More Risk, More Return: Is it true in Stock Market?

The essence of successful investing lies in the way an individual manages the risk. Gambling is just a synonym for speculation and when use guessing as pillar of your investment strategy you are bound to lose, incessantly. Making an informed choice based on the measurement of an investment option’s systematic and unsystematic risk is cardinal while investing in stock markets. But before we jump into the discussion of the correlation between risk and return, I feel that understanding the concept of risk in financial terms is fundamental and a topic of paramount importance.

What is risk?

Risk in financial terms is the difference between the investment’s actual return and the expected return by an investor. Risk portrays the probability and the magnitude of loss which comes hand in hand with the chosen investment product and the investment horizon of an investment. In the world of finance, risk is calculated by using standard deviation as a metric which measures the volatility or fluctuation in the price of an asset when it is compared to its historical averages in the given time frame for assessment.

Types of Risk?

There are certain situations in this world which you cannot avoid but there are other situations in which the risk associated with them can be mitigated by excersing the prescribed methodologies and measures. Here is the graphical representation of the two major types of investment risks along with their sub divisions.

Well, well, well!!!!! we will not be getting into the detailed explanation of each and every type of risk for the reason that it would derail us from the agenda of this article but we will definitely discuss the blanket types of risk which is systematic and unsystematic risk.

What is systematic risk?

Systematic risk refers to the undiversifiable/ market risk which has the potential to disrupt the entire global markets. It is a highly unpredictable and unavoidable kind of risk to a humongous extent. Systematic risk includes interest rate changes, inflation, recessions, and wars, among other major economic, geo-political and financial shifts in the world like ‘The Great Recession, 2008’.

What is unsystematic risk?

Unsystematic risk refers to a diversifiable type of investment risk which can be minimized and hopefully mitigated by proper asset selection and allocation in accordance with the prevailing sentiments in the target market. Unsystematic risk includes risks such as entry of a new market participant in a specific industry, launch of a substitute at a marginal shifting cost by a competitor or recall of a sold product from a customer due to safety or other major concerns and then providing them with compensation as done by Samsung after the launch of its smartphone labelled as “Galaxy S7” in 2016.

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What are the financial ratios that can used to measure the risk-return trade-offs?

As you already discussed, standard deviation is used to calculate magnitude of risk associated with an investment product but it has some shortcomings like it only shows how annual returns of an investment is spread out which does not validates the consistency in performance in the future. We have two other ratios which can help you understand the risk associated with the investment option that you have chosen.

Sortino – It is a financial ratio which gives a realistic idea of the downside or the negative deviation associated with a company’s stock. It helps you to measure the amount of return that you will be able to generate on a per unit basis for the given magnitude of downside risk which can also be referred as a chance of avoiding large losses. A higher sortino ratio is always desirable.
Sharpe – It is a financial ratio which considers both upside and downside volatility and then arrives at a conclusion of a stock’s performance. Sharpe ratios is a statistical tool which predicts risk adjusted return on an investment. Higher sharpe ratio translates into higher return potential along with higher risk.
Mid-cap stocks have performed ravishingly throughout these years with a considerable amount of risk associated with them. There are various conclusions that can be drawn out from these graphs and tabular data but the one of utmost importance is that high risk gives no guarantee or validation of high returns. Look at standard deviation of small cap stocks, they are the highest in the pack but the return from US Mid-cap stocks and US large-cap stocks is the highest when risk is taken into the consideration.

Why aren’t the gamblers the richest?

There is a vanilla answer to this, ‘THEY ARE JUST SPECULATING’. Gamblers are the hardcore speculators. If you are into stock markets and you are making decisions based on mere assumptions, grapevines, pseudo talks and emotions then there is no power in this world which has the potential to protect from heavy, big, gigantic losses in the future.

Conclusion

Stock market is a blend of speculative risk (risk of potential gain or loss) and pure risk (the possibility of loss or no loss only). To magnify your returns, you need have a blend of risk averse and risk prone investment products in your portfolio. There is no such financial instrument which falls under the category of absolutely risk-free-investment in the world of stocks, even the treasury securities which are government backed carries a low magnitude risk of default.

As an add on from our side, here is the thorough segregation of financial instruments based on the level of risk associated with them.

Having a balanced portfolio is all you need for generating a decent amount of return with minimal risk. Risk profiling is another vital part of risk management and is a cardinal step in maximising returns for a portfolio. An individual needs to select his/her goals and the time in which they want to achieve them. Based on that we can select the asset class which has the potential to exude desired returns while keeping our risk appetite into consideration. For example, a young person can have aggressively invest in stocks and can even have a major part of their portfolio invested in financial instruments which portray the high risk-reward trade-off but a person who is about to retire must not construct their portfolio with small-cap or mid-cap stocks or with any other financial instrument which requires a long time horizon to appreciate in value and carries a risk of wiping out your investment corpus. Taking informed decisions which can further be translated into taking calculated risk is the heart of any investment strategy. Risk forms a negative correlation with return when you make an investment based on your emotions and not the basis of facts and figures which is available to you.

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