Complete Guide To Corporate Finance

AAA

Capital Market History - Risk And Returns

Returns are the gains or losses from a security in a particular period and are usually quoted as a percentage. What kind of returns can investors expect from the capital markets? A number of factors influence returns.

Risk: In the investing world, the dictionary definition of risk is the chance that an investment's actual return will be different than expected. Risk means you have the possibility of losing some, or even all, of your original investment. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. Investment risks can be divided into two categories: systematic and unsystematic. (Read Financial Concepts: The Risk/Return Tradeoff to learn more; also see sections 11 and 12 of this walkthrough.)



Systematic Risk: Also known as "market risk" or "un-diversifiable risk", systematic risk is the uncertainty inherent to the entire market or entire market segment. Also referred to as volatility, systematic risk is the the day-to-day fluctuations in a stock's price. Volatility is a measure of risk because it refers to the behavior, or "temperament," of your investment rather than the reason for this behavior. Because market movement is the reason why people can make money from stocks, volatility is essential for returns, and the more unstable the investment the more chance there is that it will experience a dramatic change in either direction.

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. Systematic risk can be mitigated only by being hedged.


Unsystematic Risk: Also known as "specific risk," "diversifiable risk" or "residual risk," this type of uncertainty comes with the company or industry you invest in and can be reduced through diversification. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk. (Find out more in Extreme Investing: World's Riskiest Investments.)

Credit or Default Risk: Credit risk is the risk that a company or individual will be unable to pay the contractual interest or principal on its debt obligations. This type of risk is of particular concern to investors who hold bonds in their portfolios. Government bonds, especially those issued by the federal government, have the least amount of default risk and the lowest returns, while corporate bonds tend to have the highest amount of default risk but also higher interest rates. Bonds with a lower chance of default are considered to be investment grade, while bonds with higher chances of default are considered to be junk bonds. Bond rating services, such as Moody's, allows investors to determine which bonds are investment-grade and which bonds are junk. (To read more, see Junk Bonds: Everything You Need To Know and What Is A Corporate Credit Rating.)

Country Risk: Country risk refers to the risk that a country won't be able to honor its financial commitments. When a country defaults on its obligations it can harm the performance of all other financial instruments in that country as well as other countries it has relations with. Country risk applies to stocks, bonds, mutual funds, options and futures that are issued within a particular country. This type of risk is most often seen in emerging markets or countries that have a severe deficit. (For related reading, see What Is An Emerging Market Economy? and Country Risk: What Happens When A President Dies?)

Foreign-Exchange Risk: When investing in foreign countries you must consider the fact that currency exchange rates can change the price of the asset as well. Foreign-exchange risk applies to all financial instruments that are in a currency other than your domestic currency. As an example, if you are a resident of America and invest in some Canadian stock in Canadian dollars, even if the share value appreciates, you may lose money if the Canadian dollar depreciates in relation to the American dollar.

Interest Rate Risk: Interest rate risk is the risk that an investment's value will change as a result of a change in interest rates. This risk affects the value of bonds more directly than stocks. (To learn more, read How Interest Rates Affect The Stock Market.)


Political Risk: Political risk represents the financial risk that a country's government will suddenly change its policies. This is a major reason why developing countries lack foreign investment.

Some additional factors that influence actual returns are as follows:

Taxes: Different types of investments are taxed differently. The type of account an investment is held in and a taxpayer's tax bracket also affect the amount by which taxes diminish investment returns. For example, the interest paid on municipal bond investments is generally not taxable, and gains on investments held in a retirement account like an IRA or 401(k) are not taxable until the money is withdrawn. (Check out Capital Gains Tax 101 and Retirement Savings: Tax-Deferred Or Tax-Exempt? for further reading.)

Fees: Investors pay brokerage fees to buy and sell certain investments. They also pay management fees. These fees diminish investment returns. (To learn more, read Don't Let Brokerage Fees Undermine Your Investment Returns.)

Compounding: As we discussed in Section 4, the frequency with which your investment returns are reinvested and able to earn additional returns can significantly impact your total returns. The more frequently earnings are compounded, the better. Daily compounding is better than annual compounding.

Now that we understand the major factors that influence returns, let's look at the historical returns, average returns and variability of returns from investing in the stock and bond markets.

Historical Record Of Stocks And Bonds


Related Articles
  1. Retirement

    Risk and Diversification: Different Types of Risk

    Let's take a look at the two basic types of risk: Systematic Risk - Systematic risk influences a large number of assets. A significant political event, for example, could affect several of the ...
  2. Professionals

    Types of Investment Risks

    FINRA Series 6: Section 9 Types of Investment Risks. This section explains different types of risks, exchange rate risk, Interest Rate Risk, Business Risk, Credit Risk, Taxability Risk, call ...
  3. Professionals

    The Risk Premium

    CFA Level 1 - The Risk Premium. This topic covers risk premium, which is a component of required rate of return. Examines business, financial, liquidity and political risk.
  4. Fundamental Analysis

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  5. Investing Basics

    Understanding Market Risk

    Market risk is the chance that an investment’s value will decrease due to a factor that affects all investments across the market.
  6. Options & Futures

    Financial Concepts: The Risk/Return Tradeoff

    The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test." While some people can handle the equivalent of financial skydiving without batting an eye, others ...
  7. Investing

    Systematic Risk

    Systematic risk, also known as volatility, non-diversifiable risk or market risk, is the risk everyone assumes when investing in a market. Think of it as the overall, aggregate risk that comes ...
  8. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  9. Savings

    Being too Safe with Your Money Could Turn Risky

    Find out why playing it safe with your retirement savings can actually turn risky, including the basics of inflation risk and interest rate risk.
  10. Professionals

    Investment Risk (Part 1 of 2)

    Series 7 - Section 2: Investment Risk
RELATED TERMS
  1. Country Risk

    A collection of risks associated with investing in a foreign ...
  2. Systematic Risk

    The risk inherent to the entire market or entire market segment. ...
  3. Risk

    The chance that an investment's actual return will be different ...
  4. Market Risk

    The possibility for an investor to experience losses due to factors ...
  5. Company Risk

    The financial uncertainty faced by an investor who holds securities ...
  6. Specific Risk

    Risk that affects a very small number of assets. Specific risk, ...
RELATED FAQS
  1. What is the difference between market risk and country risk?

    Learn about market risk and country risk, some examples of each and the main difference between these two types of risks. Read Answer >>
  2. What are the primary sources of market risk?

    Learn about market risk and the four primary sources of market risk including equity, interest rate, foreign exchange and ... Read Answer >>
  3. Why are mutual funds subject to market risk?

    Find out why mutual funds, like all investments, are subject to market risk, including how the different types of market ... Read Answer >>
  4. Why should investors be concerned with risk management?

    Learn what risk management is, the difference between systematic and unsystematic risk, and why investors should be concerned ... Read Answer >>
  5. What are some classes I can take to prepare for the Series 6 exam?

    Learn about how the risk-return tradeoff applies to bond yields, and the different types of risks associated with investing ... Read Answer >>
  6. What is the breakdown of subjects covered on the Series 6 exam?

    Learn about the risk-return tradeoff for investing in stocks versus low-risk Treasurys and bonds, and understand the types ... Read Answer >>

You May Also Like

Hot Definitions
  1. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  2. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  3. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  4. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  5. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
  6. Society for Worldwide Interbank Financial Telecommunications ...

    A member-owned cooperative that provides safe and secure financial transactions for its members. Established in 1973, the ...
Trading Center