Understanding investment risks and returns
Every investment avenue must be selected only after a careful evaluation of the potential returns and the associated risks. In order to evaluate both, it is important to understand them.
What is the risk of investing?
As a general concept, the risk of any investment refers to the uncertainty associated with the expected returns. If the expected returns are guaranteed, there is no risk. For example, when an Indian investor invests in securities issued by the Government of India and holds the same till maturity, one is assured of getting the promised returns. This investment is considered to be risk-free.
One may look at the risk from another angle. People invest their money to achieve financial goals. The risk they face is not having enough money at the required time, i.e., the time of the goal.
There are various factors affecting this risk. Primary among these are:
•Volatility of returns due to price fluctuation:
Prices of various securities fluctuate in the markets based on the opinions and actions of various buyers and sellers. The prices also fluctuate due to changes in the company, industry, or economy.
When a short-term investor buys and sells securities, the price fluctuation can either result in a profit or a loss if the investor is able to make the right call. Or sometimes the same trade can result in a large loss if the investor’s judgement about price movement goes wrong.
For a long-term investor, the risk is reduced to some extent.
The assets that exhibit higher volatility in the short term often have the potential to deliver high returns. At the same time, assets that are less volatile or not volatile at all offer poor returns.
Volatility can be divided into two categories: security-specific and market-wide. The former can be reduced through diversification, whereas the latter cannot.
This risk refers to a borrower’s inability to repay the borrowed amount as per the agreed schedule.
This should include both a total default as well as a delay in any payment.
The measure of credit risk is the credit rating, and the compensation for taking credit risk comes from a higher expected return, often referred to as the credit spread.
•Risk of illiquidity
The inability of an investor to sell the investments and convert them into cash could be due to various factors, primary among which is the inherent illiquidity associated with the investment.
There are some assets and markets that have an inherent risk of illiquidity, while in certain cases, there are operational reasons. For example, the real estate market is inherently less liquid in that selling a property takes time, and there are phases in the market when the time taken could be years. At the same time, some mutual fund schemes may be highly liquid but may have a lock-in period for a certain duration.
Prices of items of consumption keep moving up over the years; this phenomenon is known as inflation, also called price inflation. Rising prices also mean a reduction in the purchasing power of the rupee. (Read the article Understanding Inflation.) It impacts the well-being of a person when the investment returns are lower than inflation.
Assets that do not take any of the above-mentioned risks often deliver lower returns than inflation, whereas in order to beat inflation, one must take at least one of the three risks, viz., price volatility, credit risk, or illiquidity.