When it comes to investing, risk and return are two sides of the same coin. To earn higher returns, you need to assume higher risk. By investing in safe liquid funds, you can earn just about 4-5% net of tax and hardly create wealth. However, higher risk does not --automatically guarantee higher returns. That means; risk has to be calibrated. Let us look at different types of risks and returns.
Different Ways to Measure Returns
Returns are what you earn on your investment. However, there are different ways to measure returns. Return on investment is important because any investment decision has an opportunity cost. Hence returns must be sufficient to compensate for the risk taken and the opportunity foregone. Here are some approaches to returns.
Point to Point returns
This is the simplest form of return. You just consider the starting point and the ending point. For example, if the mutual fund NAV has appreciated from Rs.100 to Rs.140 in 3 years, then the point to point return is 40%. One can just take an arithmetic average and say that the annual returns were 13.33%. This measure is also popularly known as holding period returns (HPR). However, the major shortcoming of this measure is that it does not consider the effect of compounding, which is pivotal to wealth creation.
Compounded annual growth rate (CAGR) returns
This is a more scientific way of calculating returns as it also considers the compounding effect. For example, Rs.100 does not just become Rs.140 in 3 years. Each year when you earn returns, that returns get reinvested and adds to your principal amount invested. In the above instance, if Rs.100 has grown to Rs.140 in 3 years then the CAGR returns will be lower than 13.33%, if you consider the compounding effect. You can use a basic spreadsheet to calculate that the CAGR returns will actually be 11.87%. In other words you can check that (100*1.1187*1.1187*1.1187) will be equal to Rs.140. CAGR is more scientific as it considers the compounding effect.
Risk adjusted returns
Here, you can compare the performance of two funds or portfolio managers. Two funds with CAGR returns of 13% may not be the same if one fund has earned this return with much higher risk. A risk adjusted measure like the Sharpe or Treynor ratio can be more effective for such comparisons as they are risk-adjusted.
At the end of the day, the returns you actually take home are post tax. If you earn 8% on an FD and pay 30% tax, then your post tax returns are just 5.6%. A 6% tax free return bond would be much better placed in that case. Since some bonds have tax exemptions and tax breaks, the post tax returns can be useful for a better comparison.
Understanding the Types of Risk Involved
We use risk in a very generic sense. But risk is a lot more nuanced. There is nothing like a risk-free investment and every investment carries some form of risk. Understanding these risks helps to better manage risks from a practical standpoint. Here are some key risks that investing entails.
- Default risk: is the risk that the issuer of the bond could default on payments of interest or principal. There have been several instances of such defaults as in the case of IL&FS, Cox & Kings, RCOM, DHFL etc. Since there is no commitment of payment on equity, there is no question of default risk in equities.
- Inflation risk: is the risk that your returns get eaten away by inflation. This applies to equity and debt. If you earn 7% returns on your investment and if the inflation is at 5%, then in real terms you are just earning 2% returns. Normally, inflation risk is associated with higher inflation levels.
- Interest rate risk: is one of the most important risks in debt investing. When the interest rates go up, bond yields go up. So old bonds paying lower interest rates, see a fall in price to compensate for lower than market yields. This adjustment works both ways. Bond prices fall when rates rise and bond prices rise when rates fall. Higher interest rates increase the cost of capital and so negatively impact equity value also.
- Reinvestment risk: is again common to equity and debt. When intermediate flows like interest and dividends are not reinvested at the yield, then your overall yield comes down. For example, if you opt for a dividend plan of a mutual fund, then there is reinvestment risk but there is no reinvestment risk in a growth plan.
- Business risk: This is called unsystematic risk and is a big factor for equities. While it does impact debt also, business risk has an adverse impact on equity valuations. Normally, equity valuations fall when risk rises and vice versa. Business risk is normally unique to a company or to an industry and can be diversified away by portfolio managers.
- Macro risks: refer to risks that pertain to the shifts in macro level politics or macro level economics. Things like elections, exchange rate crisis, global sell-off, shift to risk-off or risk-on impact most asset classes in a similar way. Such risks are also referred to as systematic risks or market risks. This is normally measured by Beta
- Call risk: is a unique kind of risk that exists in bonds with a callable option. When the interest rates are high, bond issuers tend to include a call option so that they can redeem and call back the bonds if the rates go down sharply. This can negatively impact investors who are looking to lock in long term returns.
Understanding the relationship between risk and return is central to investing. After all, every investment is ultimately a risk-reward trade-off.