Risk and Return Analysis

In the previous chapter, we understood the costs of investing in mutual funds, such as the expense ratio and other fees. As we continue our investment journey, it's crucial to grasp the fundamental relationship between risk and return. Whenever we invest, these two factors are inextricably linked.

Higher potential returns usually come with higher risks, but it's essential to understand the different types of risks and how they affect our investment choices.

This chapter will examine how risk and return influence each other and how we can use this knowledge to make informed investment decisions.

There are many forms of risk. The most common type is market risk. This is the risk that the market as a whole could go down and take all investments with it. Another type of individual risk is the risk that a specific asset, like a company's stock, could lose value. You might also hear about liquidity risk. It's the risk that you won't be able to sell your investment when you need to, or you may have to sell it for less than it's worth.

Return is the amount of money you make on an investment. Returns come in two forms: capital gains, the profit you realise when you sell an investment for more than you paid, and income, such as dividends or interest payments from stocks and bonds. Generally speaking, investors try to maximise return for a given level of risk, but sometimes, it is more complicated.

Understanding risk and return is crucial for making informed investment decisions. If you are a beginner, invest in safer instruments such as bonds or fixed deposits. These have a low return but carry less risk. As you gain comfort, you could add a higher risk with potentially better return—high-risk investments like equity or mutual funds.

It's essential to consider the amount of risk you could afford to take, that is, your risk tolerance. This may be characterised by one's level of tolerability, whereby in terms of the volatile stock market, people either can stand the ups and downs or cannot. Other people like more conservative kinds of investments.

Now, let's see how risk and return are measured. The common way to measure risk is to look at an investment's volatility. Volatility refers to how much the price of an investment fluctuates over time. A highly volatile investment, like stocks, can have extreme swings in price, and with that comes higher risk. Low-volatility investments like bonds do not swing that much, meaning less risk.

Investors generally measure return by looking at the average annual or total return. These figures represent an investment's historical performance but do not guarantee its future performance. Past performance will never be an exact predictor of the future.

The key to balancing risk and return is diversification. By spreading your investments across different types of assets-stocks, bonds, and maybe real estate-you reduce the risk of losing everything if one investment does poorly. Diversification doesn't eliminate risk, but it can help smooth out the ups and downs of the market.

Another essential concept is that of the risk-return tradeoff. If you want higher returns, you must take on more risk. For example, stocks generally offer higher returns than bonds. However, they also involve more risk. If you're investing for the long term, such as for retirement, you may be willing to take on more risk because, through the years, you can recover from downturns in the market. On the other hand, if you need the money much sooner, you might opt for safer investments with lower returns.

Conclusion:

As Ravi and Priya explore the complex relationship between risk and return, they realise that the more risk they take, the greater the potential for returns and losses.

However, understanding risk and return is just one part of the equation. As investors move forward, they will need to consider the tax implications of their investments.

In the next chapter, we will examine how taxes affect mutual fund investments and explore strategies for minimising tax liabilities while maximising returns.