Risk vs Return: The tradeoff

Posted by Mehul Kothari | Published on 13 Mar 2019
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Risk vs Return: The tradeoff

The risk return tradeoff is a principle of investment, which means that higher the risk in the portfolio, higher is the potential return possibility. However, high returns from a risk return trade off is not always guaranteed.

To clarify the risk and return trade off and understand what is risk return trade off with an example, any investment with high risk may have a chance of high return, say, equity stocks. So, if the risk in an investment is high, then the possibility of return is also high, around 20-25% annually and may not be limited to just 6-8%. It basically means that the investment return is volatile and may fluctuate depending on market movements. However, the average return of equity would typically be 12-15% annually.

On the other hand, if the risk in any particular investment is low, for instance in a fixed bank deposit, the chances of getting 20-25% annually may never happen. The returns will be more in the 6-8% bracket. However, it also means that the return can never become lower than 6%, especially negative. This is the trade off between risk and return.



Hence, you need to take greater risks if you need a higher return on your investments. The concept of risk return trade off in finance is a widely accepted fact, but the associated risks with the portfolio are often neglected.

Risk-return trade off in finance

As far as investing is concerned, each and every investment has an associated risk with it. When you are looking to choose an investment, you need to look into its risk too so that the overall risk of the portfolio is managed accordingly.

 

There are multiple risks associated with an investment product. Some of these include:

1. Inflation risk reduces the purchasing power of cash reduces over time.
2. There is credit risk because credit rating of bonds/papers, etc. determine the value of the product
Liquidity risk arises when selling an investment product at the right time can be a hassle.
3. There is tax risk as governments usually make taxation changes every year.
4. Concentration risk occurs when you buy too many of a particular investment product.
5. There is market risk because equity market is volatile.


Risk levels of asset classes



To sum up


You need to find the right blend of risk and return. This is quite an important task because the return needs to be in line with your long-term financial goal. However, it is equally important that you don’t ignore the risk factor. The investment option you choose should match your risk appetite.

 

Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.

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Where all can you invest?

Posted by Mehul Kothari | Published on 13 Mar 2019

“Make your money work so you don’t have to work all your life” – you probably hear this a lot. Everybody knows the importance of investing, but do you really know where all can you invest? Here are your investment options:   EquityAs one of the popular investment options, equity or stocks is the probably the first investment product you can think of. Issuing shares to the public is one way companies raise money to grow their business. Known to be one of the best investment options, you can either buy shares directly from a stock exchange or indirectly by investing in an equity mutual fund.Every share you buy gives you a tiny stake in the business. Share prices track company performance – they increase when the company does well and decrease when it performs poorly. Invest in companies that you expect to do well and you can profit by selling their shares in later.Who should invest in stocks?Stock prices are sensitive to market developments and don’t guarantee a minimum return or a periodic income. This makes them risky investments. They are an important investment product because they can jack up your portfolio returns. But only invest big sums if you are willing to take the extra risk.DebtBonds issued by companies and the government are called debt instruments. They are issued for a fixed term and generally pay a periodic interest, called coupon. Unlike shares, bonds do not give you an ownership stake in the issuer. Instead, they make the issuer liable to repay your money and the coupon, as per the promised schedule. This is why bonds are called debt instruments.Who should invest in bonds?Bond returns are more stable and predictable than stocks because bonds are issued for a fixed term and they pay a regular coupon. However, a fixed coupon means that bonds don’t have the growth potential of stocks. Invest in bonds if you are looking for average but stable returns, without taking much risk. Mutual FundsThese are pools of funds created by fund houses by raising money from investors like you. They are managed by professional fund managers and invested in shares, bonds, and other financial assets.A fund house floats several funds at a time and each of these has a well-defined mandate and objective. For example, a fund may have the mandate of investing only in stocks. Some funds have even narrower mandates, such as investing only in bank or IT stocks. Mutual funds also have specific maturities, payment schedules, and risk levels. This helps you pick a fund that best suits your requirements.Who should invest in mutual funds?Mutual funds are an excellent investment option if you are new to the market or can’t devote enough time to picking stocks. Since they are managed by investment professionals, they increase your chances of earning good returns.Real EstateProperty is the most favored asset for Indians. Owning land or an additional house gives more satisfaction than other assets because these are tangible. You can quickly sell the property or use it yourself in adversity. In addition, it generates stable and predictable income when you put it on rent. Who should invest in real estate?Real estate investments are ideal for those who are looking for stable, passive returns over the long term. It is also a great option if your investment objective is to secure your children’s future. The only catch is that investing in a house is not as easy as buying a stock. You’ll have to spend much more to buy a house than to buy a stock or a bond. You may even have to take a loan. Alternative AssetsETFs, derivatives, commodities, structured products, private equity, and hedge funds are some of the other products you can invest in. These are jointly called alternative assets. They are built on top of assets we discussed earlier and can, therefore, be complex to understand and invest in. Some of these also have a high minimum investment threshold. For these reasons, you need to be careful while investing in these. However, you can generate big returns by investing in these. We will discuss each of these in the detail in later chapters.Who should invest in alternative assets?Alternative assets are a good option if you are looking to diversify your portfolio. Retail investors actively invest in ETFs, commodities, and derivates. Structured products, private equity, and hedge funds are high-risk investments that are popular only among high net worth individuals. You can consider them if you are looking to invest some idle cash and don’t mind losing it if things don’t work out. ConclusionThere are so many good investment options including short term investment options and long term investment options that you probably have a favorite by now. But investing is not only about picking the asset you like the most. To make investing work, you need a well-defined strategy. Build a portfolio that has several assets, in a proportion that is attuned to your unique circumstances and investment objectives.      Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.

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Risk is not just about loss

Posted by Mehul Kothari | Published on 13 Mar 2019

People usually associate risk with stock markets and losses. But risk is a far deeper concept than just loss. It is a challenge to understand and managing the risks associated with investing.Risk AssessmentTo understand your risk appetite, it is important to conduct risk assessment which means to first assess your needs and financial goals. Then, you can assess the various types of associated risks. To understand what is risk assesment, let’s consider an example - you need to withdraw money from the investments you have made during an emergency. But your money is locked in. This is when you run the risk of lacking liquidity. Although there is no technical loss of money, it is still a disadvantage you stand to face at important times. This can thus be considered a risk too.Thus, to maximize your investments, understand the various types of associated risks and create a risk management plan.Type of risks in investing: Before understanding other types of risks, look at what market risk refers to: • Equity risk: This is the most obvious form of risk wherein the equity investment rises and falls. But remember, equity risk is only one of many types of risks associated with investments.• Interest rate risk: This occurs due to changing interest rates. • Currency Risk: This applies to foreign investment. Here, the value of an investment changes due to changes in the value of the currency.There are other risks too that you may not know of. But all these risks are equally important. They impact the overall risk associated with the portfolio.• Reinvestment risk: This occurs when the investor has to reinvest his investments. For example, take your bank fixed deposits, which mature from time to time. You must reinvest these upon maturity. But at the time of reinvesting the amount, the interest rate might not remain the same. This is the Reinvestment Risk. Investors must consider this when opting for renewal of investments.• Credit risk: This can arise when you invest in securities or bonds. For instance, bonds with a credit rating of AAA are lesser risky than AA ones. Even though AA bonds might have a better yield, the inherent credit risk is a consideration.• Tax risk: This refers to the risk of unnecessarily paying a higher tax. Tax riskoccurs when you ignore the tax-saving provisions laid down by the Income Tax Act. So, when opting for investments, do consider the tax efficiency of the product. This will reduce your tax risk, especially at the time of maturity.• Inflation risk: The returns on your investment may be lower than the inflation rate. This is the inflation risk. So, while planning for investments, think of the future. Think of the purchasing power of money and how it changes.• Concentration risk: This risk comes when there is a lack of portfolio diversification. You can curtail this risk with a diverse portfolio. That is, your investments must include different asset classes, horizons, and products, etc.Conclusion: People’s horizon of investment defines their risk-taking capacity. Also, risk is associated with high returns. If losses are on one side of a coin, so are the returns. Hence, the risk-return trade-off is of extreme importance and so is the need to understand types of risk management for better investing. Avoiding risk can be equally risky. For example, an investor may avoid equity to reduce his/her market risk. But this increases the risk of not beating inflation or having a concentrated portfolio.So, weigh the various risks to reduce your over portfolio’s risk and employ risk management strategies in your portfolio. If you need support, turn to IndiaNivesh which specialises in this.What next?We spoke about how avoiding market risk can affect your ability to beat inflation. This is because risk has a close relation with your returns. Let’s look at the risk-return trade off next.   Disclaimer: Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.

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  • Real Estate Investment in India
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