Risk and Return: Two Sides of the Same Coin

Dhiraj had a chance encounter with his friend, Ashok, after a couple of years at a restaurant. Bumping into his friend after so many years gave him an excuse to reminisce old memories and gossip about their teen days. After some time, the conversation obviously changed its track to serious businesses such as future plans, real estate prices, investing, etc.

“You see, I’m from IT sector. I understand nothing about investing. Can you just give me some insights on basics of investing, I see so many of my colleagues taking a keen interest in investing these days.,and I simply feel like a fish out of water. I heard that you’re an Investment guru! Please help this bhakt of yours!”

“Hmn you should first understand that every investment entails risks, though, of course, the primary objective of any investor is returns. Let me get you acquainted with some basics of risks and return.”

Readers, similar to Dhiraj, if you’re keen on understanding investing, below is a simple explanation of risks and returns.

The basic rule of economics is: profit is the reward for risk-bearing. Similarly, when an investor invests, his intention is to get a return out of the investment and his main objective is to maximize these returns which are prone to various constraints, especially risk. Return is the reward for the investment decision taken and it also motivates and inspires the investors. With returns, an investor can compare various investment alternatives available to him. Also, it helps to keep a track of their investment performance and estimation of future returns.

Thus, as an advisor to the different investors, who have their own set of financial objectives and investment banking ratios, you have to consider, before planning their portfolio.

There are two types of returns namely ‘Historical or Realized Return’ and ‘Expected Return’.

Historical Return

An amount of Rs.10, 000 deposited in a bank with an annual interest rate of 8% will be worth Rs.10, 800 after one year. In this case, 8% would be the historical or realized rate of return.

Expected Return

Expected Return is the return anticipated by the investor to be earned in some future period. These expected returns are exposed to uncertainty and may or may not occur. Hence, an investor expects a return known as Expected Return that is sufficiently high to offset the risk or uncertainty.

Types of Risk of Stocks in a portfolio:

1. Diversifiable or Unsystematic Risk

Diversifiable or Unsystematic Risk is the risk that is specific to the company or the industry and can be eliminated by means of diversification. Eg: Strike or Lockout, raw material shortage etc.

2. Non-Diversifiable or Systematic Risk

Non-Diversifiable or Systematic Risk is the risk that is due to the stock market or general economy and hence cannot be eliminated. Eg: Interest Rate Risk, Inflation etc.
It is generally measured by Beta (β) coefficient. Beta measures the relative risk associated with an individual portfolio as measured in contrast to the risk of the market portfolio.
Systematic Risk of asset
Β = ———————————
Risk of market Portfolio
.
Β > 1, then the stock has above-average risk i.e. more risky than a market portfolio
Β = 1, then the stock has an average risk
Β < 1, then the stock has below average risk i.e. less risky than the market portfolio
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