By now you would be aware of the need to invest and also the different avenues of investing. Well done! You are progressing well. While going through the blogs you must have come across two terms- Risk & Return. I am sure most of us have heard these terms. Let’s take a look at what actually they mean.
Risk is involved in every aspect of life. It is basically the possibility of something going wrong or contrary to our expectations. How many times have you crossed the road running or driven rashly to reach work on time? When we do this, we run the risk of meeting with an accident Well one risk I always live with is uttering something foolish in front of my boss (more on that some other day!!).But what is the risk that we undertake when we invest our hard earned money? Here, risk implies the chance or probability of the actual returns on our investment being different from our expected return. We tend to associate risk with loss. But, if you consider the definition of risk, it also includes the probability of returns being higher than our expectations. We wouldn’t mind this though, would we? Thus, concluding it is quite easy to understand that more the chance of the actual earnings being lower than our expectations, higher is the risk!
Believe it or not when you invest your money, you are exposed to different types of risk. Let’s have a look at a few of these
Capital Risk: As an investor you are exposed to various forms of risk. Now, as a beginner, what is the first fear that you have when you invest your money? I am sure it’s Loss, a complete or partial loss of the value of your investment. Thus capital risk is the risk that you might end up losing all or part of the money that you invested.
Liquidity Risk: Have you ever tried selling a house? Even if you haven’t, I am sure you are aware of the time and energy involved in doing it. It can take anywhere from week, months to even a year. Thus the second type of risk you face is Liquidity Risk. It is the risk that you might not be able to convert your investment into cash, quick enough. With real estate it can take you a long time, but to convert your Infosys stock into cash, it might just take you seconds!!!
Firm Specific risks: Be it through direct investment in stocks or through Mutual funds and ULIPS, quite a few of us invest in stocks. Thus, we get exposed to what are called Firm Specific risks. This can include competition , certain projects not working out (a new product launched which is not accepted by the market), entire sector being affected due to government regulation (the current scenario in the Telecom sector).
Market risk: This is the risk which affects not only a particular sector but the whole economy. For example Change in interest rates, a slowdown in the economy, affect many, if not all, investment options. Some other risks like foreign exchange fluctuations, commodity prices may affect a certain class of investment options but in varying degrees.
This was all about risks. Now let’s talk about returns. Return is the money that you expect to make out of your investment. In the earlier blog you would have seen that there is different level of risk and return associated with savings deposit, fixed deposit, real estate, stocks etc. Certainly, you would expect to earn higher returns if you are taking on higher risk. The chart given below explains the relationship between risk and return.
Thus, where you invest your money depends on your risk-taking capacity as well as your return expectations. You may tend to think that stocks are high risk investment options and may shy away from it. But there is a way that you can lower the risk involved in stock investing without lowering your returns. But before you learn this way, it is important to understand your investment profile which we will do in the next blog.
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