Risk & return relationship is important in Investments
When we undertake to learn about any subject, we need to learn the basic terms used, just as we learn different words when we learn a new language. Once we learn and understand them they will become part of our everyday use. You must be already familiar with these terms in your day-to-day life. Still, here we go!
The terms include:
• Principal amount or amount initially invested.
• Date of investment.
• Period of investment.
• Date of encashment of investment.
• Return of investment or interest.
Let us take the example of Mr Swapnil, a medical representative who earns Rs 30,000 per month. He needs about Rs 20,000 for his monthly expenses and is able to save Rs 10,000 per month. He wants his son to be a doctor. He asks his wife to invest the amount in the right scheme so that they will have enough money to help their son pursue his medical studies. Mrs Swapnil knows that after five years it will cost Rs 5 lakhs to earn a medical degree. So she decides to invest Rs 5,000 per month in a five year scheme (we will explain this later) that will help meet the cost of Rs 5 lakhs.
• The amount of money invested is Rs 5,000 into 60 months (five years) or Rs 3 lakhs.
• They need Rs 5 lakhs or more at the end of five years.
• If this happens, their investment has given them their desired return.
Using the calculator you can easily find out the total amount with a 10 per cent return. If that does not materialise she needs to opt for different investment strategies.
In any activity undertaken by us there is an element of risk. For example, when you toss a coin, you are not sure about the exact outcome - it could be head or tail. There are two possible outcomes and the risk is 50 per cent.
In a football match there are three possible outcomes - win, lose or draw. In the same way, in business too the degree of risk varies. However, in investments, the degree of risk is quite high but could be minimised with proper knowledge and assessment.
Consider, for example,
That Mrs Swapnil purchased a share for Rs 200 of an oil company based on the fact that the same share was quoting only Rs 150 a year back, thus giving an approx. annual return of 33 per cent (200-150/150). Her plans were based on the recommendations of Mr Moneybhai who said that the company is doing well. In case of an unexpected event such as an increase in oil prices the company’s performance will be affected and the share price may fall to Rs 150, thereby resulting in a loss of 25 per cent.
There are several types of risks. Investors will never be able to quantify them completely. That’s why all investments carry a risk warning. Risks need not deter the investors - they just make them cautious and help them carefully choose the different investment options and plan their strategies, which we will learn in the later part of this course. Each option may have low, medium or high risk and likewise expected returns too may be low, medium or high. A good investment decision will take these risks into account and try to achieve a balance between the risk of the investment and the returns expected. This is essentially what is called risk management.
The intent of a course like this is to help people like you make informed decisions. This does not mean that the risk is eliminated. It means that the risk will be understood and by careful planning it could be minimised. The rule of any market investment is: ‘No risk, no gain’. Unless you are ready to take the risk you will never gain.