Investing, generally, comes with risks. Returns and risks, both are in correlation to an investment. Correlations are used in advanced portfolio management by financial planners. Let us discuss each of these two.
In the stock market, a return is an amount of money earned or lost on an investment over a specified period. Simply a positive return represents a profit and if negative, it is a loss.
- A return represents a percentage obtained from the ratio of profit/loss to investment.
- When a return for the holding period of investment is expressed as a percentage, it is the rate of return (RoR) such as annual return, monthly return etc.
- The shorter or longer period returns are converted to annual returns. Annual returns accounts to compare different investments.
- The real return is used to determine the effects of external factors such as inflation.
Nominal Return vs. Real Return
Nominal return expressed in nominal terms is the return on investments without taking inflation, taxes, and expenses like investment fees into account. It represents the change in the investment worth over a specified period. On the other hand, the real return on investment represents the final amount after deducting outlays paid by an investor on an investment such as inflation, taxes, and fees. Thus, the real return is the return in real terms.
Importance of real rate of return
An investor must determine the real rate of return on investment to evaluate its future worth before making an investing decision. Because inflation can affect adversely and reduce the investment worth as time goes on. Taxation terms will also affect the returns in the long run. You can open demat account online to invest in the stock market.
Investors should give attention to the risk associated with an investment. Before investing they should determine their risk tolerance and risk associated with an investment. They should consider whether the risk associated with an investment is reasonable to tolerate for the given real rate of return. During a high inflation period, get a clear picture of investment. Risk of inflation is also involved in intraday trading.
Following are the types of risk associated with investments:
1. Market Risk
The risk of declining investment value because of economic factors that affect the entire market. Currency risk and interest rate risk are also market risks.
2. Credit risk
This risk involves debt investments. To estimate the credit risk associated with an investment, look at the credit rating of an investment. An investment with the credit rating of AAA is safe to invest.
3. Liquidity risk
If you are facing any issue to sell an investment at a reasonable price due to the unavailability of buyers, there is liquidity risk. You may have to sell it at a lower amount than its cost due to illiquidity.
4. Inflation risk
Inflation can erode returns on investment over time. If your investments do not keep up with inflation, it is inflation risk. You will find inflation risk with debt investments like bonds.
5. Horizon risk
The risk is associated with investor’s needs due to which the investment horizon may be shortened. It may arise due to an unforeseen event or emergency such as loss of a job that may force an investor to sell investments that were expected to hold for a long term.
The risk involved in investing can be managed with thoughtful investment selections. What’s your financial objective, what’s your risk profile and to what extent an investment can meet your objective will decide the success of your investment portfolio. However, one cannot have control over all risks. Then, there is the need to adjust portfolios to ride out the storm.