Question

How to explain the following questions:

1. Risk and return for Sm Stock, LG Stock, Bonds....

2. Systematic and unsystematic risk, names etc

3. Beta for risk free and the market and what is usually used to reference each

4. Someone tells you there is a reward for taking on risk so they say you are correctly rewarded when you buy a single stock. How do you respond?

Answer 1

ANSWER TO 1

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.

There are four primary aspects of small-cap stocks that make them potentially riskier than large-cap stocks. One is that, when it comes to trading, small-cap stocks have less liquidity. For investors, this means enough shares at the right price may be unavailable when they wish to buy – or it may be difficult to sell shares quickly at favorable prices.

Another aspect is that, in comparison to large-cap companies, small-cap firms generally have less access to capital and, overall, not as many financial resources. This makes it difficult for smaller companies to obtain the necessary financing to bridge gaps in cash flow, fund new market growth pursuits or undertake large capital expenditures. This problem can become more severe for small-cap companies during lows in the economic cycle.

A third aspect of potential added risk with small-cap stocks is simply a lack of operational history and the potential for its unproven business model to prove faulty. These two factors can make it difficult for smaller companies to effectively compete with larger companies. Because small companies are not as likely to have an established, loyal customer base, they are more vulnerable to consumer preference changes.

The fourth aspect of risk with small-cap companies comes has to do with data. Not as much information about small companies is commonly available to the public, and this makes an informed evaluation of small-cap stocks more difficult for potential investors.

Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that is easier for small companies to generate proportionately large growth rates. Sales of $500,000 can be doubled a lot more easily than sales of $5 million. Also, since smaller companies are often run by a small, intimate managerial staff, they can more quickly adapt to changing market conditions in somewhat the same way it is easier for a small boat to change course than it is for a large ocean liner.

Another advantage of investing in small-cap stocks is the potential for discovering unknown value. The general rule of the investment world is that the majority of Wall Street research is aimed at a fraction of publicly traded companies, and most of these companies are large caps. Small-cap companies fly more under the radar and, therefore, hold greater potential for those seeking undervalued stocks.

Lack of market liquidity can sometimes be of benefit to small-cap investors who already own shares. If large numbers suddenly seek to buy a less-liquid stock, it can drive up the price faster and further than it would for a more liquid stock. Good portfolio management includes mixing in a moderate proportion of well-chosen small-cap stocks with less volatile large-cap stocks. It is precisely because there are different levels of risk between large- and small-cap stocks that market capitalization of the equities is a key consideration in achieving proper diversification in an investment portfolio.

large Cap stocks or companies are the first class in market capitalization. As the name itself suggests, these companies are having large market capital, these are stocks of reputed companies that have been around for decades. The market capitalization of such companies is very high – above Rs20,000cr.

Large-cap companies have a strong market presence and their stocks are generally considered to be very safe and less volatile (low risk). Most of these listed companies regularly disclose information through exchange filing or media, such as newspapers, television or company’s website. In other words, information on large-cap companies is very easily available for investors, clients or customers.

In India, examples of large-cap companies include Reliance, Tata Steel, and Hindalco, among others. Nifty 50, BSE 100, SENSEX 30 indices comprise of large-cap companies. Generally, market indices which are designed comprise of large-cap companies for example – Nifty 50, SENSEX etc.

For investors who want to invest in an index or a large number of companies into a large market cap, can choose mutual funds or large-cap funds. Depending on the size of the companies, some mutual funds schemes are categorized as a large-cap fund, mid-cap fund, small-cap funds. As their name suggests, large-cap funds comprise large-cap companies. Mid-cap funds & small cap funds comprise mid-cap companies and small-cap companies respectively.

Risks of Investing in Bonds

All investments offer a balance between risk and potential return. The risk is the chance that you will lose some or all the money you invest. The return is the money you stand to make on the investment.

The balance between risk and return varies by the type of investment, the entity that issues it, the state of the economy and the cycle of the securities markets. As a general rule, to earn the higher returns, you have to take greater risk. Conversely, the least risky investments also have the lowest returns.

The bond market is no exception to this rule. Bonds in general are considered less risky than stocks for several reasons:

Bonds carry the promise of their issuer to return the face value of the security to the holder at maturity; stocks have no such promise from their issuer.

Most bonds pay investors a fixed rate of interest income that is also backed by a promise from the issuer. Stocks sometimes pay dividends, but their issuer has no obligation to make these payments to shareholders.

Historically the bond market has been less vulnerable to price swings or volatility than the stock market.

The average returns from bond investments have also been historically lower, if more stable, than average stock market returns.

Difference Between Large Cap vs Small Cap

Depending on their current market capitalization, stocks or companies are classified into three categories

• Large-cap company,
• Mid-cap company
• Small-cap company

A market capitalization of a company calculated by the current price per share multiplied by the total number of its outstanding shares in the market. It gives the investor with an estimated valuation of the company or it shows the size of the company. For example: Suppose a company has 20,000 outstanding shares in the market, and price per share is at Rs. 20.

Thus, its market capitalization can be calculated as outstanding shares * price per share.

20,000 * 20 = Rs. 4,00,000 (Market cap of the company)

What is large Cap stocks or company?

These stocks or companies are the first class in market capitalization. As the name itself suggests, these companies are having large market capital, these are stocks of reputed companies that have been around for decades. The market capitalization of such companies is very high – above Rs20,000cr.

Large-cap companies have a strong market presence and their stocks are generally considered to be very safe and less volatile (low risk). Most of these listed companies regularly disclose information through exchange filing or media, such as newspapers, television or company’s website. In other words, information on large-cap companies is very easily available for investors, clients or customers.

In India, examples of large-cap companies include Reliance, Tata Steel, and Hindalco, among others. Nifty 50, BSE 100, SENSEX 30 indices comprise of large-cap companies. Generally, market indices which are designed comprise of large-cap companies for example – Nifty 50, SENSEX etc.

For investors who want to invest in an index or a large number of companies into a large market cap, can choose mutual funds or large-cap funds. Depending on the size of the companies, some mutual funds schemes are categorized as a large-cap fund, mid-cap fund, small-cap funds. As their name suggests, large-cap funds comprise large-cap companies. Mid-cap funds & small cap funds comprise mid-cap companies and small-cap companies respectively.

What is small cap stocks or company?

Large cap stocks are having highest market capitalization whereas Small-cap stocks lie at the other end of the market capitalization spectrum with a low market cap. Most small-cap companies are either companies in the development stage or start-up enterprises. As the name suggests, small-cap companies have a small number of employees and low revenues and clients. Information on these companies isn’t easily available to investors, clients or customers.

As small cap companies are small in size, they have tremendous potential for growth. This gives an opportunity to investor multiply their money. But small cap companies are highly volatile and high risk. As growing business is not an easy task many hurdles are faced by small cap companies due to this, small cap stocks are considered to be a highly risky investment.

Generally, small cap stocks are having a market capitalization of fewer than 500 crores. Small cap companies have small cap index from where an investor can track the performance of the small-cap stocks.

For investors who want to invest in an index or a large number of companies into a small market cap, can choose mutual fundsdepending upon their growing appetite and risk profiling.

Four major risks small-cap companies have –

Liquidity risk – It means, when an investor wants to buy share it may not be available or when an investor wants to sell his stocks buyer might not be there.

Limited access to financial resources –Compared to large cap, small cap companies has limited options for capital raising and also these companies need to pay more premium for debt as a risk associated is high compared to large cap companies.

Lack of operational history and the potential for its unproven business model. It might happen the business model may not be scalable or cannot sustain for a longer time.

Limited availability of data for analysis.

Although small-cap stocks are considered riskier investments than large-cap stocks, there are enough small-cap stocks offering excellent growth potential and high potential returns on equity. Another major advantage offered by the small cap is growth potential if the business model gets successful. It is relatively easy to double sales from 10 million to 20 million, but it is tough to double the sale from 1 billion to 2 billion. So compared to large cap small cap companies has high growth potential.

Large Cap vs Small Cap Infographics

Below is the top 7 difference between Large Cap vs Small Cap:Large cap vs Small Cap Infographics

Key Differences Large Cap Stocks vs Small Cap Stocks

Both Large Cap vs Small Cap are popular choices in the market; let us discuss some of the major Difference Between Large Cap vs Small Cap:

Market size wise large cap companies are having more than 20,000 crores market capitalization whereas small-cap companies are having a market capitalization of fewer than 500 crores.

Large-cap companies are the well-established player having present in the market from decades whereas small-cap companies are newly established players or start-ups.

Large cap companies are considered to be safe and less volatile whereas small cap companies are considered to be risky and highly volatile.

As analyst tracks large cap companies, getting information on such companies is relatively easy.

ANSWER TO 2

Systematic Risk does not have a specific definition but is inherent risk existing in the stock market. These risks are applicable to all the sectors but can be controlled. If there is an announcement or event which impacts the entire stock market, a consistent reaction will flow in which is a systematic risk. For e.g. if Government Bonds are offering a yield of 5% in comparison to the stock market which offers a minimum return of 10%. Suddenly, the government announces an additional tax burden of 1% on stock market transactions, this will be a systematic risk impacting all the stocks and may make the Government bonds more attractive.

Unsystematic Risk is an industry or firm-specific threat in each kind of investment. It is also known as “Specific Risk”, “Diversifiable risk” or “Residual Risk”. These are risks which are existing but are unplanned and can occur at any point of causing widespread disruption. For e.g. if the staff of the airline industry goes on an indefinite strike, then this will cause risk to the shares of the airlines industry and fall in the prices of the stock impacting this industry.

Answer to 3

A zero-beta portfolio is a portfolio constructed to have zero systematic risk or, in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the risk-free rate. Such a portfolio would have zero correlation with market movements, given that its expected return equals the risk-free rate or a relatively low rate of return compared to higher-beta portfolios.

A beta coefficient is a measure of the volatility, or systematic risk, of an individual stock in comparison to the unsystematic risk of the entire market. Beta is used in the capital asset pricing model (CAPM), which calculates the expected return of an asset using beta and expected market returns. In statistical terms, beta represents the slope of the line through a regression of data points from an individual stock's returns against those of the market.

BETA for risk free is 0 and is used as reference for Risk Free Assets

BETA for the market portfolio is 1 and is used as reference for Market Porfolio

Answer to 4

The risk-return tradeoff states that the potential return rises with an increase in risk. Using this principle, individuals associate low levels of uncertainty with low potential returns, and high levels of uncertainty or risk with high potential returns. According to the risk-return tradeoff, invested money can render higher profits only if the investor will accept a higher possibility of losses.

The risk-return tradeoff is the trading principle that links high risk with high reward. The appropriate risk-return tradeoff depends on a variety of factors including an investor’s risk tolerance, the investor’s years to retirement and the potential to replace lost funds. Time also plays an essential role in determining a portfolio with the appropriate levels of risk and reward. For example, if an investor has the ability to invest in equities over the long term, that provides the investor with the potential to recover from the risks of bear markets and participate in bull markets, while if an investor can only invest in a short time frame, the same equities have a higher risk proposition.

Investors use the risk-return tradeoff as one of the essential components of each investment decision, as well as to assess their portfolios as a whole. At the portfolio level, the risk-return tradeoff can include assessments of the concentration or the diversity of holdings and whether the mix presents too much risk or a lower-than-desired potential for returns.

When an investor considers high-risk-high-return investments, the investor can apply the risk-return tradeoff to the vehicle on a singular basis as well as within the context of the portfolio as a whole. Examples of high-risk-high return investments include options, penny stocks and leveraged exchange-traded funds (ETFs). Generally speaking, a diversified portfolio reduces the risks presented by individual investment positions. For example, a penny stock position may have a high risk on a singular basis, but if it is the only position of its kind in a larger portfolio, the risk incurred by holding the stock is minimal.

That said, the risk-return tradeoff also exists at the portfolio level. For example, a portfolio composed of all equities presents both higher risk and higher potential returns. Within an all-equity portfolio, risk and reward can be increased by concentrating investments in specific sectors or by taking on single positions that represent a large percentage of holdings. For investors, assessing the cumulative risk-return tradeoff of all positions can provide insight on whether a portfolio assumes enough risk to achieve long-term return objectives or if the risk levels are too high with the existing mix of holdings.