Concept of Risk and Return in Investment
Image Credits © Kees van Duyn.
The risks associated with investment are:-
- Inflation risk : Due to inflation, the purchasing power of money gets reduced.
- Interest rate risk : Due to an economic situation prevailing in the country, the interest rate may change.
- Default risk : The risk of not getting investment back. That is, the principal amount invested and / or interest.
- Business risk : The risk of depression and other uncertainties of business.
- Socio-political risk : The risk of changes in government, government policies, social attitudes, etc.
The returns on investment usually come in the following forms:-
- The safety of the principal amount invested.
- Regular and timely payment of interest or dividend.
- Liquidity of investment. This facilitates premature encashment, loan facilities, marketability of investment, etc.
- Chances of capital appreciation, where the market price of the investment is higher, due to issue of bonus shares, right issue at a lower premium, etc.
- Problem-free transactions like easy buying and selling of the investment, encashment of interest or dividend warrants, etc.
The simple rule of investment management is that:-
- The higher the risk, the greater will be the returns.
- Similarly, lesser the risk, the lower will be the returns.
This rule of investment management is depicted in the following diagram:-
The above diagram showing risk and return indicates that:-
- Low risk instruments such as small savings, and bank deposits bring low returns.
- Medium risk instruments such as company deposits and non-convertible debentures will earn medium returns.
- High-risk securities like equity shares, and convertible debentures will earn higher returns.