-term history of the asset classes you have selected.

Expected Risk

Since a higher expected return requires you to accept more risk, it is important that you know your risk-tolerance level, or your willingness to accept risk. Your age and feeling of financial security will likely have a big impact on how much risk you are willing to take. In general, when people are younger they are more willing to accept risk because their investments will have more time to grow and overcome loses. As people grow older, they usually become less willing to accept risk because they will need their investment funds sooner for retirement and other purposes. Investors that have a low tolerance for risk should typically devote the majority of their portfolios to bonds and cash because these investments are the least risky of all asset classes; however, these investments also have the lowest returns. Investors that are willing to accept more risk may allocate more of their portfolio to US and international stocks, versus investments in bonds and cash. The challenge of wise investing is to balance your risk and return expectations with your situation in life and your personal goals.

Defining risk in your portfolio is a challenge. Professional investors usually state an annual standard deviation as the acceptable risk level for their portfolio—for example, 12 percent. From a financial standpoint, this means that 66 percent of the time the investor’s risk will be within one standard deviation (plus or minus 12 percent) of their mean or average return. If an investor’s average return is 8 percent, this means that there is a 66 percent chance that the investor’s returns will be between -4 percent (8 percent - 12 percent) and 20 percent (8 percent + 12 percent). While using a standard deviation to define risk may be helpful for some, this method will not work for everyone. I would like to propose a simpler way of defining risk: using investment benchmarks.

Instead of defining your risk tolerance level in terms of a standard deviation, you can simply define your risk tolerance level by deciding that you are willing to accept the risk of the benchmarks you have chosen for your portfolio. You can determine how risky a particular asset is by looking at your investment benchmark. If you have a small-capitalization stock mutual fund or asset that has had a return of 7.5 percent over the last ten years and a standard deviation of 25.3 percent, you can compare this asset to an investment benchmark for small-capitalization stocks.

You can also determine a portfolio’s risk level by comparing the portfolio to weighted individual benchmarks. For example, if you choose a portfolio that is made up of 50 percent US stocks, 20 percent international stocks, 25 percent bonds, and 5 percent real estate (all percentages should add up to 100 percent), then your risk is equal to the risk defined by the benchmarks of each of these asset classes. In this case, your risk would be equal to the benchmarks of each element in a portfolio that contains 50 percent US stocks (as measured by Standard and Poor’s 500 Index, a major benchmark for large-capitalization stocks); 20 percent international stocks (as measured by MSCI Europe Australia, Far East Index, or EAFE, a major benchmark for international stocks); 25 percent bonds (as measured by the Lehman Aggregate Index, a major benchmark for bonds); and 5 percent real estate (as measured by Standard and Poor’s REIT Index, a major benchmark for real estate investment trusts).

Risk

The term financial risk is broad, but can be broken into categories to understand it better:

· Asset-backed risk affects investments in asset-backed securities, such as home loans. In order to finance home sales, banks issue bonds that serve as a debt obligation to its buyer. The buyer of the debt is essentially receiving the interest from the bank that the home-buyer is paying to it.

· Prepayment risk is the risk that the buyer goes ahead and pays off the mortgage. Therefore, the buyer of the bond loses the right to the buyer’s interest payments over time.

· Interest rate risk refers to an asset whose terms can change over time, such as a variable rate mortgage payment.

· Credit risk or default risk, is the risk that a borrower will default (or stop making payments).

· Liquidity risk is the risk that an asset or security cannot be converted into cash in a timely manner. Some investments (i.e., stocks) can be sold immediately at the current market rate and others (i.e., houses) are subject to a much higher degree of liquidity risk.

· Market risk is the term associated with the risk of losing value in an investment will lose value because of a decline in the market.

· Operational risk is another type of risk that deals with the operations of a particular business. If you are invested in the Boston Red Sox, your operational risk might include the chance that starting pitchers and recently acquired players won’t perform, that your manager will turn the clubhouse into a mess, or that ownership will not be able to execute a long term strategy. Any of these risks might result in decreased revenues from ticket sales.

· Foreign investment risk involves the risk associated with investments in foreign markets.

· Model risk involves the chances that past models, which have been used to diversify away risk, will not accurately predict future models.

A recent phenomenon that applies the concepts of these risks and how they interact with each other happened in 2008 when the housing market crashed. Can you find an example of each form of risk here?

Leading up to the crisis, many people received loans to buy houses which they really couldn’t afford. The mortgages often featured variable rate annuities, meaning that the interest rate terms of the mortgage started low and increased over time. Over the prior 20 years, house prices had risen constantly, and investors assumed the trend would continue. Buyers worried about an adjustment to their interest rate, and all of a sudden a 1,500 monthly payment became 2,000. When interest rates climbed two percentage points and the mortgage climbed to $2,000, some owners had to default (stop making payments). They were promised that their investment would appreciate in value and they would be able to refinance it. The home loans were packaged and shipped off to investors all over the world in the form of complex investment vehicles. They seemed rewarding and highly safe at first, but then a few started breaking down. By now, these vehicles had made their way all the way around the world. When some investors defaulted, the world realized there were no mechanics around to fix these vehicles. After a few vehicles broke down, no one wanted to buy them, leading to the worst crash across world markets since 1929.

Measuring Risk

The higher the risk undertaken, the more ample the expected return and the lower the risk, the more modest the expected return.

Risk refers to the variability of possible returns associated with a given investment. Risk, along with the return, is a major consideration in capital budgeting decisions. The firm must compare the expected return from a given investment with the risk associated with it. Higher levels of return are required to compensate for increased levels of risk. In other words, the higher the risk undertaken, the more ample the return; and conversely, the lower the risk, the more modest the return.

This risk and return tradeoff is also known as the risk-return spectrum. There are various classes of possible investments, each with their own positions on the overall risk-return spectrum. The general progression is short-term debt, long-term debt, property, high-yield debt, and equity. The existence of risk causes the need to incur a number of expenses. For example, the more risky the investment the more time and effort is usually required to obtain information about it and monitor its progress. Moreover, the importance of a loss of x amount of value can be greater than the importance of a gain of x amount of value, so a riskier investment will attract a higher risk premium even if the forecast return is the same as upon a less risky investment. Risk is therefore something that must be compensated for, and the more risk the more compensation is required.

When a firm makes a capital budgeting decision, they will wish, as a bare minimum, to recover enough to pay the increased cost of investment due to inflation. Thus, inflation is a pivotal input in a firm’s cost of capital. However, since interest rates are set by the market, it happens frequently that they are insufficient to compensate for inflation.

Inflation

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

Risk aversion also plays an important role in determining a firm’s required return on an investment. Risk aversion is a concept based on the behavior of firms and investors while exposed to uncertainty to attempt to reduce that uncertainty. Risk aversion is the reluctance to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff. For example, a risk-averse investor might choose to put his or her money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value. Risk aversion can be thought of as having three levels:

1. risk-averse or risk-avoiding

2. risk-neutral

3. risk-loving or risk-seeking

Beta is a measure firms can use in order to determine an investment’s return sensitivity in relation to overall market risk. Beta describes the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. This benchmark is generally the overall financial market and is often estimated via the use of representative indices, such as the S&P 500. Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset’s returns to market returns, its nondiversifiable risk, its systematic risk, or market risk. Higher-beta investments tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta investments pose less risk, but generally offer lower returns.

Traditionally, a firm’s risk management function ensured that the pure risks of losses were managed appropriately. The risk manager was charged with the responsibility for specific risks only. Most activities involved providing adequate insurance and implementing loss-control techniques so that the firm’s employees and property remained safe. Thus, risk managers sought to reduce the firm’s costs of pure risks and to initiate safety and disaster management.

Typically, the traditional risk management position has reported to the corporate treasurer. Handling risks by self-insuring (retaining risks within the firm) and paying claims in-house requires additional personnel within the risk management function. In a small company or sole proprietorship, the owner usually performs the risk management function, establishing policy and making decisions. In fact, each of us manage our own risks, whether we have studied risk management or not. Every time we lock our house or car, check the wiring system for problems, or pay an insurance premium, we are performing the same functions as a risk manager. Risk managers use agents or brokers to make smart insurance and risk management decisions.

The traditional risk manager’s role has evolved, and corporations have begun to embrace enterprise risk management in which all risks are part of the process: pure, opportunity, and speculative risks. With this evolution, firms created the new post of chief risk officer (CRO). The role of CROs expanded the traditional role by integrating the firm’s silos, or separate risks, into a holistic framework. Risks cannot be segregated—they interact and affect one another.

In addition to insurance and loss control, risk managers or CROs use specialized tools to keep cash flow in-house. Captives are separate insurance entities under the corporate structure—mostly for the exclusive use of the firm itself. CROs oversee the increasing reliance on capital market instruments to hedge risk. They also address the entire risk map—a visual tool used to consider alternatives of the risk management tool set—in the realm of nonpure risks. For example, a cereal manufacturer, dependent upon a steady supply of grain used in production, may decide to enter into fixed-price long-term contractual arrangements with its suppliers to avoid the risk of price fluctuations. The CRO or the financial risk managers take responsibility for these trades.

They also create the risk management guideline for the firm that usually includes the following:

· writing a mission statement for risk management in the organization

· communicating with every section of the business to promote safe behavior

· identifying risk management policy and processes  

· pinpointing all risk exposures (what “keeps employees awake at night”)  

· assessing risk management and financing alternatives as well as external conditions in the insurance markets

· allocating costs  

· negotiating insurance terms  

· adjusting claims adjustment in self-insuring firms  

· keeping accurate records

· writing risk management manuals set up the process of identification, monitoring, assessment, evaluation, and adjustments.

In larger organizations, the risk manager or CRO has differing authority depending upon the policy that top management has adopted. Policy statements generally outline the dimensions of such authority. Risk managers may be authorized to make decisions in routine matters but restricted to making only recommendations in others. For example, the risk manager may recommend that the costs of employee injuries be retained rather than insured, but a final decision of such magnitude would be made by top management.