What is the relationship between risk and return?

Risk:

Risk means uncertainty about the outcome. In investments, risk is generally used to mean the probability of not meeting the expected returns in an investment. This could mean three possibilities:

  • The investment returns lesser profits than expected.
  • The investment does not give any return.
  • The principal invested is also lost either partly of fully.

For example, you may have invested Rs 10,000 in a stock which has the probability to give you a 30% return and it may so happen that the price of that stock unfortunately plummets to Rs 7500. It has given you a negative return (or loss) of Rs 2,500. That’s partial loss of principal invested. Such a scenario generally happens only in case of equities and equity based investments like mutual funds, futures and options etc. however, other categories of investments like gold and real estate are also subject to value risk.

In stock markets, risk is the degree of price volatility expected in a share. For example, if we have invested in a share that has a price volatility of 10% it means that, the price of that share could go up or down 10%. To attempt to get that 10% profit, you also take the risk of losing 10%. So, as the risk level increases, the expected return is high, the probable loss is also high. These two go hand in hand.

Risk is present for any financial product. Hence, Fixed deposits, equity mutual funds, ULIPs, ETFs, index funds, derivatives – all carry the risk of not hitting the expected target of beating inflation rates and generating real returns.

Depending upon the type of Investment, risk comes from many sources. For example, variation in inflation rates primarily affects returns from fixed income investments and commodity prices are primarily affected by variations in its demand and supply. In the case of stock market investments – business entities function in an environment that’s dependent on various factors – within the business, within the sector and the economy as a whole. Any change in these variables impacts the business negatively or positively depending upon the direction of change. When the change is negative, it affects the profitability of the business and its future prospects. As a result, the stocks respond with a fall in prices.

Types of risk

Business risk – for example, IT sector may face problems if the American government decides to curb outsourcing of jobs to India. Such changes in the environment in which the business functions may affect adversely and hence stock prices may fall. Apart from that, business men may face risks in the form of irregular supply or shortage of raw materials, break down of machinery, labour problems, change in taste of its customers, new technological advancements and introduction of innovative products by competitors.  There’s a lot of sources from where a business may face risks, that would ultimately affect its performance and hence, it’s stock prices. One part of business risk is financial risk which is the risk of businesses relying too much on loan funds. Businesses that thrive on huge loans would find it difficult to expand and lower its production costs, as a chuck of its profits would go into paying off interest on loans. Connected with financial risk is the interest rate risk – ie, the probability that the general interest rates would go up. Such a situation would further bring down the profits of a company since, now the company has to pay more interest on loans than expected. Generally, there is an inverse relationship between interest rates and stock markets. One final risk within the business risk is management risk – which is nothing but the risk associated with the key persons of the company under-performing.

Market risks– risks that are external to the business like political instability, war and earth quakes, inflation, depression etc. Such scenarios may create environments that are not favorable for the stock markets to function smoothly.  Another external risk to the business is legislative risk or regulatory risk which is the possibility that the government wouldintroduce new laws which may have far reaching impact on the business of the company. Laws that may impose strict regulations or controls on certain type of industries may be introduced by the government. For example price control by the government may reduce the profits of certain industries or a manufacturing company can be adversely affected by the stricter norms of the government against pollution.

Risks can also arise to a business from fierce competition from peers and new entrants. Such competition may be stronger or weaker than expected. For example, recently we saw the telecom company’s tariff war which was very intense. Such risks are called competitive risk.Certain risks may affect an entire sector leaving the other sectors untouched. For example – a significant change where outsourced jobs flow to other countries may affect IT service providers in India. Such risks are called sectoral risks.

Due to all this, if the investor finds it hard to sell his investments since there are no takers for it, another risk opens up called – liquidity risk. It’s the risk that an investor may not be able to sell his stock at the right price and instead he may have to offer it suffering a huge loss. The liquidity position of stocks can change with time – for example a stock that’s been traded in high volumes today may find no buyers two years down the lane.

Apart from all this, from the investor’s point of view, there is one more risk called Market timing risk which is the possibility that you may enter the market at the wrong time or you may sell off your investments at the wrong time.

In short..

Risk is always present in any form of investing – that’s because, nothing is sure in investing. We cannot spot a share and say that it will surely give a return of, say, 40%. We can only talk about its potential to give 40% return considering the future prospects, present and past financial performance etc. You have to take the risk.

How much risk can you withstand?

Now, the basic question is, whatever be the asset you choose to invest in, how much risk can you withstand? That is, in case the asset you invested falls in price, how far can you hold on? This ability to withstand losses varies for different persons. It depends on your age, number of dependants, living costs, and alternative sources of income you have. Risk tolerance capacity is something you have to analyze yourself before you start investing, especially in the case of investing in shares.

Return:

Now we know how risky it is to start and run a business. For investing funds in businesses that functions in such a risky environment, investors would naturally expect greater returns as compensation. If an investment carries a lower rate of risk, investors may be satisfied with a lower rate of return. That’s the reason why people expect more return from stock markets when compared to fixed deposits and bonds.

Higher your risk tolerance, higher is your ability to invest in risky assets. The following table shows the risk return trade off- or the maximum possible risk you are able to take and hence, the maximum type of investments you can participate in.

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