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Risk and Return

Risk & return are the basic concepts to understand in order to invest effectively.

Risk defined
For most of us the word "risk" means "losing money" but in the investing world, risk is defined as the rate of fluctuation of an investment's price--ie. the more the price of an investment fluctuates over a given time frame, the higher its volatility and the higher its risk. So if we may need to sell that investment in the next 3 months (the short term), we should probably not invest in a stock fund which has a relatively high rate of volatility over that time period but invest instead in a CD or a money market fund which have relatively lower volatility. We "lose" money only when we sell an investment and "realize" the loss. Until then, it is only a paper loss, not a real loss.

There are basically three types of risk:

  • Business risk: The risk associated with that particular investment. eg. a gold mining company stock will have risks because of the country it is in, the labor pool that will bring up the gold, its management expertise and so on.
  • Market risk: The risk associated with the overall markets and the economic environment as a whole. For example, the precious metals sector being out of favor when we want to sell.
  • Inflation risk: Even if our investment goes up in value over time, if it does not keep up with the cost of living (inflation), we are actually losing purchasing power and wealth because the same dollar we invested will now buy us less. Which brings us to investment returns.

Return defined
Most investments go up in value and price over time so typically, the farther away the date at which we will need the money, the higher the chances we will get more than we paid for it. In other words, the longer our timeframe, the lower our risk and the shorter our timeframe, the higher our risk.

There are basically two types of investment rates of return:

  • Nominal rate of return: The return that is based on the nominal rate and calculated without considering the effect of the inflation index.
  • Real return: The return that is calculated by factoring in the rate of inflation and the nominal rate. So if our investment in a CD returns 3% and the rate of inflation is 2%, our real rate of return is 1%.

The object of investment strategies is to maximize our real rate of return subject to the amount of risk we are able or willing to take over a given time period. An understanding of the real nature of risk and return makes our job much easier and contributes greatly to our mutual fund investing success.

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