Understanding Risk and Return in Investments

In the world of investments, risk and return share an intrinsic relationship: higher potential returns typically come with higher risks, while safer investments generally offer lower returns. This trade-off forms the cornerstone of investment strategy, requiring investors to carefully balance their desire for growth with their tolerance for uncertainty. And time in the market plays a significant role, too.

Let’s break it down.

What are Risk and Return in Investments?

In the context of investing, risk refers to the possibility that actual returns may differ from expected outcomes, potentially resulting in financial losses. It’s essentially the uncertainty about an investment’s outcome.

On the other hand, return refers to the profit or gain you earn from an investment when things go well. Any growth above your initial investment is considered a return. For example, if you invest Rs. 1,000 and it grows to Rs. 1,100, the extra Rs. 100 is your return (10% gain).

Importantly, risk and return tend to be directly related. Based on historical data, investments that offer higher potential returns usually come with higher risk, meaning a greater chance of losses, while safer (lower-risk) investments typically give lower returns. This is known as the risk-return trade-off.

But risk doesn’t guarantee loss; it only means there’s a chance of loss. What’s interesting is to calibrate these risks. So, rather than avoiding risk completely, investors can learn to manage it.

Types of Risks

All investments can carry some risk. As an investor, you should be aware of several common types of investment risks and what they mean:

1. Market Risk: Also called systematic risk, this is the risk of your investments losing value due to broad economic or market factors. If the stock market (equities/debt schemes) crashes or the economy faces a downturn, most investments can be affected. For example, during the COVID-19 outbreak, the BSE Sensex plunged 13.15% to 25,981.24, and the NSE Nifty declined 12.98% to 7,610.25 points, the lowest since 2016, on March 23, 2020, according to news reports, showcasing significant fluctuations in the Indian stock market.

2. Inflation Risk: This type of risk occurs when investment returns fail to keep pace with rising prices, resulting in diminished purchasing power. For example, if your investment earns 6% annually but inflation stands at 7%, your real return is negative 1%.

3. Interest Rate Risk: Interest rate risk: This refers to the potential loss in investment value due to changes in interest rates, primarily affecting fixed-income securities like bonds. When interest rates rise, the market value of existing bonds typically falls because new bonds will be issued with higher yields, making the older, lower-yielding bonds less attractive.

4. Liquidity Risk: This occurs when an individual, company, or financial institution is not able to meet its short-term financial obligations when they become due. The risk may sometimes come with some substantial loss. Certain investments, such as ELSS or some fixed deposits, may have lock-in periods that restrict immediate access to funds.

5. Credit Risk:  This occurs when there is a potential for financial loss due to a borrower’s failure to repay a loan or meet contractual obligations. This risk can affect certain types of financial instruments, including securities, bonds, loans, and derivatives. Even structured products like collateralised debt obligations (CDOs) and credit derivatives like credit default swaps (CDS) are influenced by changes in underlying credit risk.

6. Concentration Risk: Putting all investments in a single asset class, sector, or geography creates concentration risk. Diversification across different investment types helps mitigate this exposure.

Types of Returns

Just as there are different kinds of risk, there are various types of returns you can earn from investments. Here are a few:

1. Capital Appreciation: This is the profit you earn when an asset increases in value over time. If you buy something at a lower price and later sell it at a higher price, the difference is your capital gain. This applies to stocks, real estate, gold, or any asset that can appreciate.

Any profit or gain that arises from the sale of such a ‘capital asset’ is known as ‘income from capital gains’. Such capital gains are taxable in the year the transfer of the capital asset takes place. 

2. Income Returns: Regular income from investments includes dividends from stocks, interest from bonds, rental income from real estate, to name a few.  These may provide steady cash flows to investors.

3. Total Returns: Total returns combine both capital appreciation and income, providing a comprehensive measure of investment performance.

Understanding the types of returns helps you anticipate how you’ll earn money from an investment. For example, a long-term portfolio typically combines growth (capital gains) as well as income (interest/dividends) to build wealth over time.

Benefits of Managing Risk and Return

Once you understand risk and return, you can align your investments with your financial goals. Here are some key benefits of managing risk-return balance:

1. Optimised Investment Decisions

By understanding and managing the trade-off between risk and return, investors can make more informed decisions that resonate with their financial goals and risk tolerance. This, in turn, can help in selecting investment options that offer the best possible returns for an acceptable level of risk.

2. Role of Diversification

Holding a single asset type can make your portfolio more volatile, as your entire investment is exposed to the risks of just one market. A basket of stocks and ETFs (spanning assets like bonds, commodities such as gold or silver, or debt), on the other hand, tends to reduce dependence on any single asset’s performance and opens up more diverse investment opportunities.

3. Stability Over Time

Maintaining a balance between risk and return can potentially lead to steady investment behaviour over the long term. This can allow investors to navigate market cycles without abrupt strategy changes, potentially benefiting from recovery phases and long-term growth trends.

4. Awareness of Market Uncertainty

Familiarity with risk concepts tends to make investors more conscious of market unpredictability. This awareness may lead to the adoption of common risk-mitigation practices like maintaining liquidity buffers or regularly reviewing portfolio allocations.

The Power of Long-term Investing

What might a balanced long-term portfolio look like? The exact mix will depend on an individual’s risk tolerance and goals, but the key idea is to include a variety of asset types so that safer ones offset high-risk investments. This diversification can help balance risk and return over time.

For example, a sample balanced portfolio for long-term growth could be:

Disclaimer: This information is for general educational purposes only and not financial advice. Please consult your financial advisor before making any investment decisions, as investing involves risks.

In other words, by not “putting all your eggs in one basket,” one captures growth from multiple sources and reduces the impact if any one asset class underperforms. Additionally, through systematic investment plans (SIPs), investors can average their purchase costs via Rupee Cost Averaging (RCA). In RCA, you invest a fixed amount at regular periods, that is, buying more units when prices are low and fewer when prices are high, which brings down the average cost over time.

Please note that this is a general example of a generic risk-return portfolio. A balanced long-term portfolio typically reflects an individual’s risk tolerance and financial goals. 

To Wrap Up

Understanding risk and return can help investors navigate market fluctuations with greater clarity and confidence. While risk cannot be eliminated entirely, it can be managed through diversification, appropriate asset allocation, and long-term investing strategies.

Indian investors have access to a wide range of investment options across the risk spectrum, allowing them to build portfolios based on their goals and risk tolerance.

In a nutshell, the key to creating wealth* via investments lies in starting early, investing regularly, and maintaining a long-term perspective.

*Past performance is not indicative of future results. Before making any investment decisions, investors should conduct their own research and seek advice from qualified financial advisors to ensure that the respective funds, products and strategies are suitable for their specific financial situation and objectives.

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