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Investment - Risks of Investing in Equity Securities
There are two primary hazards inherent with equities investing:
Specific risk, also referred to as unsystematic risk
Market risk, commonly referred to as systematic risk
Specific risk (unsystematic risk) refers to the risk that a specific firm may have bad performance owing to a number of variables (e.g., increasing competition, operational issues, higher regulatory supervision), resulting in its equity shares falling in value.
In the case of preferred shares, the risk of loss is missing dividend payments that may not be made by the corporation. In the case of common stock, the risk of loss is high because common shareholders are the last in line to receive cash flows after creditors (which are described in the following module) and preferred shareholders.
The second important risk inherent in equities investing is general market risk, or systematic risk. Market risk is the risk of loss from stock shares dropping in value due to reasons external to the company, such as adverse changes in macroeconomic conditions (e.g., recessionary periods or high inflationary periods).
Investors can generally eliminate company-specific risk by diversification – holding portfolios of diverse stocks whose stock price movements display minimal (or negative) correlation.
Of course, certain equities are perceived riskier than others, as reflected in their larger stock price volatility. In financial markets, a stock’s amount of systematic risk is assessed by beta. Beta is a measure of the stock price volatility of a particular stock relative to the price volatility of the market as a whole.
Beta of 1.0 implies that the stock’s price tends to move in accordance with the general market. Stocks with betas larger than 1.0 are judged riskier (and those with less than 1.0 are deemed safer) than the average stock in the market — that is, in terms of their price volatility compared to the market’s volatility.
1.0 Stock’s price moves in accordance with the entire market; considered an average-risk equity security. >1.0 Stock’s price fluctuations are more volatile than the general market; considered an above average-risk equity security. <1.0 Stock’s price movements are less volatile than the overall market; considered a below average-risk equity security.
Return Expectations Models
To construct their return expectations, equity investors, particularly prospective buyers of preferred shares, will typically analyze a company’s dividend yield. A preferred or common stock’s dividend yield is the estimated annual dividend to be paid over the following year divided by the price. A stock’s dividend yield provides potential owners with an estimate of the annualised return from dividend income solely, without consideration for the effect of any capital gain or loss resulting from changes in the stock’s price over time.
Another approach used by equity investors to determine a stock’s expected annualised return is based on the capital asset pricing model (CAPM), which asserts that a stock’s expected return equals the sum of the risk-free interest rate plus the product of the stock’s beta and the equity risk premium (ERP):
CAPM: E(ri) = rf + βi(ERP)
The equity (market) risk premium is the extra annual return that an equity investor anticipates to earn above a risk-free asset on an average-risk equities investment. It is generally evaluated using historical data on the difference in average returns between a broad equity index and the risk-free asset.
So, if a particular stock is considered riskier than the average stock as measured by beta, it will have a beta greater than 1.0 and investors should expect to earn a higher risk premium compared to the risk-free asset (and if safer, it will have a beta of less than 1.0 and earn a lower risk premium).
For example, say that the current risk-free rate is 2.0% and the market risk premium has been calculated to be 6.0%.
Consider two stocks, one with a beta of 0.75 and another with a beta of 1.50.
An investor employing the CAPM to predict expected returns for the two equities would estimate them to be 6.5% (= 2% + 0.75 x 6%) and 11% (= 2% + 1.50 x 6%), respectively.
In conclusion, the risk–return profile of owning preferred shares is very different from the profile of owning common shares.
Owners of preferred shares know in advance the expected return they will receive each year from income because the annual dividend amount is explicitly known. Although it is certainly possible that the dividend may not be paid during years of poor company performance and missed dividends may not ever be received in the case of non-cumulative preferred stock, it is also the case that the annual dividend payment does not increase during years of good company performance.
Consequently, the prices of preferred shares do not display as much volatility as common share prices because the predicted dividend amount does not vary with corporate performance. Some investors are attracted to this set return and the generally low-volatility investment profile of preferred shares.
In contrast, common stockholders are not assured any set dividend amount each year. In periods of good company performance, the common share price is likely to climb due to increasing earnings and dividends, and vice versa for poor company performance. Relative to preferred shares, the upside price potential for common stockholders can be much higher, but the downside price potential can also be significantly lower. Some investors are attracted to the significant upside potential given by common shares, even with the increased possibility for loss.
There are two primary hazards inherent with equities investing:
Specific risk, also referred to as unsystematic risk
Market risk, commonly referred to as systematic risk
Specific risk (unsystematic risk) refers to the risk that a specific firm may have bad performance owing to a number of variables (e.g., increasing competition, operational issues, higher regulatory supervision), resulting in its equity shares falling in value.
In the case of preferred shares, the risk of loss is missing dividend payments that may not be made by the corporation. In the case of common stock, the risk of loss is high because common shareholders are the last in line to receive cash flows after creditors (which are described in the following module) and preferred shareholders.
The second important risk inherent in equities investing is general market risk, or systematic risk. Market risk is the risk of loss from stock shares dropping in value due to reasons external to the company, such as adverse changes in macroeconomic conditions (e.g., recessionary periods or high inflationary periods).
Investors can generally eliminate company-specific risk by diversification – holding portfolios of diverse stocks whose stock price movements display minimal (or negative) correlation.
Of course, certain equities are perceived riskier than others, as reflected in their larger stock price volatility. In financial markets, a stock’s amount of systematic risk is assessed by beta. Beta is a measure of the stock price volatility of a particular stock relative to the price volatility of the market as a whole.
Beta of 1.0 implies that the stock’s price tends to move in accordance with the general market. Stocks with betas larger than 1.0 are judged riskier (and those with less than 1.0 are deemed safer) than the average stock in the market — that is, in terms of their price volatility compared to the market’s volatility.
1.0 Stock’s price moves in accordance with the entire market; considered an average-risk equity security. >1.0 Stock’s price fluctuations are more volatile than the general market; considered an above average-risk equity security. <1.0 Stock’s price movements are less volatile than the overall market; considered a below average-risk equity security.
Return Expectations Models
To construct their return expectations, equity investors, particularly prospective buyers of preferred shares, will typically analyze a company’s dividend yield. A preferred or common stock’s dividend yield is the estimated annual dividend to be paid over the following year divided by the price. A stock’s dividend yield provides potential owners with an estimate of the annualised return from dividend income solely, without consideration for the effect of any capital gain or loss resulting from changes in the stock’s price over time.
Another approach used by equity investors to determine a stock’s expected annualised return is based on the capital asset pricing model (CAPM), which asserts that a stock’s expected return equals the sum of the risk-free interest rate plus the product of the stock’s beta and the equity risk premium (ERP):
CAPM: E(ri) = rf + βi(ERP)
The equity (market) risk premium is the extra annual return that an equity investor anticipates to earn above a risk-free asset on an average-risk equities investment. It is generally evaluated using historical data on the difference in average returns between a broad equity index and the risk-free asset.
So, if a particular stock is considered riskier than the average stock as measured by beta, it will have a beta greater than 1.0 and investors should expect to earn a higher risk premium compared to the risk-free asset (and if safer, it will have a beta of less than 1.0 and earn a lower risk premium).
For example, say that the current risk-free rate is 2.0% and the market risk premium has been calculated to be 6.0%.
Consider two stocks, one with a beta of 0.75 and another with a beta of 1.50.
An investor employing the CAPM to predict expected returns for the two equities would estimate them to be 6.5% (= 2% + 0.75 x 6%) and 11% (= 2% + 1.50 x 6%), respectively.
In conclusion, the risk–return profile of owning preferred shares is very different from the profile of owning common shares.
Owners of preferred shares know in advance the expected return they will receive each year from income because the annual dividend amount is explicitly known. Although it is certainly possible that the dividend may not be paid during years of poor company performance and missed dividends may not ever be received in the case of non-cumulative preferred stock, it is also the case that the annual dividend payment does not increase during years of good company performance.
Consequently, the prices of preferred shares do not display as much volatility as common share prices because the predicted dividend amount does not vary with corporate performance. Some investors are attracted to this set return and the generally low-volatility investment profile of preferred shares.
In contrast, common stockholders are not assured any set dividend amount each year. In periods of good company performance, the common share price is likely to climb due to increasing earnings and dividends, and vice versa for poor company performance. Relative to preferred shares, the upside price potential for common stockholders can be much higher, but the downside price potential can also be significantly lower. Some investors are attracted to the significant upside potential given by common shares, even with the increased possibility for loss.
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