Understanding Risk and Return

Your Risk Appetite

Investments Risky Hai. Yes, that’s true. But it’s not a bad thing. It’s just something that needs to be understood and appreciated for better decision making. 

Let’s repeat that: risk is not a bad thing. 

You cannot get a decent return without any risk 💸, but you can invest according to your risk    appetite. 

What does that mean?🤔

The only guide to understanding your risk appetite is you. How?

By thinking about this fundamental question: 💭

how much can you bear to lose if your investments don’t meet the expected results?

Learning Risk from Dhoni 

Slight detour to cricket! 🏏

We've all been there: a nail biting game where Dhoni keeps you on the edge of your seat in anticipation of his helicopter shot. 🚁

When he attempts a six 6️⃣ and achieves it, there is a cheer from the audience. But, he could also get out. If he played it safe, he may make one or two runs. Dhoni takes a risk by attempting a six - he understands his reward (hitting the six and winning the game), and the downside too (getting out and potentially losing the game).

People’s acceptance of risk is different even to the same life situations. And that’s why there are different types of investments to accommodate different types of people.

Understanding this will help you decide how and what to invest in.

Determining Risk

Typically, the younger you are, the more risk you should be willing to take, since you have time ⏳ and opportunity on your side to brave storms.

But, how much risk you are willing to take is very personal to you.

It could depend on a variety of factors: your financial responsibilities, your expenses and income, and how much ups and downs you are comfortable to deal with.

Risk and Reward

Return, very simply, is the amount you make on your investments. Risk and Reward go hand-in-hand. Higher the risk, higher the reward. 

Think of returns as your profit. If you invested ₹100, and made ₹5 on it, means your return is 5/100, or 5%.

Before we proceed, let’s introduce a new word: “asset”. 

It’s anything that has value, and is expected to provide future 🔮 benefits. A high risk means that the value of an asset could swing to a large extreme on either side of its current value. Investors are willing to invest in a high risk asset with the hope of getting a high return.

What is a great way to reduce risk? Yes, by diversifying!

Diversifying

Diversifying is just a fancy word for spreading out where and how you put your money. You might have heard this before: don’t put all your eggs in one basket. 🥚

If something were to happen to that basket, you risk losing all your eggs. That’s not good. Now, think about correlation between any two “baskets” you’re putting your eggs in.

If they are highly correlated, then spreading out your money across the two doesn’t help.  If one basket breaks, and the other one also breaks, then you’ve lost all your eggs. 

The markets respond to a variety of things that happen in the world.🌏  Government policies, natural disasters and other things. These risks are beyond our control and we need to be mindful of that.

Since these risks are beyond our control, and non-diversifiable - we basically have to just live with them. The risks that can be reduced are addressed by spreading out investments across a variety of things.

Now, let's understand returns

Very simply put, a return is the profit you make on your investment. 

Returns are the reason we invest. Returns are usually calculated on an annual basis. An investment that gives you a return of 8%, means a return of 8% per year.

What’s a good return? Isn’t anything greater than 0 a “good” return, since it means you are making a profit? Well, it’s better than a negative return :) - but it’s not great. Let’s see why.

Inflation and Return

We went over inflation previously - and the number one thing you should look at is if your return is beating inflation - post taxes and fees. Yes, taxes and fees affect your returns (ugh!) - but more on that in upcoming lessons.

Another measure you can look at is the risk you’ve taken on an investment. For instance, if a low risk (let’s call this A) and high risk investment (let’s call this B) give the same return, then the return on B is NOT considered good since you could have gotten that return without taking on the additional risk.

Finally, some investments - like mutual funds - specify something called a “benchmark”. If the investment is performing at or above the benchmark, then it can be considered good.

Fees affect your returns

In an ideal scenario, you invest some money and depending on how much it grows🌱, you get a return on it. However, in reality, there are intermediaries that take a small cut as part of helping you invest your money. These are fees.

Fees eat into your returns. It’s important to understand the amount you will be paying as fees. In a mutual fund (we’ll cover these in detail in upcoming modules), there’s someone who is managing the fund 👩🏽‍💼- and needs to be compensated for that. 

The fees is determined by a TER, or total expense ratio - which is a percentage of the total amount you have invested with the mutual fund. Mutual funds also come with redemption costs, or costs that are charged when you withdraw money. More on this coming up, we promise!

Taxes affect your returns

The returns you make on your investments are considered as capital gains or income, and are taxable. If you earn more than ₹10,000 in interest income from a fixed deposit, the bank 🏦 deducts 10% of that income as TDS, or tax deducted at source.

This is assuming you make more than the minimum exempted income amount. While returns/gains are taxable, there are certain kinds of mutual fund investments that will give you tax benefits.

There’s a fun acronym for those: ELSS, or Equity Linked Savings Schemes. Don’t worry about them for now, we’ll cover them in detail!