Understanding risks and returns in financial markets

Do you know what is your Risks and Returns in Financial Markets

Risks and Returns

Risks and Returns are the two of the most fundamental concept in the financial domain. All investment decisions are made around these two figures and the relationship between them. Thus a good understanding of the risks and returns of any financial product is of utmost importance before we invest in it.

Investment return: Return is the extra money an individual earns for investing his money in a given financial product. Return is generally specified as an annual rate.

Investment risk: Risk is defined as the changeability of profits and the shot that your venture will return short of what you expect or your speculation makes a misfortune abandoning you with less capital than when you started.

Let’s consider a simple case of fixed deposit. If I deposit 10000 rupees today for 1 year and the interest rate that the bank offers is 10% annually. So at the end of 1 year, I get back Rs 11000. So my Rs 10,000 earns me Rs 1000 in a years time. I get this amount irrespective of the market and economic condition. On top of that, all bank deposits up to a sum of Rs 100,000 is guaranteed by the govt of India. So even in the worst case that the bank in which I deposited my money closes down, I can be assured that I will be able to get my money back. So in a way my returns are fixed in all conditions. So, in this case, the risk involved in very less

However, if I lend the same amount, to say my neighbor who wants to starts his business with the promise that he will pay an interest of 20% annually. If after one year the business runs well and my neighbor makes good money then he happily pays out my money along with the promised 20%. But if he does not do well he might negotiate for a lesser rate says 10% or in the worst case he may run into a big loss and may not have even enough to even pay me back the initial capital I had lent him, let alone the interest income. In this case, I might end up with a low return, zero return, negative return or even entirely lose my capital. Thus there are a number of possible returns for this investment depending on different scenarios. This variation of returns is called the risk.

In the former case, the return of my investment is almost fixed at the time of investing however in the second case it is not so. Thus the second investment is a lot riskier than the first one.

Note: While greater return implies greater inherent risk, a greater risk may not always imply a greater return. In many cases, it is possible to find a product with similar returns but with much lesser risk. Some products are riskier because of faulty structures or are suitable only for highly specific purposes and are best avoided.

For successful investing we need understand our own risk profile and based on it we have to find investments with risks and returns characteristics that best suit our profile.

Different investors will have to allocate their portfolios in different ways, depending on their investment goals and ‘risk profile’. An investor who is aiming for capital growth over the long term, and who has the capacity to tolerate greater volatility and fluctuations in the value of their investments, may choose to include higher risk/higher return investments than an investor who relies on their investments for a regular income.

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