Understanding Stock Risk and Return Analysis

June 23, 2022 3 min read

Understanding Stock Risk and Return Analysis

Understanding Stock Risk and Return Analysis

One of the many concepts of Stock trading you should be familiar with is the Risk and Return analysis. You could get so many things from understanding this concept – for instance, your gains and losses depend on it. Moreover, you may get to know a bit more about diversification as a tool for eliminating risks during trades. 

What is Stock Risk and Return? 

Risk and Return are related terms since one affects the other. In this tradeoff, investments with high risk often come with potentially high returns. With this risk-and-return analysis, investors can easily know what might get them more profits or incur possible losses. 

However, this principle is only valid for certain risks, i.e., market, project-specific, international, competitive, and industry-specific. And when talking about returns, it could either be gains or losses, often expressed in percentages. 

Stock risk and return is always higher compared to other securities. For instance, there is a likelihood of getting higher when you invest or trade in the stock market than in the U.S. Government's securities. The reason is that there are more risks with stocks, and by making the wrong move, you may lose all your investments. 

While you are still on this analysis, you must understand certain tools and factors influencing risks and returns. They include the Capital Allocation Line (CAL) and Diversification. 

Capital Allocation Line

One of the tools that could influence the possible returns of a stock is the Capital Allocation Line. It focuses on using standard deviation to measure the risk involved. In this case, standard deviation gets returns variability over a period of time. 

To calculate the expected return of a high-risk stock, the formula is: 

Er = W(Rf) x Er(Rf) + W(Rr) x Er(Rr)

Where: 

Er is the expected return

W is the weight or % of the investment

You can plot a Capital Allocation Line graph based on what you get from your stock investment with varying weights. On the other hand, the government's, i.e., low- to zero-risk securities, always come back as zero. 

Diversification

Every investment is a diversified portfolio. With this diversification, it is possible to reduce risk around a portfolio to limit potential returns. In short, it gives investors a clue of what the effect of risk may mean to the entire portfolio. 

Likewise, diversification can eliminate firm-specific risk, which automatically affects the prices of individual assets positively or negatively. Interestingly, it is only at the small level because, with a large or the entire portfolio, the negatives and positives even out to keep the risk level uninfluenced. 

What are the Various Risk and Return Models?

There are different models in the Risk and Return concept. They include:

Multifactor Model

The Multi-Factor model often involves using several factors to discuss the market's state and the equilibrium prices of stocks. In this case, it is used to discuss market risk and estimate alternatives for investments with each factor listed. The model is divided into three types – Macroeconomic, Fundamental, and Statistical. 

Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is the commonest. It often establishes the relationship between a calculated risk and expected returns for stocks. That means as it is used to price high-risk securities like stocks, it can also determine the expected returns. 

Proxy Model

Proxy Model, however, is different. It focuses on statistically defined functions. In the stock rate and return analysis, the Proxy Model looks out for certain attributes that can influence regression, such as the stock size. With the size, stock returns can be calculated by comparing with the size of other higher returns in the past. 

Arbitrage Pricing Model 

The Arbitrage Pricing Model or Theory is almost similar to the macroeconomic multi-factor model. It simply involves comparing a stock's expected return with different macroeconomic variables to determine its actual return. These variables are only those with their primary focus on systematic risks. 

Accounting and Debt-Based Model

In the Accounting and Debt-Based Model, there are considerations for short-term, long-term, equity, and high-yield debt to determine the expected returns of stocks. By discovering the financial leverage ratio, investors can know whether gains or losses will be incurred at the end of the investment period. 

Conclusion

You don't just become a stock investor without understanding important concepts like the Risk and Return analysis. You could get so much at the end of an investment period by understanding how high risks can potentially influence your stock returns. And whichever model you use, ensure that you pay attention to the various factors or parameters involved.


JOIN INVESTOR UPLIFT NOW