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