Investment Rate of Returns
A required rate of return is the minimum level of expected return that an investor requires in order to invest in the asset over a specified time period, given the asset’s riskiness. The required rate of return on common stock and debt are also known as the cost of equity and cost of debt, respectively, taking the perspective of the issuer. From other side stands internal rate of return (IRR), which measures profitability of particular investment. Common rule is to invest into the project if IRR is greater than investor’s required rate of return.
Investment return comes close with its risk and in order to understand full picture, it is needed to evaluate project risks as well. Modern portfolio theory assesses each investment by comparing it to similar companies in the market, or in other words market benchmarks. Some ways and indicators from this theory to measure risks are: alpha, asset beta, r-squared, standard deviation and the Sharpe ratio. Investor should also understand that each method has its pros and drawbacks, so decision should be based on complex analysis. (Frankfurter, 1977)
Investment or project risk can be divided into systematic and unsystematic. Systematic risk (non-diversifiable or market risk) affects whole economy and cannot be diversified. Systematic risk reflects business risk of asset and can be described by asset beta, which is based on covariance between current asset returns with the return of all market.
Nonsystematic risk refers to particular industry, this risk doesn’t affect other security types or assets from different industries. Investors are capable of avoiding nonsystematic risk through diversification by forming a portfolio of assets that are not highly correlated with one another. One study shows that with 30 different investments in the portfolio, investor can almost avoid unsystematic risk. (Statman, 1987)
Above interpretation can be also described with the following formula:
Required return on equity = Current expected risk-free return + Equity risk premium
United States Treasury bonds are considered most conservative and risk-free investments and their rates are taken into the calculation of risk-free rates. From other hand investments into young pharmaceutical companies can be extremely risky with default rates up to 95%. Diversification can be applied here as well – by holding large portfolio of different pharmaceutical companies can significantly decrease firm-specific risks.
Other example is Sharpe ratio. Sharpe ratio measures the reward of investor, in terms of mean excess return of portfolio over risk-free asset, per standard deviation or unit of risk. Risk-reward tradeoff is the principle that potential return rises with an increase in risk. Low risk and low level of uncertainty corresponds with low returns. From this principle it is concluded that extraordinary returns only come with extraordinary risk taken.
By analyzing risk and return of major asset classes in the United States during 1926-2008 it was shown that small-cap stocks had highest average returns and highest standard deviation of returns. (Ibbotson, 2009)That is why such widespread term as risk tolerance is taken into account - the amount of risk an investor is willing and …