Topic: Understanding Risk and Return Dynamics in Equities: Navigating the Complexities of the Stock Market

Risk tolerance governs investment behavior and determines the magnitude of individuals’ investments in various asset classes.

Asset classes are categories of securities that share common characteristics. They include equities (stocks), fixed income (bonds), cash equivalents (money market funds, commercial papers, treasury bills), and alternative investments (investments in real estate, commodities, cryptocurrencies). Equity refers to an ownership stake in a company. Although this asset class can yield great returns in the long run and may have higher returns than investments in other asset classes, it also comes with greater risks.

Investors can trade equities through the stock market. By dealing in equities, they invest in companies that are listed on the stock exchange, giving them a chance to share in the firm’s growth and subsequent profits while providing the company with access to investors’ capital. An understanding of the workings of the stock market is essential for anyone interested in equity investing.

This article explores the basic concepts of equity investing including risk and return, types of risk, and the strategies for managing them. By understanding how equities work and how to navigate risk, investors can make informed decisions and build a diversified portfolio that meets their financial goals.

Understanding the Stock Market

The stock market is a form of the capital market whose primary function is to facilitate the buying and selling of equity securities. The market facilitates price discovery and operates on the principles of supply and demand, where buyers and sellers interact to trade shares of companies.

The capital market operates through two main channels: primary and secondary markets. In the primary market, entities such as governments and companies issue securities to raise capital, while in the secondary market, investors buy and sell these securities. The prices of shares fluctuate based on various factors, including company performance, economic conditions, and investor sentiments.

The Nigerian Exchange (NGX) is the primary platform for trading equities in Nigeria. Key players include companies, investors, regulators, and market intermediaries. Companies issue equity securities to raise long-term funds, while investors seek to generate returns through dividends, capital appreciation, or both. Regulators ensure fair markets and protect investors, and market intermediaries facilitate transactions.

Stock market indices, such as the NGX All-Share Index, NGX 30 Index, NGX Banking Index in Nigeria, the S&P 500 (US), FTSE 100 (UK), and Nikkei 225 (Japan), generally serve as benchmarks for tracking the performance of specific sectors or the overall national stock markets. These indices represent a basket of securities and provide a snapshot of market performance, allowing investors to gauge their portfolio’s performance relative to the market.

Understanding Risk in Equities

Investing in the stock market involves some risk that must be fully understood in order to be effectively managed. The various types of risk include:

1. Market Risk (Systematic Risk): The risk of overall market declines due to economic downturns, geopolitical events, or other macroeconomic factors, impacting investment values.

2. Company-Specific Risk (Unsystematic Risk): The risk of individual companies facing financial difficulties or challenges, affecting their stock prices.

3. Liquidity Risk: The risk of investors being unable to quickly sell shares without significantly impacting the market price. This risk can become more pronounced for investors with significant shareholdings.

Additional types of risk include regulatory risk, economic risk and geopolitical risk.

To manage risk, investors can:

• Diversify investments across various asset classes and sectors.
• Conduct thorough research on companies and their prospects.
• Regularly review and adjust their portfolios.

Understanding Return in Equities

Return on Investment (ROI) is a crucial aspect of stock market investing, representing the profit or gain generated by an investment, typically expressed as a percentage. In equities, there are two primary sources of return:

1. Dividend Return: The profit generated by dividend payments made by companies to their shareholders.

2. Capital Appreciation: The profit generated by the increase in a company’s stock price over time.

The combination of dividend return and capital appreciation represents the overall return on investment.

It is important to note that there is a secondary source of equity return which is associated with the compounding effects of reinvested dividends. Dividend reinvestment by shareholders has the potential to exponentially increase the overall return from equity securities.

To evaluate and compare investment performance, investors use return metrics such as:

Earnings Per Share (EPS): Computed as a ratio of a company’s earnings represented by profits after tax divided by its number of outstanding shares, EPS provides a powerful indication of the dividend-paying capacity of the company.

Dividend Yield: A financial ratio that measures a company’s annual dividend payment as a percentage of its current share price, the dividend yield offers an indication of the return an investor would earn from an equity investment based wholly on its dividend payments. As dividends are paid out of earnings, companies that generate consistent and stable profits are more likely to pay regular dividends barring other important considerations such as reinvestment opportunities.

Earnings Yield: This is measured as a ratio of a company’s earnings represented by profits after tax divided by its current market price. The earnings yield, which is the inverse of the popular price-to-earning (P/E) ratio, is an important return metric used by investors to gauge the relative valuation of a stock. A lower earnings yield may indicate that the stock is overvalued and vice versa.

When evaluating potential returns, investors should consider historical returns, industry and market trends and company fundamentals. Additionally, factors such as inflation and interest rates can impact an investor’s total return over time.

Risk-Return Trade off

The risk-return trade off is a fundamental concept in investing, where investments with higher potential returns typically come with higher levels of risk. There is always an inverse relationship between risk and return. This tradeoff is often depicted on a graph, with risk on the horizontal axis, and return on the vertical axis of the graph.

Investments with low risk, such as bonds, typically offer lower returns, while investments with higher risk, such as stocks, offer potentially higher returns but also come with a greater chance of losses. Diversification is an important strategy for managing the risk-return trade off, as it allows investors to reduce risk while optimising potential returns.

For example, investing in a high-growth company may offer higher potential returns, but also comes with higher volatility and risk. In contrast, investing in an established and mature company may offer lower potential returns, but with lower risk and volatility.

Consider the case of Jide and Jola, two investors with different approaches. Jide invests in a diversified portfolio of value and growth stocks with a moderate risk profile, earning an 8% annual return. Jola, on the other hand, invests heavily in a single high-growth stock, earning a 12% annual return but with more volatility.

When making decisions about risk and return, investors should also consider their investment horizon, risk tolerance and financial goals. A longer investment horizon may allow for more aggressive investments, while a shorter horizon may require more conservative choices.

Investment Strategies

Popular investment strategies include active and passive investing, value, growth, and dividend investing, as well as index investing and exchange-traded funds (ETFs).

Active vs. Passive Investing

Active investing involves a hands-on approach, where investors or fund managers actively select securities to buy and sell. This approach requires significant research, analysis, and market expertise. Active investors aim to beat the market’s average returns; however, this approach comes with higher fees and increased risk.

Passive investing, on the other hand, takes a more hands-off approach. Investors invest in a fund or ETF that tracks a specific market index, such as the NGX All-Share Index. Passive investing offers broad diversification, lower fees, and reduced risk.

Value Investing

Value investors focus on identifying undervalued companies with strong fundamentals. They search for stocks trading at a discount to their intrinsic value, offering potential for long-term growth. This approach demands patience, discipline, and a thorough understanding of a company financials, industry analysis and market dynamics.

Growth Investing

Growth investors target companies with high growth potential, seeking stocks with increasing earnings, rising revenue, and expanding market share. This approach involves higher risk, as investors are betting on future growth rather than current value. Growth investors are willing to take on this risk in pursuit of potentially higher returns.

Dividend Investing

Dividend investors focus on generating regular income from their investments, seeking stocks with a proven track record of consistent dividend payments and growth. This approach offers relatively lower risk compared to other investment strategies and can provide a steady income stream, making it an attractive option for income-seeking investors.

Index Investing and ETFs

Index investing in Nigeria involves tracking a specific market index, such as the Nigerian Exchange (NGX) All-Share Index or the MSCI Nigeria Index. Investors can access index investing through Exchange-Traded Funds (ETFs) listed on the NGX. These ETFs offer flexibility, diversification, and low fees, allowing investors to replicate the performance of the underlying index. ETFs are traded on the NGX like individual stocks, enabling investors to buy and sell throughout the day.

By recognizing the types of risk associated with each strategy, assessing potential returns, and optimizing their portfolios, investors can make informed decisions to achieve their long-term financial goals.

At Coronation Securities, we employ a research-driven investment philosophy and risk management strategy to balance risk and returns effectively. Our approach focuses on thorough research and strategic diversification to enhance returns while managing risk, integrating a deep understanding of market trends and economic conditions. Our risk management framework also adopts global standard methodologies to ensure efficiency and effectiveness.

For personalised advice and comprehensive management of your equity investments, investors can leverage Coronation Securities’ expertise and deep financial market knowledge to achieve their investment goals. Our digital investment platforms support investors in making effective investment decisions. These platforms include the Coronation Investment Academy, which provides self-paced financial knowledge, and the Coronation Wealth App, which allows for easy access to stock purchases.