IMPLICATIONS FOR CORPORATE MANAGERS AND INVESTORS

The connection between risk and return is an important concept, and it has numerous implications for both corporate managers and investors. As we will see in later chapters, corporate managers spend a great deal of time assessing the risk and returns on individual projects. Indeed, given their concerns about the risk of individual projects, it might be fair to ask why we spend so much time discussing the riskiness of stocks. Why not begin by looking at the riskiness of such business assets as plant and equipment? The reason is that for a management whose primary goal is stock price maximization, the overriding consideration is the riskiness of the firm’s stock, and the relevant risk of any physical asset must be measured in terms of its effect on the stock’s risk as seen by investors. For example, suppose Goodyear, the tire company, is considering a major investment in a new product, recapped tires. Sales of recaps, hence earnings on the new operation, are highly
uncertain, so on a stand-alone basis the new venture appears to be quite risky. However, suppose returns in the recap business are negatively correlated with Goodyear’s other operations—when times are good and people have plenty of money, they buy new cars with new tires, but when times are bad, they tend to keep their old cars and buy recaps for them. Therefore, returns would be high on regular operations and low on the recap division during good times, but the opposite would be true during recessions. The result might be a pattern like that shown earlier in Figure 8-5 for Stocks W and M. Thus, what appears to be a risky investment when viewed on a stand-alone basis might not be very risky when viewed within the context of the company as a whole.

This analysis can be extended to the corporation’s stockholders. Because Goodyear’s stock is owned by diversified stockholders, the real issue each time management makes an investment decision is this: How will this investment affect the risk of our stockholders? Again, the stand-alone risk of an individual project may look quite high, but viewed in the context of the project’s effect on stockholder risk, it may not be very large. We will address this issue again in Chapter 12, where we examine the effects of capital budgeting on companies’ beta coefficients and thus on stockholders’ risks. While these concepts are obviously important for individual investors, they are also important for corporate managers. We summarize below some key ideas that all investors should consider.

1. There is a trade-off between risk and return. The average investor likes higher returns but dislikes risk. It follows that higher-risk investments need to offer investors higher expected returns. Put another way—if you are seeking higher returns, you must be willing to assume higher risks.

2. Diversification is crucial. By diversifying wisely, investors can dramatically reduce risk without reducing their expected returns. Don’t put all of your money in one or two stocks, or one or two industries. A huge mistake many people make is to invest a high percentage of their funds in their employer’s stock. If the company goes bankrupt, they not only lose their job but also their invested capital. While no stock is completely riskless, you can smooth out the bumps by holding a well-diversified portfolio.

3. Real returns are what matters. All investors should understand the difference between nominal and real returns. When assessing performance, the real return (what you have left over after inflation) is what really matters. It follows that as expected inflation increases, investors need to receive higher nominal returns.

4. The risk of an investment often depends on how long you plan to hold the investment. Common stocks, for example, can be extremely risky for short- term investors. However, over the long haul the bumps tend to even out, and thus, stocks are less risky when held as part of a long-term portfolio. Indeed, in his best-selling book Stocks for the Long Run, Jeremy Siegel of the University of Pennsylvania concludes that “The safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds.”

5. While the past gives us insights into the risk and returns on various investments, there is no guarantee that the future will repeat the past. Stocks that have performed well in recent years might tumble, while stocks that have struggled may rebound. The same thing can hold true for the stock market as a whole. Even Jeremy Siegel, who has preached that stocks have historically been good long-term investments, has also argued that there is no assurance that returns in the future will be as strong as they have been in the past. More importantly, when purchasing a stock you always need to ask, “Is this stock fairly valued, or is it currently priced too high?” We discuss this issue more completely in the next chapter.

  • Explain the following statement: “The stand-alone risk of an individual corporate project may be quite high, but viewed in the context of its effect on stockholders’ risk, the project’s true risk may not be very large.”
  • How does the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk?
  • What are some important concepts for individual investors to consider when evaluating the risk and returns of various investments?