Risk And Return On Investment
The exact return you get from investments can be calculated with the ROI (Return On Investment), a performance measure you may have already heard of before. The ROI is expressed as a percentage and is used to compare investments efficiency.
The return on investment may not follow the investor’s expectations because assets are subject to a wide range of risks. These can generally be divided into the following two macro-categories:
- Unsystematic risk refers to risks that depend on the issuer or group of issuers representing a market sector. For example, if you invest in a Google stock, the risk depends on the company. The combination of assets issued by different entities can amortise this type of risk.
- Systematic risk affects the market as a whole, together with other asset classes. You can’t avoid it, as it is intrinsic to investments.
Risk is defined in financial terms as the possibility that the actual result or yield of an investment will differ from the expected result. Therefore the possibility of losing part or all of the invested capital is real.
The Risk-Return Pyramid
Each asset class has a different risk-return ratio. As it has clearly appeared, there is a direct proportionality between them- as one increases, the second increases as well. This happens because the investor gets a “reward” for taking a higher risk (technically called “Risk Premium“).
You can sort asset classes according to their risk-return ratio and place them in a pyramid. At the base, we find the safest, low risk-return investments, such as bonds. Going up, we find more aggressive, riskier investments with higher return potential. At the top, we can find commodities and derivatives.
Depending on your objectives, you will choose certain instruments, but it is always good to diversify. In this way, if one investment does not go as planned, the others will absorb any losses.
Let’s recap all the instruments at your disposal, their risk and return rates, as well as advantages and disadvantages.
Once the risks have been assessed, it is necessary to consider exploiting them to your own advantage.
The next step is to learn what a wealth cycle is, and how to calculate the amount of capital you should invest, moving from theory to practice.