Risk and Return of Equity Securities

The type of security and its features affect its risk/return profile. Therefore, as an investor’s risk increases, its expected return should also increase to compensate.

Equity Return Characteristics

There are two main sources of total return for equity securities – capital appreciation and dividend income:

$$ \text{Total Return} = \frac{P_1 – P_0 + D}{P_0} $$

Where:

P₁ = Sale price (or price at t = 1).

P₀ = Purchase price (or price at t = 0).

D = Dividend income paid to the investor between t = 0 and t = 1.

Exam tip: Most of the return calculations in finance follow the same logic:

$$ \text{Return (%)} = \frac{ \text{Ending price} – \text{Beginning price} + \text{Dividend income}}{ \text{Beginning price}} $$

The Reinvestment of Dividends

Historically, the reinvestment of dividend income has been an extremely important source of compound growth. Of course, the total return of non-dividend-paying stocks is entirely based upon capital appreciation.

Direct investments in foreign securities or depository receipts have an additional source of return: foreign exchange gains (or losses) arising from changes in exchange rates.

Equity Risk Characteristics

Typically, investors anticipate lower risks and returns from preference shares in comparison to common shares. This is because preference share dividends are fixed, and these shareholders have priority in receiving dividends and known (though not guaranteed) liquidation proceeds.

Preference shareholders usually rely more on dividend income for their total return, whereas common shareholders typically expect their return to come more from capital appreciation.

Callable common or preference shares are riskier than their non-callable counterparts, while putable common or preference shares are less risky than their non-putable counterparts.

Question

A US investor makes a direct investment in a foreign equity security with a current dividend yield of 2.5%. If the investor holds the stock for ten years, how many components are likely to make up the investor’s total return?

1. One.
2. Two.
3. Three.

Solution

The correct answer is C.

The investor should earn a total return made up of capital appreciation, dividend income, and foreign exchange (gains or losses).