Definitions
Definitions
Risk
The potential of losing some or all of the original investment. It's measured by the extent to which the investment's actual returns differ from expected returns.
Return
The gain or loss on an investment over a specified period, expressed as a percentage of the original investment amount.
Volatility
The degree of variation in the price of a financial instrument over time, typically measured by the standard deviation of returns.
Types of Risk
Market Risk
Market risk, also known as systematic risk, is the risk that the value of an investment will decrease due to factors that affect the entire market. These factors can include economic changes, political events, or natural disasters.
Credit Risk
Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Credit risk applies to both individuals and enterprises.
Liquidity Risk
Liquidity risk is the risk that an entity may be unable to meet short-term financial demands. It reflects the nature of an investment that cannot be sold quickly enough to prevent or minimize a loss.
Return on Investment
Measuring Returns
Returns on investment are typically measured as either absolute returns or periodic returns. Absolute returns are the total percentage increase or decrease of the investment over the investment period. Periodic returns are calculated for specific standard periods, such as monthly or annually.
Risk-Return Tradeoff
The risk-return tradeoff is the balance between the desire for the lowest possible risk and the highest possible return. Higher potential returns on investment usually correlate with higher risk.
Diversification
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. The logic behind this technique is that a diversified portfolio will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Practical Considerations
Investment Goals
Investment goals guide the investor's decisions regarding asset selection. Goals can vary significantly, from saving for retirement to generating sufficient income streams for living expenses.
Time Horizon
An investor's time horizon is crucial because it affects the mix of assets that are appropriate. A longer time horizon allows an investor to weather short-term market fluctuations and engage in strategies that may yield higher returns over the long term.
Risk Tolerance
Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their investment portfolio. It is influenced by various personal factors such as financial situation, investment goals, and psychological comfort with risk.
To remember :
In investing, understanding the balance between risk and return is crucial for making informed decisions. Risk represents potential losses, which can arise from various sources like market, credit, and liquidity risks. Successful investors know to assess these risks and optimize their portfolio by leveraging diversification to minimize risk and maximize returns. Key practical considerations include setting clear investment goals, understanding one's risk tolerance, and taking into account the time horizon for investments. The risk-return tradeoff underscores a fundamental principle in investing: generally, the more risk an investor is willing to accept, the greater the potential return, but also the potential for loss.
