Understanding Risk & Return in Equity Securities | CFA Level I Equity Investments

In this chapter, we’ll dive into the risk and return characteristics of different types of equity securities. Buckle up, and let’s get started!

Breaking Down Equity Returns

First things first, let’s look at the main sources of equity returns:

• Capital gains: the difference between the selling price and purchase price.
• Dividends: payments received during the investment period.

The total return is the sum of capital gains and all dividends received, divided by the purchase price.

EXAMPLE: A share bought at €100, sold at €120, with €12 in dividends during the period would result in a total return of 32%.

Companies in different stages of their life cycle exhibit different return patterns:

• Growth stocks: Early-stage companies often pay little or no dividends, as earnings are reinvested for growth. Investors expect higher capital gains.
• Value stocks: Mature companies tend to pay higher dividends, as they have fewer growth opportunities. Investors may not expect significant stock price growth.

For investments in foreign shares or depository receipts, foreign exchange gains can be a third source of return.

Don’t forget about gains from reinvested dividends! Over time, this component can become significant for total returns.

Assessing Risk in Equity Securities

Risk is defined as the uncertainty of future total returns. It’s often measured by calculating the standard deviation of expected total returns. There are two common methods:

• Using historical return data as a proxy.
• Estimating a range of future returns, assigning probabilities, and calculating expected return and standard deviation.

Different types of equity securities have varying risk levels. In general, preference shares are less risky than common shares. Here’s why:

• Dividends are fixed and known.
• Preference shareholders receive dividends before common shareholders.
• In case of liquidation, preference shareholders have a fixed par value claim.

Within preference shares, cumulative shares are less risky than non-cumulative shares due to the right to receive missed dividends before common stock dividends.

For common shares, a significant portion of total return depends on future price appreciation and dividends. The liquidation value is also highly uncertain due to the shares’ lowest priority.

Among shares with embedded options:

• Putable shares are the least risky, as they can be sold back to the company at a fixed price if the market price drops.
• Callable shares are the riskiest, as the company can call them back if the market price rises, limiting the upside potential.