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. Fundamental Analysis

    How To Manage Portfolio Risk

    Follow these tips to successfully manage portfolio risk.
  2. Options & Futures

    Spice Up Your Portfolio With International Bonds

    Going global can add flavor and diversity to an otherwise bland basket of bonds.
  3. Bonds & Fixed Income

    Six Biggest Bond Risks

    Don't assume that you can't lose money in this market - you can. Find out how.
  4. Bonds & Fixed Income

    Cash Vs. Bonds: What to Pick in Times of Uncertainty

    Learn about the benefits and drawbacks of holding cash versus investing in bonds to ensure you make the right decision about how to best safeguard your money.
  5. Retirement

    Retirement Planning For 20-Somethings: Choosing And Managing Your Investments

    The types of assets in which your savings are invested will significantly impact your return on investments and, consequently, the amount available to finance your retirement. As a result, a ...
  6. Bonds

    What bonds are: Debt securities where you lend money to an issuer (e.g., a corporation or government) in exchange for interest payments and the future repayment of the bond’s face value. ...
  7. Economics

    How to Invest In Developing Markets

    Developing markets can be attractive additions to many investor's portfolios, but carry additional risks that must be considered.
  8. Mutual Funds & ETFs

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  9. Bonds & Fixed Income

    The Importance Of Diversification

    Without this risk-reduction technique, your chance of loss will be unnecessarily high.
  10. Bonds & Fixed Income

    Junk Bond

    Find out more about these bonds that have a high risk of default.
RELATED TERMS
  1. Systematic Risk

    The risk inherent to the entire market or entire market segment. ...
  2. Specific Risk

    Risk that affects a very small number of assets. Specific risk, ...
  3. Junk Bond

    A colloquial term for a high-yield or non-investment grade bond. ...
  4. Risk Averse

    A description of an investor who, when faced with two investments ...
  5. Return Of Capital

    A return from an investment that is not considered income. The ...
  6. Global Bond

    This type of bond can be traded in a domestic or European market. ...
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. How does systematic risk influence stock prices?

    Understand how systematic risk can influence the prices of stocks and how strategic asset allocation can help reduce systemic ... Read Answer >>
  4. What are the key differences between financial risk and business risk to a company?

    Understand the difference between a company's financial risk and its business risk, along with some of the factors that affect ... Read Answer >>
  5. What is the difference between inherent risk and systematic risk?

    Learn about inherent and systematic risk, two types of risk that affect investments, the differences between them and how ... Read Answer >>
  6. What are the risks of investing in a bond?

    The most well-known risk in the bond market is interest rate risk - the risk that bond prices will fall as interest rates ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center