Risk and Return
Return measures
- Absolute return: (end minus start) divided by start; ignores time.
- CAGR: (End/Begin)^(1/n) minus 1; the constant annual rate linking start and end.
- Total return: price change plus income such as dividends or coupons.
- Real return: nominal return minus inflation, approximately.
Risk taxonomy
Systematic risk affects all securities: market, interest rate, inflation, currency and regulatory risk. Unsystematic risk is issuer-specific: business, credit, liquidity and governance risk. Diversification reduces unsystematic risk but not systematic risk.
Measures: standard deviation captures total volatility; beta captures sensitivity to the market, with the market at 1; the Sharpe ratio is (portfolio return minus risk-free rate) divided by standard deviation; alpha is the return not explained by benchmark exposure; maximum drawdown is the worst peak-to-trough fall.
Worked example
Rs 1,00,000 grows to Rs 1,44,000 in four years. Absolute return is 44 percent. CAGR is (1.44)^(1/4) minus 1. Since 1.44^0.25 is about 1.0955, the CAGR is about 9.55 percent a year. If the annual returns were +30, +20, -5 and +8 percent, the arithmetic mean is 13.25 percent, but the compounded outcome is still 9.55 percent: the arithmetic average overstates what the client actually earned.
Traps
Comparing a three-year cumulative return with a one-year return without annualising. Calling standard deviation the chance of loss, when it measures dispersion in both directions. Using a fund's best year as an expected return. Forgetting that beta says nothing about credit or liquidity risk.