Complete Guide To Corporate Finance


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
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