Risk Return

The simple truth in investment is that there is no such thing as a low-risk high-return opportunity. It is a myth and we must be careful when someone comes up with a scheme which offers high returns with no risk. The golden rule is that returns in general are proportional to risk, if the market is efficient. If you invest in a risk-free instrument, such as Government bonds, your return will be around the rate of inflation. The return you get is really just the time value of money.

By opting for high quality AAA rated corporate bond, your returns are higher; but you are taking on the additional risk, albeit minimal, of default by the issuer. And if you choose lower rating bonds such as AA or A rated ones, the returns tend to increase, along with the risks. The key really is to understand the risks, know what is suitable for you as an investor and find the investment that gives the best return for your specific risk appetite.

In the case of equity investments, investors demand higher return than what they expect from debt instruments, as the risks are perceived to be higher. For instance, the price of a stock may be volatile due to local political factors, market fluctuations, global perturbations as well as sector and company specific issues. A successful investor weighs the risks and chooses to enter into a trade only if the estimated returns are acceptable.

This is not to say that the market is very rational at all times. Mis-pricing happens all the time as investors become risk averse – they demand high returns even for a small risk. As a return prices are beaten down. Anyone who picks up the bargain when the mood is negative can earn good returns when the mood turns optimistic. Equity analysts and experts who can identify which risks are real and priced in, which are not real but priced in, can help identify such opportunities.

The same logic applies to investments in real assets such as property. When you buy a completed home, there may be limited risks, as property prices do not tend to fall substantially in the Indian markets. One can earn a rental yield of 2-3 per cent annually. Add capital gains of 4-5 per cent every year, the investor can hope to earn returns inline with inflation.

By investing in an under-construction home, you take on additional risk – of delays, quality and other changes that may happen during the duration of the project. Hence you would expect higher returns. The risks in the investment can be assessed and mitigated by evaluating developers on various parameters such as delivery and quality track record.

Likewise, investing in the pre-launch stage and exiting when the developer launches the project to the wider market can deliver higher returns. The risks may also be high – plan approvals may not be received and the market may not perceive the project as interesting. These risks are in addition to location specific supply-demand dynamic changes, but all of these can be evaluated and priced. In fact, many high net-worth investors (HNIs) evaluate the developer and the project and profit from taking calculated bets.

So, investors have to assess each investment choice with the yard stick of risk and return. You must build your overall investment portfolio with debt, equity and alternate investments, to maximise risk-adjusted returns for a given level of risk. The asset allocation must be adjusted periodically as the market shifts. This is the best way to build long-term wealth.

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